In recent years, the Chinese authorities have undertaken the most aggressive stimulus package in the recent years. The Chinese Central bank would likely need to further cut interest rates, having already cut four times since November last year. Furthermore, China has had an active fiscal policy and credit expansion in the last few years as a way to counter the slowing external demand from the rest of the world. The question is – will these policies be effective?
Loose monetary policy may not work that well in China, and may be doing the opposite of what is supposed to do – that is, to lower the effective cost of capital to firms, and to raise producer price inflation. In the Chinese economy, credit is often directed to large companies and state-owned enterprises – enterprises which are not lacking in financing, and also not particularly sensitive to changes in the interest rate. Small and medium sized companies, however, are severely capital constrained, and face an increasingly higher borrowing cost. The combination of a languid business environment and distorted financial markets means that there is a severe disconnect between credit in the financial system and how it is channelled into the real economy.
Two aspects of the Chinese economy make it somewhat different from others in their responses to monetary policy shocks. The first is related to the Chinese households. In the past few years, inflation expectations have been catching up. In response to expected inflation, rather than raising current consumption, the Chinese households are saving more to protect against expected decline in their purchasing power. They are also concerned about old-age resources, as they have fewer children to provide support with China’s strict fertility policies. Wealth accumulation and the search for high rates of return have thus become a primary goal. With long periods of financial repression, where the real return on deposits have been near zero, Chinese households are shifting their saving out of bank deposit into equity markets and trust funds. With the aid of leverage, the stock market sky-rocketed. But it would be wrong to assume that Chinese households are purely speculative in nature – the limitations to investment opportunities with a heightened awareness that purchasing power may fall due to inflation in the future may also be a primary cause. In addition, concerns about retirement income simply mean that households are not left with much choice.
So the result of an easy monetary environment is not to raise product price inflation but higher and higher equity and property prices. In fact, producer prices have been slipping continuously for more than three years on end. PPI fell by 5.4 percent from a year earlier, compared to an expected 5.0 percent drop. It has been the lowest since October 2009 after a forty-one straight month decline. Falling producer prices eat into corporate profits, which further exerts pressure on Chinese firms. And as capital has flown towards financial markets rather than the goods market, consumer inflation has also remained muted at 1.6 percent. Thus, the assumption that expansionary monetary policy can induce higher consumption by Chinese households reflects an oversight that inflation expectations are catching up in China. It is in this sense that I very much agree with Fudan University Professor Sun Lijian’s analysis.
The second factor relates to the dynamism of Chinese firms. The original aim of the stimulus was to lower the effective cost of capital for private enterprises – small and medium sized companies that need the capital. But in fact, the opposite may be occurring – with the effective cost of capital rising rather than declining. First, the search for yield in the economy, as well as the gradual withdrawal of deposits from the banking system by the Chinese households, has exerted upward pressure on financing costs. Second, large enterprises with sizeable collaterals can obtain bank loans but meet difficulty in finding good investment opportunities, and therefore channel credit through the shadow banking system to lend to small and medium sized firms at high interest rates. And because the firms are facing increasing profitability problems with the sluggish economic environment combined with producer deflation, default risk is on the rise.
The easy monetary environment may mean that much of the credit is bottled inside the financial sector: banks are not eager to lend with the accumulation of bad loans and because companies are perceived to be risky in the current economic environment. In order to preserve shareholder value, they have channelled much of the funds to the equity markets and trust funds. Very little of the credit actually flows to the real economy.
The distorted financial market has created a vicious loop. As private firms face severe financing constraints, borrowing at high interest rates and often short-term, they are perceived to be even more risky by banks – which slap on an additional risk premium and in turn raise their borrowing costs further. The consequence is that rather than lowering the effective cost of capital for the small and medium sized firms that would benefit the most from funds, the opposite is effectively happening.
The disconnect between the financial sector and the real economy significantly hampers credit flows and much of the intended objectives of monetary policy. Chinese enterprises, in an increasingly difficult business environment, are turning to investing in the financial markets as a primary activity rather than focusing on their core business. But the lack of economic fundamentals underlying a high equity market valuation supported by leverage is unsustainable and cannot be a reliable source of profit – neither for Chinese firms nor for the households.
In my view, the vicious loops and key distortions are at the heart of the problem. And it is not something that a stimulus-driven environment can do much to help, not least because it may not have the benefits it intends to deliver, but especially because it may be doing just the opposite. Structural reforms are ultimately the necessary preconditions to make monetary policy more potent at a time when China needs it most.