The risks of selective easing
The Chinese government is finally getting worried about the economy. Following a series of inspection tours, Premier Li Keqiang has clearly signalled that he doesn’t want growth to slow much from the current rate. The State Council has asked the People’s Bank of China (PBOC) and various ministries to take supportive measures. The central bank is complying, reluctantly, but the risk is that its minimalist moves both fail to support growth and undermine the credibility of structural reforms.
The PBOC appears to be doing as little as it thinks it can get away with. It has cut the required reserve ratio for rural banks and for about two-thirds of small city commercial banks that can show they devote at least 30% of their loans to small and medium enterprises. This move will inject a relatively modest RMB150-200 bln of fresh liquidity into the system. In addition, there are reports that the PBOC has started a “re-lending” scheme under which it lends directly to a few banks on the condition that the funds are used for loans supporting social housing and agricultural investment. But it has left in place the 20% RRR for the bigger banks that account for over 80% of lending, and has signaled no cut in interest rates.
Why is the PBOC being so selective? Basically, it fears that a broader easing would just fatten the sectors that are causing the economy’s fundamental problems, such as property developers, big state owned enterprises, and local government financing vehicles. The head of the PBOC statistics department, Sheng Songcheng, wrote in Caijing magazine last week that there is very limited room for monetary easing, as corporate leverage in China is already higher than in Japan. Instead, he argued, the government should focus on structural reforms to improve the behaviour of borrowers.
So the PBOC is trying to strike a compromise between the premier’s mandate to support growth, and the longer-run imperative to keep up the heat on the structural reform agenda. There are two risks to this approach. First, stabilising growth may require much more support. The property market looks shaky-housing prices fell in May for the first time in two yearsand we are almost certain to see weaker construction activity and real-estate investment in the coming months. This in turn is putting pressure on local governments, which have seen their revenues from land sales and property transactions dry up. So the PBOC may be forced into a months-long stutter-step of additional targeted measures, undermining the credibility of the government’s commitment to reform.
Second, the technique of selective easing itself goes against the central tenet of Xi Jinping’s reform programme, which is to let the market play a more decisive role. By targeted RRR cuts and re-lending, the central bank is actively guiding banks’ credit decisions, and thereby reducing the market’s role in resource allocation. Some might argue that the PBOC is simply doing the same thing as the ECB, which last week announced a four-year, EUR 400 bln “targeted LTRO” programme. But the context is very different. In Europe, interest rates are already negative, and it is virtually impossible to coordinate fiscal policies across the whole Eurozone. In principle, China still has the full arsenal of conventional monetary and fiscal policy tools at its disposal.
The only thing that could bail out the central bank is a big rebound in exports, which grew at a smart 7% YoY in May and could accelerate further if US demand picks up in the second half of the year. If strong external demand enables this year’s real GDP growth to come in at 7% (which we think is roughly the floor acceptable to Premier Li), all well and good. But if exports are weak, then the government will be faced with a stark choice.
It could let growth disappoint, which would be a good signal for the commitment to reform but potentially very damaging for business confidence in the short run. Or the Premier could order the PBOC to re-open the credit taps, in a revival of the old and discredited strategy of boosting growth through inefficient investment. Selective easing may be the least bad option at the moment, but it is no silver bullet. Other reforms need to be pushed forward quickly enough so that China doesn’t find itself caught in the over-investment trap.