China’s Rate Cuts: A Short-Term Fix Ignores Deep Structural Issues

The headquarter of the People's Bank of China, the central bank in Beijing on Dec. 13, 2021. (Andrea Verdelli/Bloomberg via Getty Images)

Commentary

In a sudden and possibly desperate attempt to revive a faltering economy, the People’s Bank of China (PBOC) has slashed interest rates. This move may only provide temporary relief while potentially worsening long-term issues.

Last quarter, China’s gross domestic product grew by 4.7 percent, missing the 5 percent target set by the Chinese Communist Party (CCP). The economy is nearing deflation as factory activity contracts and consumer spending slows, with citizens hesitant to spend, despite Beijing’s encouragement.

The real estate sector is also struggling, with June home sales down by 10.1 percent from the previous year. New home prices dropped by 4.9 percent on average, while used home prices fell by 7.9 percent, leaving tens of millions of apartments vacant.

About 25 percent of bank loans are tied to real estate, and many realtors are facing bankruptcy. Smaller banks report up to 40 percent of their loans as nonperforming, leading to consolidations, with smaller banks being absorbed into larger ones, while as many as 3,800 other banks are threatened.

The CCP’s “Third Plenum“ emphasized ambitious long-term goals but provided little immediate economic relief. As a result, Oxford Economics downgraded China’s growth forecast for this year to 4.8 percent. Meanwhile, the PBOC took a proactive step to stimulate the economy by enacting a series of interest rate cuts.

The central bank has reduced key interest rates to make loans more affordable and stimulate borrowing and spending. The five-year Loan Prime Rate (LPR) for mortgages was cut by 10 basis points to 3.85 percent, and the one-year LPR was lowered to 3.35 percent. Additionally, the PBOC decreased the seven-day reverse repo rate to 1.7 percent from 1.8 percent to inject more liquidity into the banking system and ease bond market pressures. The overnight rate was cut to 2.55 percent, with the seven-day and one-month rates reduced to 2.7 percent and 3.05 percent, respectively. These measures aim to enhance banks’ capacity to trade more assets by reducing collateral requirements for the medium-term lending facility, potentially increasing overall economic activity.

The rate cuts may immediately impact the real estate sector by providing debt relief to developers and buyers. Many developers are struggling to complete projects, leaving millions of apartments unfinished, which has eroded consumer confidence and caused financial distress among property firms.

The central bank’s recent interest rate cuts aim to alleviate this pressure by making borrowing cheaper for both developers and homebuyers, hoping to boost investor confidence. By lowering borrowing costs, the PBOC aims to encourage more investment in real estate and other sectors, thereby stimulating economic activity. However, home prices in China are extremely high, and a decrease in interest rates may not be enough to persuade citizens to dramatically increase house purchases. Without a sharp increase in home purchases, property firms will still face large amounts of debt, and banks will continue to hold a portfolio of potentially distressed loans.

The PBOC’s interest rate cuts lower borrowing costs for banks and increase financial system liquidity. Consequently, banks can hold fewer long-term bonds, accessing cheaper and more liquid funding sources. This shift allows them to manage interest rate risk more effectively, reallocate assets toward more liquid or profitable investments, and increase lending to support economic growth.

The rate cuts will have mixed impacts on the United States and other foreign countries. In a market economy, a currency would typically lose value after a rate cut, but the yuan, trending downward for eight years, is only partially exposed to market forces. The impact will depend on the central bank’s actions to defend the yuan. If it allows the currency to weaken, China’s export volume could increase. However, the total value of these exports in dollar terms may not rise proportionally, as each unit would earn fewer dollars.

Lower interest rates in China typically make fixed-income investments, including Chinese government bonds, less attractive because of reduced returns. This might prompt investors to shift their capital to markets with higher yields, such as U.S. Treasury securities.

Additionally, since the yuan accounts for less than 3 percent of global foreign currency reserves, a weaker yuan and lower interest rates will likely discourage central banks from increasing this percentage. Central banks prefer stable or appreciating currencies and higher returns, making the yuan less attractive. Consequently, the rate cuts will slow CCP leader Xi Jinping’s dream of internationalizing the yuan.

Foreign direct investment (FDI) in China is at a low not seen in decades. While lower asset prices and reduced domestic borrowing rates might attract some foreign investment, the trend has been a shift of FDI from China to the United States, driven by higher returns and a more stable investment environment in the United States. The recent interest rate cut by the PBOC may further discourage FDI, as it signals deeper economic issues, such as the risk of deflation. This dual message—cheaper investment opportunities paired with potential economic weakness—can create uncertainty and mixed reactions among foreign investors.

The PBOC’s decision to cut deposit rates aligns with the CCP’s broader policy of stimulating growth and addressing structural economic issues. However, rate cuts are unlikely to save China’s economy. While they aim to boost activity by lowering borrowing costs and encouraging spending, the relief will be temporary.

China’s economy faces significant structural challenges, such as high debt, an aging population, and a struggling real estate sector, which require more than just monetary adjustments. Weak consumer and business confidence will still hinder recovery despite lower interest rates. Additionally, global economic factors, including trade tensions and geopolitical risks, impact China’s outlook, and rate cuts alone cannot address these issues.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.