China’s central bank, the People’s Bank of China (PBOC), finally cut interest rates on July 22nd in an effort to help revive the lost momentum in the Chinese economy. This interest rate cut was initially promised by top Chinese officials in a series of planning meetings months ago, but the PBOC only took action recently. Despite the urgent economic needs in China, any action is welcomed, but the help provided by these small interest rate cuts remains minimal. To truly kickstart the Chinese economy, the PBOC needs to do more.
The magnitude of the interest rate cuts can be considered cautious, especially given the economic demands. The PBOC announced a 20 basis point reduction in the one-year medium-term lending facility (MLF) rate, lowering it from 2.5% to 2.3%. The five-year loan prime rate (LPR) was also reduced by 10 basis points to 3.85%. Additionally, the one-year loan prime rate (LPR) and seven-day reverse repo rate were each cut by 10 basis points, with the former dropping to 3.35% and the latter to 1.7%.
Since spring this year, the need for the central bank to cut interest rates has been discussed in a series of policy meetings by the Chinese government, starting from the Two Sessions in March to the Political Bureau meeting in April. However, this July marks the first interest rate cut since August 2023. While the delay in implementation raises questions, the interest rate cut is still welcomed news reported in front-page headlines by both Chinese and Western media. Yet, in terms of actual impact, these interest rate cuts are not as exciting as they may seem.
It is evident that the current economic situation in China is highly complex, and a reduction of 10 or 20 basis points is unlikely to have a significant impact on an economy that is visibly struggling. Moreover, the inflation trajectory in China raises doubts that even the current level of interest rate cuts would be effective in stimulating the economy. Just consider that before the PBOC started cutting rates in early 2023, China’s consumer price inflation rate exceeded 2%, meaning borrowers were repaying loans in yuan with about a 2% decrease in purchasing power. At that time, with the loan prime rate (LPR) at 3.65%, borrowers were effectively paying a real interest rate of only 1.65%. However, now China’s average annual consumer inflation rate is close to 0.1%.
On the other hand, borrowers are seeing a continual decrease in the purchasing power of what they owe, yet they are not getting any breathing room as a result. Even with the rate cuts, the actual borrowing cost is not significantly different from the nominal rate of 3.35%. In reality, despite the nominal rate cut, the actual cost of borrowing is rising. As inflation drops to almost zero, the PBOC would need to reduce the rate to 1.65% to maintain the borrowing incentive mechanism from a year and a half ago. The central bank’s lack of proactive action and the insignificant interest rate cuts are actually making China’s monetary policy more stringent.
Fundamentally, the confidence of grassroots consumers and businesses has plummeted significantly over the past few years. Due to lack of confidence in the future, even if banks manage to lower rates enough to stay ahead in a slowing inflation environment, individuals and businesses remain hesitant about borrowing. Ordinary households have valid reasons to be cautious about spending and borrowing. Undoubtedly, the slowdown in the Chinese economy has eroded wages, and even with some wage growth, it falls far short of the expectations of Chinese workers.
Simultaneously, the real estate crisis has depressed residential property values, which for most Chinese is a primary asset. The decrease in housing value has significantly diminished people’s sense of wealth and subsequently reduced consumption. The global COVID-19 pandemic and the subsequent zero-COVID policy have severely disrupted commercial activities, leading many Chinese to doubt their ability to earn a stable income.
Private enterprises have faced similar challenges, causing them to hesitate on new expenditure and expansion plans, similar to households. Moreover, not long ago, Chinese leader Xi Jinping criticized private enterprises for prioritizing profits over adhering to the Communist Party’s principles. The actions taken by Xi Jinping and the various levels of government are enough to keep businesses vigilant about spending and expansion. While Xi Jinping has recently changed his tone, the damage to private enterprises has been done. Business owners and managers are still reluctant to spend money and, of course, to borrow. Understandably, they fear that Xi Jinping may revert to his previous hostile stance at any time.
Amid this backdrop of monetary tightening, the confidence levels of decision-makers in businesses and households are extremely low, making it understandable why the Chinese government and the PBOC are facing difficulties in stimulating economic growth through encouraging borrowing and consumption. The delayed and inadequate interest rate cuts by the China’s central bank are certain to impact the economy negatively. The road to recovery for the Chinese economy will undoubtedly be long and challenging.