The People’s Bank of China, the country’s central bank, likes to surprise people. It did it again last Friday when it unexpectedly announced a 40-basis-point cut in its one-year lending rate to 5.6 per cent. The move both surprised and delighted the market.
It’s worth noting that the Chinese central bank had been extremely reluctant over the past two years to cut its official rate. Instead, it’s tried a range of unconventional measures to lower the cost of funding for the country’s struggling small- and medium-sized companies, including a medium-term lending facility, a standing lending facility and a pledged supplementary lending tool.
The central bank, which is one of China’s leading reformist institutions, is trying to combat the scourge of soaring debt levels. Though it is aware that this interest rate cut may be interpreted as a return to the much-criticised stimulus policies that it introduced in the aftermath of the global financial crisis.
Up until Friday, the respected governor of the central bank, Zhou Xiaochuan, had resisted calls from sections of the government and the finance sector to cut interest rates. The bank’s chief economist, Ma Jun, who was recruited from Deutsche Bank, told reporters as recently as last month that Beijing did not need to introduce a broad-based stimulus plan.
So, what has prompted the central bank, or rather the Chinese leadership, to change its mind? Unlike in many other developed countries, China’s central bank is not independent.
It is easy to say that Beijing is desperate to maintain its GDP growth target of 7.5 per cent, so it wants to flood the market with cheap credit, something straight out of its old playbook. However, the central bank has been at pains to explain that the latest cut is not about broad-based monetary easing.
“At present, China’s economy continues to grow within a reasonable range, showing positive changes in economic restructuring. But as reflected in the real economy, there is a significant problem of “difficult financing, expensive financing,” says the central bank statement that accompanied the announcement of the rate cut.
The soaring cost of funding for SME is one of the Chinese economy’s most pressing problems. According to the latest report from the Ministry of Industry and Information Technology, the cost of funding for small- and medium-sized businesses increased 17.5 per cent in the first six months of 2014. Some businesses are paying as much as 30 per cent interest on their loans. The Bank of Communication chief economist Lian Ping estimates that the average cost of capital for small businesses in Shanghai is about 18 per cent. (China’s SMEs struggle to jump the credit hurdle, 28 August 2014)
Having tried, and failed, to lower the cost of funding for SMEs through unconventional means, the central bank has few options left but to cut interest rates. Ma Weihua, the former chief executive of China Merchants Bank and one of the country’s most respected bankers, said the move was designed to boost more innovative sectors of the economy that were starved of credit.
Ma, who has made a name for himself as a banker for SMEs, believes too many zombie companies from those sectors of the economy suffering from excess capacity are hogging more than their fair share of credit from the banking sector. As a result, despite the absence of significant falls in credit creation, there is still a widespread perception of a credit shortage.
Apart from the interest rate cut, another major policy shift announced by the central bank was to raise the deposit rate ceiling to 120 per cent of the benchmark, from 110 percent. This simply means banks can set their own deposit rate 20 per cent above the benchmark. This the second increase of the deposit rate ceiling following the initial increase of 10 percentage points in June 2012.
For years, the Chinese government has practised financial repression in order to squeeze depositors and guarantee a fat margin for banks so that they can channel money to the government’s industrialisation project. However, earlier this year, the central bank announced it would achieve full interest rate liberalisation within two years.
Friday’s announcement that the bank would lift the deposit rate ceiling is another step towards the eventual liberalisation of China’s interest rates. The move is designed to squeeze the margin between deposit rates and lending rates from both ends, thus forcing local banks to pay China’s long-suffering savers something closer to market rates.
Within three hours of the central bank’s announcement, Bank of Ningbo, a regional bank, said it would lift its deposit rate to 3.3 per cent, the maximum ceiling allowed. A number of Chinese banks have since followed suit.
Zhou, the central bank governor, has long advocated the need to selectively channel capital to the areas that suffer the most from credit drought. However, it is easier said than done. Despite the central bank's persistent attempts, SMEs are still crying out for cheaper credit.
So in the end, the central bank had to cut interest rates to make sure that cheaper credit flowed to SMEs. It is also encouraging to see that the bank is simultaneously pushing ahead with interest rate liberalisation.
Even Hugh Hendry, a hedge fund manager and noted China bear, has said that he admires the central bank’s discipline over the past two years.