Talking Point

It’s worse than expected

As growth slows, Beijing has a policy dilemma

China's Central Bank Governor Zhou Xiaochuan listens to a question at a news conference in Beijing

On the eve of World War II the British government printed millions of posters with the slogan: “Keep calm and carry on”. The posters were never actually displayed, reports the BBC, but in those dark times their message was clear: don’t panic; keep going about your business.

The Chinese government hasn’t issued any morale-boosting posters yet, but those watching the fortunes of the country’s economy are evidently starting to get nervous.

Worries of a slowdown began to grow when HSBC published a disappointing result for its purchasing managers’ index (see WiC157); and grew further when the central bank made a surprise interest rate cut last Friday (the second in a month).

Those fears were confirmed when GDP data was published today. This showed that in the second quarter the economy grew just 7.6%. That was a three year low, reports Bloomberg, and well below the pyschological 8% figure that’s viewed as necessary to maintain employment levels.

So how worried should we be about a hard landing? Or does this mark the trough, from which a second half rebound can be expected?

Over the past few days economists have been trying to make their minds up, analysing an array of fresh data Beijing has just published. In this Talking Point we assess those numbers and also look at the government’s policy dilemma: loosening enough to keep the economy on track, but not so much as to rekindle inflation and the property bubble.

The interest rate cut: a surprise step or a structured one?

Most agree the move by the People’s Bank of China (or PBoC) was dramatic. It was only the second rate cut since December 2008, when the global economy was heading into a tailspin. In last week’s move, the PBoC brought its one-year lending rate down by 0.31 percentage points to 6% and trimmed one-year benchmark deposit rates by 25 basis points to 3%.

Was the move purely driven by the fear that the economy was edging toward stall speed? That’s the obvious conclusion. But some China-watchers say there is another agenda too. The central bank has used to opportunity to introduce interest rate reforms.

For instance, in conjunction with June’s rate cut, the central bank announced that lenders could now choose to charge borrowers 80% of the official rate (formerly it was 90%). Last week this leeway was extended to 70%. In June, banks were told they could also pay a premium on depositors’ funds, in this case 10% above the official rate.

Those looking at the bigger picture see the recent moves as a further step towards fuller interest rate liberalisation.

Or is it more a sign of panic than planning?

Two rate cuts in such quick succession also give the China bears ammunition, bolstering their view that GDP is slowing far faster than the government would like.

And there’s anecdotal evidence from the corporate sector that the mood is darkening too. Last week we reported on rumours from major firms including Sany that staff were being sacked (see WiC157) and Thomson Reuters has been reporting that three quarters of earnings revisions from Chinese firms in the last two months have been downwards. A Financial Times headline this week didn’t bolster the case for optimism either: “China’s job market under stress amid signs of tougher times.”

So the PBoC may have deemed it wise to cut rates ahead of what it knew would be another week of underwhelming economic and trade news.

Sure enough, on Tuesday last month’s trade data was released, and although exports held up reasonably well (11.3% up in year-on-year terms), the import data was much worse than expected, almost halving to 6.3% growth on the year before, significantly below expectations.

As Chinese officials also singled out, exports to the European Union actually fell in the first half of 2012, meaning that the United States has overtaken the EU as China’s top export destination.

The picture on imports raises two immediate concerns, says HSBC: firstly that slowing imports of ordinary goods suggest diminishing demand within China itself, but also that the drop-off in processing imports foreshadows even weaker appetite for Chinese exports overseas.

In that context, the rate cut might best be interpreted as an effort to show the government on the front foot – knowing as it did that the GDP growth number might rattle markets a week later.

There was also a subtle change of tone from Premier Wen Jiabao, who indicated a more stimulative policy was brewing when he said he wanted to see “a reasonable growth of investment”. That usually means boosting the economy via infrastructure spending.

Is the rate cut going to help?

Lower rates will help companies with higher debt burdens, as well as some of the local governments on the repayment hook for the local fi nancing vehicles that sprang up during the last investment binge, primarily in infrastructure, in 2009 and 2o10.

But, while boosting growth is the underlying objective, we oughtn’t to expect a repeat of the last stimulus exercise. Insofar as investment is concerned policymakers have indicated they want to see private companies – rather than state firms – play a bigger role this time round. This is why there has been talk about opening up new sectors to private capital – the railways, for instance. The hope is that private firms will invest more efficiently than government entities and generate proportionately more jobs, tax and growth for the wider economy.

But is that investment going to materialise?

Opinion has been mixed. For a start, there’s the view that the banks will have to be pushed to lend to the private sector on the terms envisaged, as they are much more comfortable dealing with larger, state-owned customers.

Then there are questions about whether there is enough demand for new loans from firms, especially in industries that are struggling with overcapacity or increasing costs.

The latest bank lending data, which was released on Thursday, offered some insight here. New loans were up in June to Rmb919.8 billion ($144 billion), 15.9% greater than in the same month last year and above analyst expectations. HSBC economist Sun Junwei says that this is a sign that credit loosening is starting to work, with the higher loan volumes driven mainly by a rebound in lending to corporates.

Also, there are signs that fixed asset investment picked up in June too, showing 20.4% growth in year-on-year terms.

That was better than the market expected and seems to have been driven by an acceleration in infrastructure investment (government approvals are now being fast-tracked, something that WiC has mentioned before). Just as well: as HSBC points out, the spending on infrastructure has been offsetting a slowdown in investment in manufacturing and property.

Will the property sector be a beneficiary?

After last week’s rate cut China’s property developers saw their share prices rise by the most in four months on hopes that sales would get a boost.

But the exuberance quickly subsided once it was made known that the banks had been told not to offer new credit to clients wanting to invest in the sector.

“All financial institutions must continue to strictly implement a differentiated housing credit policy to continue curbing property buying for speculation and investment purposes,” warned the central bank.

As the Financial Times pointed out, the government is in a difficult position. It wants to avoid a slowdown. But it doesn’t want to reflate the property bubble.

Wen Jiabao made the same point himself during a tour of Jiangsu province, pledging to continue “unswervingly” with property controls. “We cannot allow prices to rebound,” he promised, “or all our efforts will come to naught.”

That means that current restrictions including caps on the amount of home purchases per family, higher mortgage rates on second home transactions, and higher downpayments are all likely to remain in place. Wen warned too that the authorities would “severely punish firms, agencies and individuals for obtaining their home purchase qualifications by cheating.”

This was the fifth time in seven months that Wen has vowed to keep a tight grip, noted Wang Xiangwei in the South China Morning Post, which says something for his determination to see the measures through. But Wang also thinks that it hints at the central government’s struggle to rein in its local subordinates on property policy. Vigilance will need to be maintained: more than 40 cities are said to have tried to dodge the rules in one form or another since restrictions were imposed.

Of course, previously a large portion of bank lending has gone into property or related construction activity, which made up about a tenth of Chinese GDP last year. But as that route looks set to remain blocked, at least one option for stoking growth is unavailable.

Beijing’s dual objectives make for a delicate balancing act, which was apparent too in some of the more awkward phrasing in Wen’s headline commentary. The government would “preset and fine-tune its policies in a more aggressive manner,” he promised, while also sticking to “pro-active and prudent monetary policies”.

How will the banks respond?

Regular WiC readers will recall that Wen also targeted China’s leading banks back in April, complaining that they were enjoying easy, monopoly profits.

Might those days be numbered? Another feature of the rate reductions is that loan rates have been cut further than payouts on deposits (in what analysts call an “asymmetric” move). This shrinks the banks’ spread, or net interest margin – whose erstwhile generous cushion has made Chinese financial institutions some of the world’s most profitable.

With the new rules also allowing banks to price loans and deposits at rates that are straying ever further from the benchmark levels, the impact could be significant, the Shanghai Daily suggested this week. The change of circumstances has also been rapid. The best-case one-year rate for depositors is now 3.3%, while the most competitive one-year lending rate has fallen to 4.2%. That would mean only 90 basis points of spread, a sharp drop on the 240-point margin that banks enjoyed as recently as the middle of May.

Of course, the comeback is that lenders will be hesitant to pass on the best rates to all but their most important customers. Currently, that’s not the way that they operate, and HSBC’s Todd Dunivant says that only 5% of new loans are priced below benchmark level anyway.

Further, although Dunivant does expect some impact on profitability, he notes that it will take at least six months for banks to complete their loan and deposit re-pricings, meaning that it won’t be evident until next year.

Meanwhile the banks appear to have gone onto the defensive, still smarting from Wen’s remarks about their monopoly profits.

Take it easy on us, seemed to be the message emanating from one of the country’s top bankers at a conference last week. China Daily reported that Xiao Gang, boss of Bank of China, warned that the banking system faces new pressures from an increase in non-performing loans and a decline in profits. That was due to a “faster-than-expected economic slowdown”, Xiao said, as well as a narrowing of net interest margins.

A coded message to Wen, perhaps, that if the net interest margin is compressed any further banks might enter dangerous territory – after all, if profits shrink too fast China’s big lenders will find it harder to cope with rising NPLs.

So is it gloom or boom?

The good news, says HSBC, is that China has more options than most for stimulating growth, especially after Monday’s inflation data, which showed prices remain in check. In fact, top line inflation came in at 2.2% for June, the lowest level since January two years ago, and well below the annualised target of 4%.

That leads HSBC to forecast another reduction in the bank reserve requirement (freeing up more money to lend) and perhaps another interest rate cut later this year, especially if inflation falls further. More fiscal spending and tax cuts for specific industries, especially exporters, could be on the agenda too.

All in all, that leaves HSBC talking about a “modest growth recovery” in the coming quarters, as “more easing steps” take effect. The bank thinks that China’s economy will accordingly grow by 8.5% in the second half of the year.

Perhaps it should also be remembered that in March the government set an official GDP target for the year of just 7.5%. That means the latest number is still technically within Beijing’s comfort zone.

Should growth fall below that level, we really ought to worry.


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