China Reaches Into Its Monetary Tool Kit

Model of the ECB's new headquarters, which is ...

Model of the ECB's new headquarters, which is due to be completed in 2014. (Photo credit: Wikipedia)

As Americans were taking time off last week to celebrate Independence Day amid sweltering heat in most parts of the country, the European Central Bank (ECB) and the People’s Bank of China (PBOC) unexpectedly cut interest rates, stoking yet again fears of a global recession. On Friday, the ECB announced that it was reducing its benchmark interest rate to a record low 0.75 percent, down from 1 percent, while the PBOC lowered interest rates on one-year loans from 6.31 percent to 6 percent, and said that banks can discount rates by as much as 30 percent below that benchmark, an increase from the previously allowed 20 percent.

Given the plight of most European economies, the ECB’s effort to stimulate growth through lower interest rates was understandable. With so much of the global economy riding on China, however, China’s move caused concern because it was unexpected, coming as it did just four weeks after a twenty-five basis cut from 6.56 percent to 6.31 percent in June. The PBOC’s unexpected action seemed to confirm everyone’s worst fears as to the state of the Chinese economy.

Lumping China’s slowdown with the poor U.S. jobs report that also came out on Friday and the continued struggles in Europe, many commentators came to the opinion that the world may indeed be headed for a global recession. Neil Cavuto, a well-regarded talk show host, noted the July 5 rate cuts and concluded that the “Whole planet is having a sale” and wondered whether it is sign of “generosity” or “desperation.” In Cavuto’s opinion, “when China pulls out all the stops” it is a sign of desperation for the global economy.

As evidenced by interest rate levels, however, China is in a very different place than the other large developed economies of the world and should not be lumped with them. Even with Friday’s lowering of rates, China’s benchmark rate of 6 percent is higher than it was in 2009 when China, like all countries in the world, were trying to jumpstart their economies in the aftermath of the global financial crisis. Moreover, China’s benchmark rate of 6 percent is substantially higher than Europe’s 0.75 percent and the 0.25 percent in the United States. While the United States and Europe have now fallen into the same liquidity trap that Japan fell into twenty years ago as a result of the massive de-leveraging that has occurred in the wake of the financial crisis, China’s situation is much different. Having fully recovered from the financial crisis in 2009, China’s leaders are now trying to maneuver the country’s economy into a long-term sustainable growth model.

In January 2007, interest rates in the United States and China were at similar levels. In the U.S., they were just over 5 percent, and in China a point higher at just over 6 percent. Beginning in January 2008, when U.S. rates had already been lowered to 3 percent and China’s had been raised to 7.5 percent, the two economies began to diverge as far as interest rate policy. By January 2009, the gap widened, even though China had lowered rates to 5.5 percent, because U.S. rates had been slashed to near zero. Interest rates have remained at 0.25 percent in the U.S. ever since, but in 2010, China began raising interest rates to combat real estate speculation and inflation, reaching a peak of 6.56 percent by January 2012.

There is little question that growth in China is slowing. The Chinese economy grew at 10.4 percent in 2010; 9.2 percent in 2011; and consensus estimates are that it will grow by 8.0 to 8.5 percent in 2012. The slowing of the country’s growth rate is what China’s leaders have intended all along. In March, Premier Wen Jiabao announced that China’s official growth target for 2012 was 7.5 percent.

Against this backdrop, China’s Gross Domestic Product (GDP) grew by 8.1 percent in the first quarter, and many analysts predict that the soon to be released figures for the second quarter will show that growth in the second quarter will have slowed further to 7.6 percent. Many analysts point to the fact that electricity consumption in China only grew by 3.7 percent year-on year in April, the slowest in the past 16 months, to suggest that China’s economic slowdown may be even greater than indicated by the GDP numbers.

While electricity consumption is often viewed as a more reliable barometer of the health of the Chinese economy, China’s efforts to increase energy efficiency over the past years, as well as the shift that is now underway from an economy dominated by heavy manufacturing to one where less energy dependent light manufacturing and services play a greater role, this may not be as reliable an indicator as it may have been in the past.

In any event, with growth slowing, it should not have surprised anyone that China would reach into its monetary tool kit and use the interest rate flexibility that it enjoys in order to achieve the growth targets that it has set. Rather than being seen as a sign of desperation, this should be viewed instead as a mid-course correction to offset the impact of the restrictive monetary policy that the country has implemented over the past two years.

It appears that easier monetary policy is already having an impact. The average home price in China’s 100 major cities edged up 0.05 percent in June from May, snapping a nine-month decline and reinforcing signs that property prices are stabilizing. The China Real Estate Index System (CREIS) data suggests that the property market has already benefitted from June’s twenty five basis point rate cut, as well as efforts by the local governments to stimulate housing purchases.

The fate of the global economy does not rest on China, but on the shoulders of the United States and Europe. If anything, China’s actions to create a sustainable growth model are not only best for its own economy, but also best for the global economy.

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