Has China lost control of interest rates due to industrial overcapacity?

One Chinese economist believes Joseph Schumpeter holds the key to understanding recent movements in interest rates.

Domestic observers have sounded the alarm over the narrowing net interest margins of China's state-owned banks, which could weigh heavily on their profitability.

A leading Chinese economist believes the culprit for this contraction is overcapacity in certain sectors of the economy, leading to a fall in the rates of return on capital.

He cites Joseph Schumpeter's business cycle theory in further arguing that these declining returns have hampered the ability of the central bank to influence interest rates via monetary policy adjustments.

Net interest margins narrow sharply

The latest round of performance results for China's listed banks shows their net interest margins have continued to narrow since the start of 2024, after contracting steadily for more than two years.

Since Q4 2021, net interest margins for state-owned lenders have fallen from 2.02 percentage points to 1.48 percentage points by Q1 2024, for a cumulative decline of 54 basis points.

The net interest margin is the difference between the interest payments that a bank earns on its loans, and the interest charges it pays for the money it borrows.

It's a core performance indicator for banks, with a higher net interest margin serving a sign of greater profitability, and a contraction pointing to a decline in earnings.

The faltering profitability of China's state-owned banks could have major adverse impacts for the country's financial system, given the dominant role they continue to play in the intermediation of funds, and the comparatively underdeveloped state of bond and equity markets.

Can the Chinese central bank adjust net interest margins?

One prominent Chinese analyst believes it could prove difficult for the People's Bank of China (PBOC) – the Chinese central bank, to deal with the problem of narrowing net interest margins by means of monetary policy and rates adjustments.

In an opinion piece widely circulated by state-owned media ,Liu Xiaoshu (刘晓曙), chief economist at the Bank of Qingdao, argues that it's a mistake to believe that PBOC is in full control when it comes to determining interest rates and levels of return on assets. 

He instead contends that it's the performance of the real economy and returns on capital that are the key drivers of interest levels.

"Advocates of the theory that the central bank determines all interest rates believe that it is necessary to keep an eye on the central bank when tracking future movements in net interest margins," Liu writes. "In reality, this is all wrong - it's a huge error.

"It's not the central bank that determines trends in interest rates, it's returns on capital."

Liu cites Joseph Schumpeter's theory on business cycles in support of this view. Schumpeter contends that returns on capital determine both the demand from enterprises for loans to make investments, as well as the level of interest charges that enterprises are willing to bear.

"Any businessperson will do the math on how much the expected returns from an investment will be, and what the cost of capital will be for the investment, in order to determine whether or not they'll be profitable or loss-making and whether or not to invest," Liu writes.

"Consequently, the most important variable that supports the level of loan interest rates is returns on capital.”

Liu's own research points to lending rates being more strongly correlated with the return on invested capital (ROIC) than the Chinese central bank's policy rates – the rates on the reverse repos and the medium-term lending facilities used for its open market operations.

He compared the ROIC of all of China's A-share companies (excluding financials, petroleum and petrochemicals) with the weighted average interest rate of ordinary loans, and discovered that trends in lending rates more consistently match ROIC than they do policy rates.

For this reason, Liu believes that the central bank uses monetary policy adjustments simply to ensure that the cost of capital better matches the ROC as determined by market fundamentals.

"Stated frankly, it's a case of passively adjusting interest rates to match changes in the ROC," he writes.

"It's just as Howard Marks of Oakland Capital says – the policymakers of the central bank are just the same as us.

"They're ordinary human beings who are no smarter than the market, and also prone to occasional errors."

Declining returns blamed for narrowing net interest margins

Given his Schumpeterian take that ROC is a key determinant of interest rates, Liu believes the current cause of narrowing net interest margins is faltering revenues on assets held by banks.

He points out that the funding or liability costs of Chinese banks have remained comparatively stable in recent years, as inflation has held steady and PBOC has refrained from ratcheting up interest rates in the same way as the monetary authorities of other major economies.

The deposit rates of China's listed banks rose from 1.83% in Q4 2021 and 2.06% in Q1 2024, for an increase of just 23 basis points – less than half the contraction in net interest margins.

Returns on bank assets in the form of loans, however, have posted sizeable declines, even after China weathered the worst parts of the pandemic.

The weighted average interest rate for ordinary loans fell from 5.2% at the start of 2022, to 4.35% by September 2023.

This amounts to a cumulative decline of 85 basis points, making it highly evident that most of the squeeze on net interest margins was the result of weaker returns. 

"It's the sizeable decline in the rate of return on capital for the real economy that has led to the rate of return on assets declining," Liu writes. 

"This is to say that the fall in the ROC is the fundamental reason for the current downtrend in net interest margins."

Returns on China's bond market have also seen sizeable declines during the same period, beginning to fall more precipitously towards the end of 2023. Liu views this as as further evidence of the determining role of ROC.

During the period from September 2023 to April 2024, 10-year treasury yields fell by around 50 basis points. 

"We can see that as lending rates have continued to fall, long-term market interest rates have also experienced major volatility," Liu points out.

"Long-term rates have seen such sizeable declines under conditions where monetary policy has not undergone marked adjustments."

Industrial overcapacity the culprit for ROC declines

When searching for the reasons behind the Chinese economy's declining capital returns, Liu believes the chief culprit to be excess industrial capacity.

"If declining ROC has led to a fall in lending rates, then it's productive overcapacity that has exacerbated this process of interest rate declines," Liu comments.

He takes the view that the manufacturing sector is equivalent to the productive capacity of the economy, and infrastructure, exports, real estate and consumption are representative of usage.

For this reason, Liu employs the difference between growth in manufacturing investment and the combined growth in exports, real estate and consumption to measure levels of excess production.

"Since 2022, production overcapacity has continued to remain in positive territory and worsened," Liu writes.

"It's worth noting that the pace of overcapacity accelerated at two key inflection points for lending rates - December 2021 and September 2023.

"There is a high level of correlation between lending rates and overcapacity, further attesting to overcapacity worsening the trend of the decline in lending rates."

Will aiding banks worsen China's economic woes?

China’s economic stewards currently face the dilemma of pursuing key policy objectives that could be mutually conflicting and involve difficult trade-offs.

These include supporting post-pandemic growth, maintaining the profitability of banks, averting speculative bubbles and restructuring the economy to give greater play to consumption.

The central government is currently preoccupied with reducing the cost of funds for businesses and households, in order to spur spending and support a recovery in the housing market.

The reduction in interest rates that this entails could put further pressure on net interest margins and undermine profitability.

Keeping a lid on deposit rates is one means of widening net interest margins to boost the profitability of banks as loan rates decline.

It could also, however, resurrect other problems for the Chinese economy that policymakers have grappled with in the past as a result of financial repression.

During the peak days of its rise as the world's leading export power in the 00's, China used financial repression to help spur the development of its manufacturing and export sectors.

Regulators kept deposit rates low, enabling companies to access credit at a reduced cost from banks. This was the equivalent of a tax on household savers and a subsidy for enterprise borrowers.

While these policy settings helped to drive China's boom in the first decade of the century, they also created a slew of legacy issues that policymakers still contend with today.

Artificially low deposit rates essentially caused households to forgo years of income as they subsidised companies, with the real one-year deposit rate dipping into negative territory for most of the period from 2004 to 2010.

This undermined the propensity of Chinese households to spend, causing structural imbalances in the economy by squeezing consumption as a share of national GDP.

Economists also argue that artificially low interest rates contributed to a bubble in China's property sector, by prompting savers in search of higher returns to pour their money into real estate as a lucrative investment alternative.

These two challenges gave impetus to the liberalisation of interest rates, with PBOC eventually announcing the removal of the ceiling of deposit rates in October 2015.

Tamping down deposit rates to widen net interest margins could have the same negative repercussions as financial repression in the past, undermining household consumption and contributing to speculative investment.

As a consequence, maintaining the profitability of Chinese banks could be caught between the horns of reducing lending rates to encourage economic growth, and keeping deposit rates high enough to achieve structural rebalancing by adequately compensating household savers.