Will rate cuts enrich Chinese households and boost demand?

Chinese economists continue to brood upon the dilemma of boosting lacklustre demand

In this edition on Thursday, 13 June, 2024:

• Interest rate cuts can enrich Chinese households and boost demand: Zhang Bin

• Is China's bond market panicking over GDP growth, or strapped for assets?

Interest rate cuts can enrich Chinese households and boost demand: Zhang Bin

Observers in China have highlighted the role of lacklustre demand and weak consumption in undermining the country's post-Covid economic growth.

The problem has prompted some leading analysts to call for far more accommodating monetary and fiscal policy, with claims that reduced interest rates could enrich households by reducing their debt payments and boosting asset prices.

Low inflation and wage growth stifle consumption

Li Xunlei (李迅雷), chief economist at Zhongtai Securities, believes that inadequate consumer demand is due to growth in household incomes falling short of expectations in the wake of the Covid era.

Official data from April indicates that this issue is ongoing, with commercial retail sales growth standing at just 2%, and food and beverage consumption rising just 4.4%.

Zhang Bin (张斌 ), a senior researcher from the China Finance 40 Forum and formerly a researcher at the Chinese Academy of Social Sciences (CASS), said lacklustre income growth is the result of the tepid inflation that has prevailed in China in the wake of Covid.

"The most pronounced problem faced by the economy at present is low prices," Zhang writes.

"On the labour market, increases in employment opportunities are restricted, and growth in household incomes is low.

"If enterprise earnings and labour income continue to be low, then both consumption and investment will remain inadequate."

Another factor constraining the propensity of Chinese households to spend is the modest sum of their financial assets.

Zhang says average household financial assets in China stand at around USD$60,000, as compared to more than $1 million in the US, and over $200,000 in the EU and Japan.

"China's financial assets are not considerable," he writes. "The size of the 'wallets' of the Chinese people isn't large at all, and over the past two years their growth has rapidly slowed.

"This has directly led to a drop in the purchasing power of society as a whole."

Ailing credit growth further compounds demand slump

Zhang Bin says weak household demand is further compounded by tepid credit growth ever since China's property market hit the skids.

He makes the case that for at least a decade, the main source of new credit creation has been local government financing vehicles and real-estate-related loans, accounting for around 70% of the total.

For this reason, once the property market succumbed to problems and local government financing vehicles were forced to rein in their activities, both lending and demand commenced a sharp decline.

"We can see that total social financing growth has declined from 12% to 13% in the past to 9% to 10%, before dropping further to 8% this year," Zhang writes.

"The large-scale decline in credit growth means that growth in financial assets has eased, and the nominal growth in purchasing power has slowed in tandem," Zhang writes.

Monetary policy can boost demand via wealth effects

Given these factors, Zhang Bin believes looser fiscal and monetary policy is the urgently needed shot in the arm for China's faltering economic growth.

"If we just make full use of standard, counter-cyclical policy tools, then this problem is solvable," Zhang writes.

On the monetary policy front, Zhang wants large-scale reductions to interest rates for credit provided by the central bank to Chinese financial institutions.

This could help to improve spending by reducing the interest payments for heavily leveraged market actors, as well as induce a wealth effect by boosting asset prices.

"China currently has more than 300 trillion yuan in debt," Zhang observes.

"If policy rates fall sizeably by 100 to 200 basis points, at a conservative estimate this will reduce interest payments by 2 - 3 trillion yuan per year.

"At the same time, we estimate that financial assets will rise in value by at least 10 trillion yuan, and real estate prices will also find support."

Zhang estimates that the cumulative effect would be to increase household wealth by several tens of trillions of yuan, providing impetus to spending.

Li Xunlei also believes active fiscal and monetary policy is the best prescription for the current woes of the Chinese economy.

"If we wish to solve the problem of an asset drought and an asset panic, this will be determined by how much the central government increases leverage and the central bank reduces rates.

"If the scope of debt issues by central fiscal authorities exceed expectations, and the central bank makes purchases in the secondary market, then this will be highly critical for stabilising growth."

Li expects the Chinese central government to deliver these policies soon, based on statements made at the most recent Central Economic Work Conference.

"The Conference called for dealing with countercyclical issues primarily by means of the injection of funds, which means that active fiscal policy and looser monetary policy must both play a role," Li writes.

Is China's bond market panicking over GDP growth, or just strapped for assets?

The recent performance of the Chinese bond market has prompted domestic observers to ask whether it signifies pessimism over future growth prospects, or an "asset drought" due to a scarcity of quality fixed-income securities.

Do long-term treasury yields correlate with GDP growth?

Yields for China's longer-term treasuries have recently faltered, falling to 2.3% for 10-year treasuries and less than 2.5% for the 30-year treasuries issued earlier this month.

Li Xunlei (李迅雷), chief economist at Zhongtai Securities, points out that the yield on 10-year treasuries is oftentimes strongly correlated with GDP growth.

He cites historical data indicating that yields on long-term debt and nominal GDP growth closely approach each other in both advanced and developing economies.

"According to classical economic theory, nominal interest rates are determined by the supply and demand for funds, and nominal economic growth reflects demand for funds," Li writes.  

"In a rational, sustainable debt environment, nominal growth is equal to nominal interest rates, which means that yields are equal to costs."

Li points to South Korea and the US as countries where this relationship has held up in the years since the Covid pandemic.

In China, however, Li believes the correlation has been absent since the turn of the century.

10-year treasury yields have steadily hovered at 2 - 3% since 2002, far lower than the nominal GDP growth that has been north of the two-digit threshold throughout much of this period.

The likely culprit for this lack of correlation is the copious size of China's money supply.

"China's M2 money supply exceeds the sum of [M2] in the US and EU," Li writes.

"For this reason, 10-year or long-term treasury yields have rarely reflected future growth prospects for China's economy. "

Asset drought persists as risk preferences shift

Many observers believe the likely culprit for the low yields on Chinese treasuries is increasing risk aversion in the wake of Covid, combined with a scarcity of secure assets relative to investment demand.

This thirst for secure assets was reflected by the tremendous popularity of China’s recent issues of ultra-long treasuries, driving up yields for bond-backed wealth management products (WMPs) and triggering an exodus from bank deposits that undermined money supply growth.

For this reason, Li says China is still in the grip of an "asset drought" coinciding with an "asset panic” - two homonymous terms whose pronunciations are the same in Chinese (zichan huang).

While this is distinct from expectations of low GDP growth, it nonetheless reflects falling returns on investment across the board within the Chinese economy.

"The asset drought in actuality reflects a decline in the risk preferences of investors, which is the same rationale behind private investment easing because investment returns in the real economy are on the decline," Li writes.

Li believes this shift in risk preferences is also reflected by the performance of China's equity market.

"The strong performance of stocks with large market capitalisations and comparatively high dividends, such as utilities and banking, clearly shows investors have become more conservative, and are seeking steady and strong dividend returns."

Conversely, smaller-cap stocks with high profits but low dividends have dropped across the board since the start of 2024.

Li concurs with the Chinese central government in identifying lacklustre demand - and consumption in particular, as the chief cause for risk aversion amongst Chinese investors.

The latest Central Economic Work Conference outlined a total of six major challenges facing China, chief amongst them "inadequate effective demand."

According to Li, the chief trigger for insufficient consumer demand is the failure of household income growth to meet expectations.

Weak demand worsens structural imbalances

In addition to putting a drag on growth, Li says this lack of effective demand will exacerbate long-standing structural imbalances in the Chinese economy that have arisen as a result of an obsolete development model.

"The Chinese economy has gone through over 30 years of high growth that was dependent on investment drivers, and the problem of a supply-demand imbalance has since become more pronounced," Li writes.

This issue is embodied by China's massive manufacturing capacity, which accounts for 31% of added value in the global manufacturing sector, despite China's population accounting for 17.6% of the world total.

Inadequate domestic demand could lead to worsening underutilization of this vast productive capacity. While China's average industrial utilisation rate was around 77% during the 12-year period from 2006 to 2019, it currently stands at around 73%.

Li points out that tepid demand and structural imbalances are reciprocal counterparts of the same equation. Weak demand threatens to compound structural imbalances, but resolving structural imbalances could also help to boost demand.

Unfortunately, however, China faces other cyclical economic challenges that forestall the use of structural reform as a primary means of boosting growth.

"If the only problem with the Chinese economy was structural issues, then we could solve it all via reform," Li writes.

"However, China faces cyclical challenges, such as the real estate market entering a long-term downward cycle.”

For this reason, Li sounds a note of pessimism on China’s future growth prospects should policymakers fail to achieve a deep-seated overhaul of its economic development model.

"It's not hard to see that 2021 was the turning point for many indicators - not just growth in real estate investment, but also the total scale of equity mutual funds,” he writes.

"China's GDP as a share of the global total hit a peak, and as of 2023 has fallen by a percentage point."