Pulling Out All the Stops

China implemented further macro-economic stimulus today as it slashed interest rates in support of growth. Benchmark lending and deposit rates were reduced by 108 basis points to 5.58% and 2.52% respectively. The reduction in the lending rate was the largest since October 1997. The adjustments will come into effect on Thursday. The People's Bank of China (PBoC) also announced a further reduction in the reserve requirement ratio for banking entities. The ratio for the country's five largest banking institutions will decline to 16.0% from 17.0% and to 14.0% from 16.0% for smaller financial institutions.

Aggressive Monetary Easing Cycle

The cuts are the fourth since the People's Bank of China began lowering interest rates on 15 September, but the scale of today's reduction is noteworthy. The initial three reductions in interest rates were concerted, implemented intensively over a six-week period. Ostensibly, the easing cycle was implemented to stabilise financial markets in the wake of the global convulsions that followed the collapse of Lehman Brothers. However, liquidity constraints have not emerged in the Chinese economy, indeed the reverse—excessive liquidity growth—has been a core risk. Monetary policy was progressively tightened in the first half of the year as authorities attempted to rein in surging credit fuelled by abundant money supply. Liquidity has been generated by central bank intervention to neutralise the impact of foreign capital inflows on the renminbi exchange rate. The huge investment cycle implemented since 2002 has aggravated the existing problems with excess capacity in the economy while threatening to create a fresh generation of non-performing loans (NPLs) in the financial system.

Growth Concerns Intensify

Yet, the real subtext of monetary easing has been the intensifying concerns over the growth outlook. The real economy has begun to manifest signs of cooling in recent months. The economy slowed more sharply than expected in the third quarter, as gross domestic product (GDP) in real terms expanded 9.0% year-on-year, decelerating from the 10.1% gain recorded in the second quarter. It stood as the slowest rate of expansion since 2003 and marked a continued retrenchment of growth from its expected peak in the second quarter of 2007. Growth has been circumscribed by a weakening of net exports and by the collapse of the country's real estate bubble, which has contributed to a sharp drop in demand for cement, steel, and other construction materials.

The steady weakening in export growth witnessed since the third quarter of 2007 is expected to intensify markedly, as the global economic ramifications of recent financial market instability intensify. The G3 economies of the United States, Europe, and Japan are now in a synchronised downturn, and account for over 50% of China's total exports. Export growth is expected to slow drastically in the closing stages of 2008 and through 2009, as the G3 economies fall into serious recession. Investment will be hit, as company earnings atrophy, while concomitant rising unemployment and stalling income growth will further inhibit consumer spending growth. The monetary easing cycle is also aimed at protecting the profit margin of Chinese companies, especially small and medium-sized firms. IHS Global Insight's current baseline forecast calls for growth to slow to 7.3% in 2009 from 9.4% in 2008, although risks remain weighted very much to the downside.

Outlook and Implications

Further monetary easing is expected. Growth in China remains a highly-politicised issue with an annual rate of 7.0% highlighted as necessary to absorb the shocks of state sector restructuring and labour market growth. The stunning four-trillion renminbi stimulus package unveiled by the government for the final quarter of 2008 through 2010 is a further indication of central concern over the economy's outlook and the potential socio-economic implications. The government has also increased the export tax rebate for an expansive list of industries, slashed the housing transaction tax, and expanded subsidies to the agriculture sector. The government also indicated that it will increase the credit available to the small- and medium-sized enterprises. The level of real interest rates is accentuated by recent marked declines in inflation. As food prices decline, latent deflationary pressures in the economy will reassert, eroding the pricing power of firms already operating on slim margins. IHS Global Insight expects inflation to decline to an average of 2.0% in 2009 from 6.1% in 2008. Subsequently, the PBoC is expected to continue lowering rates aggressively, while further administrative measures are likely to be implemented. However, while these actions will support the growth floor, China's outlook remains intimately entwined with developments globally and the timing of any pick-up in the G3 economies.