The loose liquidity approach of China’s central bank since early 2014 has guided the country’s short-term rates lower. But long-end rates, which are more important for corporates’ borrowing and investment activities, are still too high, in our view.
Moreover, with disinflationary pressure intensifying, real rates risk rising higher. Consumer-price inflation has stabilised at a low level and producer prices have been contracting for two years. The risk of deflation is thus increasing, and that is as worrying as softer real growth.
High interest rates have depressed private sector investments and made the Chinese economy ever more reliant on policy support
The Chinese economy has probably seen more volatile periods but such sustained disinflation is unprecedented and looks set to continue. The uncertainty has now shifted from the known risk of a growth slowdown to the unknown risk of deflation.
Given that the nominal five-year bond yield has increased by around 30 basis points this year, it means China’s real five-year interest rate for corporate borrowing has increased by almost 1 per cent or 100 basis points, with disinflation contributing 60 basis points to the overall increase in real borrowing cost.
The real economy can ill afford a combination of high nominal rates and deflation risk. The difference between corporate returns and cost of funding has sharply narrowed since 2011. Indeed, the break-even threshold may well have been crossed. In other words, the cost of funding is now higher than the Chinese operators can bear. High interest rates have depressed private sector investments and made the Chinese economy ever more reliant on policy support.
Debt dynamics is also a delicate balancing game. Debt in the Chinese economy is around 200 per cent of GDP – mostly corporate borrowing. With 3 per cent inflation, 7.5 per cent growth and the nominal interest rate at 6 per cent, the debt ratio could fall below 170 per cent in just five years.
But if the risk of deflation becomes real and growth slows to 6 per cent, debt-to-GDP could rise to almost 230 per cent in five years. Worse, if investors are slightly more nervous and the nominal rate rises to 7 per cent, the ratio could top 250 per cent. The current combination of slower growth and disinflationary pressure could increase the debt burden and turn a cyclical problem into a structural one.
With all eyes on China’s reforms and its debt pile, it is easy to forget how important growth can be. But appropriate easing can help revitalise private investment, which is the best antidote to the depressing effect of deleveraging in other parts of the economy. It will also help the economy work off its debt more quickly.
What can the People’s Bank of China do? Lots of ideas have been floated. We think that targeted cuts in banks' reserve ratios would be most appropriate. The key is to adopt a proactive stance to bring down the long-term cost of funding, which will benefit both growth and debt management.
This research was first published on 5 May 2014.