Markets cheered China's surprise rate cut that was announced last week, as lower borrowing costs should stimulate fixed-asset investment, which has been faltering in recent months. But the market’s enthusiasm overlooks a critical point: China hardly suffers a lack of investment. In fact, China's problem is just the opposite: too much investment.
Recharged investment outlays might boost headline gross domestic product, but it will also exacerbate excess capacity throughout the economy and add to the country's growing pile of bad debt. Long-term-focused investors should be concerned about Beijing's unwillingness to endure the short-term pain that it will take to put the economy onto a more sustainable growth trajectory. Another shot of whiskey will ultimately make this hangover worse.
The November 21 announcement from the People's Bank of China, or PBoC, included three changes. First, the central bank cut the one-year benchmark lending rate by 40 basis points to 5.6% from 6%. Second, it cut benchmark one-year deposit rates by 25 basis points to 2.75% from 3.0%. Third, it lifted the deposit rate "ceiling" banks are permitted to offer to 1.2 times the benchmark rate from 1.1 times. This had the effect of holding the deposit rate ceiling steady at 3.3%, despite the cut to the benchmark deposit rate.
Judging by the surge in share prices, particularly in the basic materials sector, the announcement seems to have taken the market by surprise. Mining stocks, among the most leveraged to Chinese fixed-asset investment, are soaring. Miners with the heaviest exposure to the construction side of the economy and those with the greatest debt burden are enjoying the biggest bump.
We're also surprised by the move. Public statements by President Xi Jinping and Premier Li Keqiang had signalled a willingness to endure weaker growth in a bid to transition away from the investment-led economic model. Just as importantly, Xi's consolidation of power and elimination of rivals put him in a stronger position to cope with elite discontent that will inevitably accompany such a transition.
Rate Cut Will Have a Mixed Impact on Consumer Spending
What will the rate cut mean for household consumption? Not much, in our view.
Lower deposit rates affect the decision to save or consume in two ways. On one hand, getting paid less to save discourages thrift and promotes consumption. On the other, getting paid less to save mean that households must save more in the near term to meet long-term savings goals. In drier economic terms, the former is the substitution effect, while the latter is the income effect.
Generally, in rich countries with robust social safety nets, well-developed consumer finance, and a broad array of investment options, the former effect dominates, so rate cuts spur consumption. But in poorer countries like China, academic research has found that the opposite is true. As a result, the deposit rate cut may prompt households to save more and consume less.
However, there could be an indirect positive and offsetting effect on household consumption. If the rate cut puts a floor under falling real estate prices – prices dropped in 69 of China's 70 largest cities in October – consumer sentiment around the real estate market could take a turn for the better. Because real estate accounts for roughly 60%-80% of urban household wealth, improving sentiment would have a meaningfully positive impact on consumer willingness to spend.
