China made a surprise move to cut the cost of capital for businesses and reform its creaking approach to setting interest rates, a shift that signals the depth of concern among leaders about the unfolding European crisis and its impact on China's economy.
The People's Bank of China moved on Thursday to cut the benchmark interest rate for savers and borrowers by a quarter of a percent. The cut, which takes the one-year lending rate to 6.31%, is the first since December 2008, and aims to reduce the cost of borrowing across the economy, pushing investment and growth higher.
Markets around the world cheered the move. The Australian dollar, which is highly sensitive to Chinese demand for raw materials, rose by 0.3% against the U.S. dollar when the move was announced. Stock markets in Europe and the U.S. rose, though Wall Street pared its gains after U.S. Federal Reserve Chairman Ben Bernanke stopped short of signaling new stimulus measures in a testimony to Congress.
Meanwhile, global commodity prices from soy beans to oil all moved higher after China's rate cut, which follows a swathe of data that signaled fading growth both in China and abroad. China's industrial output growth in April disappointed at 9.3%, down from 11.9% in March and the lowest level since the financial crisis. In the U.S., May jobs data disappointed, and the unemployment rate rose to 8.2%.
A spiraling debt crisis in Europe—China's biggest export partner—is also weighing on leaders' minds. China's exports to Europe contracted 2.0% in the first four months of the year. Lou Jiwei, the head of China Investment Corporation, China's sovereign-wealth fund, thought there could be worse to come. "There is a risk the euro zone may fall apart and that risk is rising," he said.
The move came just 10 days ahead of a Group of 20 meeting scheduled for June 18-19 in Mexico, expected to focus on encouraging European leaders to take bolder steps to calm the crisis. Eswar Prasad, an economist at the Brookings Institution, said that China's pro-growth move could shift the debate on Europe.
"China's move increases the pressure on European leaders to emphasize growth-promoting measures and ease the focus on short-term fiscal austerity. This strengthens the hand of the International Monetary Fund, the U.S. and others who have been calling for Europe to do more to support growth" he said.
Louis Kuijs, China economist at the Fung Global Institute, said the interest-rate cut "removes some of the stress on the hardest hit parts of the Chinese economy like real estate; it also signals that China's policy makers are serious about supporting growth."
In parallel with the rate cut, China's central bank also announced reforms to the way interest rates are set. Banks will now be allowed to offer interest rates to depositors equivalent to 110% of the benchmark deposit rate—now 3.25%, and make loans at 80% of the benchmark lending rate.
Under China's old system for setting interest rates, banks had zero flexibility to offers depositors rates above the benchmark, while lending rates were only allowed to go down to 90% of the benchmark lending rate. The changes effectively mean that the maximum deposit rate will rise to 3.58% from 3.50% earlier, while the minimum lending rate will fall to 5.05% from 5.90%.
Mr. Prasad saw this as a victory for China's reformers. "Reform-minded officials are taking advantage of political and economic circumstances to push forward financial and other reforms. Giving banks more flexibility in setting rates above or below the official benchmark rates on both loans and deposits is a significant step toward the ultimate goal of interest-rate liberalization," he said.
The old approach to setting rates—a system that shovels cheap capital from household savers to state-owned enterprise borrowers, with a wide margin in between for bank profitability, has been the linchpin of China's financial system and growth model for the last thirty years. But critics say that the costs have begun to outweigh the benefits.
Low returns to savers, with deposit rates that are below the level of inflation, depress household income. The result is lower levels of consumption, and bubbles in the real-estate and equity markets as savers exit the banking system in search of higher returns. Cheap capital for borrowers has resulted in runaway investment, with the attendant problem of industrial overcapacity.
Investment's share of gross domestic product soared to 49.2% in 2011, up from 36.5% a decade earlier. The share of household consumption fell to 34.9% from 45.3% over the same period.
Thursday's move appears to be a compromise between the immediate need to support growth, and the equally pressing need to reform the system. Allowing banks to offer deposit rates above the benchmark means household savers could now receive slightly higher returns on their savings than before the rate cut.
In most economies, higher deposit rates would give consumers an incentive to save more, but in China that is not necessarily the case. Due to the country's weak social safety net, many Chinese save out of caution, for fear that they could fall ill or lose their jobs. Analysts say a higher return on their savings means households have to squirrel away a smaller sum to hit their savings target, freeing up more resources for consumption.
The losers are China's banks. A narrower spread between lending and deposit interest rates eats into the interest margin that is their main source of profitability. For Industrial & Commercial Bank of China, China's biggest bank by assets, the interest margin accounted for 77% of income in 2011. Thursday's move threatens to take a significant bite out of that.
Lowering the cost of capital for borrowers also comes with a price tag attached, risking reinflating China's house price bubble, and exacerbating the economy's unbalanced reliance on investment as a source of growth. Wang Qinwei, China economist at Capital Economics, said "There could be no stronger signal of the government's commitment to growth than this, but another round of stimulus will make the economic structure worse not better."
