China cuts rates
24 November 2014
The collapse of the cost of capital (the interest rate) has mostly been a developed world phenomenon. China and other developing economies have had comparatively 'normal' interest rates. China, by fixing its currency to the $US has been able to avoid the kind of currency volatility that has hit the $A, which has been in part the result of Australia's higher interest rates.
So China's decision to cut rates is of great significance to what is happening in the global economy. It suggests that even the burgeoning economies that are in an industrial, rather than post-industrial, phase are seeing a lowering cost of capital.
The AFR reports:
"China's leadership and central bank are ready to cut interest rates again and also loosen lending restrictions, concerned that falling prices could trigger a surge in debt defaults, business failures and job losses, said sources involved in policy-making.
Friday's surprise cut in rates, the first in more than two years, reflects a change of course by Beijing and the central bank, which had persisted with modest stimulus measures before finally deciding last week that a bold monetary policy step was required to stabilise the world's second-largest economy.
Economic growth has slowed to 7.3 per cent in the third quarter and policymakers feared it was on the verge of dipping below 7 per cent - a rate not seen since the global financial crisis. Producer prices, charged at the factory gate, have been falling for almost three years, piling pressure on manufacturers, and consumer inflation is also weak.
"Top leaders have changed their views," said a senior economist at a government think-tank involved in internal policy discussions.
The economist, who declined to be named, said the People's Bank of China had shifted its focus toward broad-based stimulus and were open to more rate cuts as well as a cut to the banking industry's reserve requirement ratio (RRR), which effectively restricts the amount of capital available to fund loans.
China cut the RRR for some banks this year but has not announced a banking-wide reduction in the ratio since May 2012."
Economic growth in China is still at stellar levels -- 7% -- so there is good reason not to over react. And an interest rate of 5.6% is very much within the 'normal' range. China also has an economy too skewed to investment and not enough towards consumption. Lowering interest rates may be an attempt to make Chinese consumers spend more.
But there are a number of implications for DIY super investors. One is that a slowing China will probably add impetus to declining commodity prices, which will adversely affect the Australian economy, and $A. The opportunity to invest offshore, taking advantage of a high $A, may be short lived.
Another is that the declining cost of capital around the world implies that investors should not expect high returns any time soon. If the cost of capital is low, its corollary is that the expectations for investment returns are also low. This is not an era that favours investors, the holders of capital.
Goldman Sachs interprets the move as "policy liberalisation", which is doubtful. China has gained great protection from fixing its currency to the greenback, which it is not about to give up by floating the currency. "Liberalisation" is very limited:
Thus the move itself is unlikely to have a big direct impact on the economy. But the indirect effects could be meaningful because today’s move sends a very clear signal to the market on policy intention. When the government intends to loosen its macro policy stance, it typically uses a range of policy tools instead of relying on just one or two. Full RRR cuts face a higher hurdle as they have more substitutes such as targeted RRR cuts, relending and its equivalents (PSL, MLF etc.). We expect the government to step up fiscal expenditure allocation and add more pressure on local government to act to support the economy, especially via speeding up infrastructure construction. These measures were the key in the growth rebound in 2Q of this year and will likely to be supportive of growth again in the rest of the year.
The upshot is not likely to be massively significant for Australian investors. But it may imply a weaker $A and a weaker Australian economy. And it is a further sign that things remain tough for investors in the global economy.