Abstract: Monetary policy is only effective when it can increase the willingness and capability of businesses and residents to borrow. The first step for China's central bank to stimulate credit demand is to lower interest rates, which has the potential to lower the cost of borrowing, increase asset valuation, and boost investment and consumption.
The central bank does not simply release money and expect everything to work out on its own. It gives money to commercial banks, which lend it to businesses and residents, who use the money for business operations or consumption. But to stimulate demand, the central bank has to use monetary policy to encourage the willingness to borrow and ensure that loans are available at low rates. It is not a simple matter of expanding base money (net money injection in the open market) or banks lending money to customers and businesses (increasing credit and social financing).
The credit data for January appears to be encouraging, but it should be interpreted with caution. With supply shocks receding and a lack of demand becoming the major impediment to economic performance, the monetary authorities must act. Did the increase in corporate and consumer credit demand drive credit growth in January? Credit expansion, at least in China’s experience, is not sustainable in the absence of real estate and infrastructure investment. It is possible that the increase was caused by the central bank pumping money into commercial banks, which had a strong willingness to lend to companies with good qualifications, who then borrowed a lot of money to keep their relationship with the banks. If the money remains on the books rather than being used for business activities, actual demand will not rise, even though credit and social financing figures appear to be surging.
Monetary policy will only work when it makes businesses and customers willing and able to borrow. But how exactly? Giving more money to commercial banks is not a solution; commercial banks have got enough money. Pushing commercial banks to lend isn't the point; to maintain credit quality, commercial banks seek out quality customers who are not cash-strapped and may not increase their spending with the money. Monetary policy should aim at reducing the cost of financing, or at the very least, lowering interest rates.
How can there be more demand for credit? Take a look at what other central banks are doing. The first step is to lower the cost of money?—to lower interest rates so that businesses can afford loans. That's why many developed countries have reduced their interest rates to zero. But what if businesses and residents are still reluctant to borrow? The next step is for the monetary authorities to purchase risk assets in order to reduce the risk premium. The cost of borrowing is the sum of the risk-free rate and the risk premium; if zero risk-free rate doesn't work, the risk premium should be reduced as well. What if none of these things works? In the third step, monetary authorities can issue forward guidance informing businesses and residents that financing will be cheap for a long time ahead, allowing people to borrow and spend with confidence.
Interest rate cuts can significantly reduce the cost of borrowing. In China, the total debt of the government, corporate (including platform companies), and household sectors has exceeded RMB 310 trillion. A 100 bps reduction in the interest rate could save them approximately RMB 3 trillion in debt interest payments. Meanwhile, rate cuts could increase asset valuation. Both will provide a big boost to investment and consumer spending.
Credit demand from businesses and residents is stifled by high interest rates. The question of whether the interest rate is too high or not cannot be answered in comparison to other countries or the past, but rather to whether it is appropriate for the current state of the economy. Furthermore, consider not only the nominal but also the real interest rate. Since 2012, both economic growth and return on capital have fallen, but real interest rate has risen rather than fallen because interest rate reduction is far smaller than inflation reduction. While the nominal interest rate decreases, the real interest rate increases. Real interest rates are not aligned with economic fundamentals, stifling private sector investment and consumer demand.
In China, monetary policy has a lot of leeways. Since the financial crisis, monetary policy practices of other countries have demonstrated that there is much more room for monetary policy than previously thought and that monetary authorities can invent new tools to lower the financing costs of businesses and residents, stimulate their investment and purchasing power, and thus boost economic vitality. With nominal interest rates in China currently well above zero, there is still plenty of conventional policy space, which is further cushioned by the innovative policy tools mentioned in the second and third steps above. Since economies with much weaker economic fundamentals than China, such as Japan, Europe, and the United States, all enjoy monetary policy space or can create some, China has even less to worry about.
This article was first published on CF40's WeChat blog on February 14, 2022. It is translated by CF40 and has not been reviewed by the author himself. The views expressed herein are the author's own and do not represent those of CF40 or other organizations.
