Abstract: In this paper, the author states that the Chinese economy is faced with insufficient demand, featured by the sluggish recovery of consumption and insufficient investment. The author believes China needs to adopt price-based measures, that is, lower interest rates, to solve the problem of insufficient demand. In the face of market worries, the author also clarifies that lowering interest rates will not necessarily lead to renminbi depreciation. On the contrary, improving economic fundamentals through rate cuts will prop up the renminbi exchange rate.
After the end of the pandemic, the economy recovered significantly in the first quarter. However, the inflation level has remained low, with CPI and core CPI growth at only 0.7%. However, the unemployment rate is still high. The unemployment rate of youth aged 16-24 has reached 19.6%, and the wage growth rate of migrant workers is only 1.5%.
In general, sluggish prices, weak labor market, and low economic growth reflect that the current economy is in a typical situation of insufficient demand.
Insufficient demand can be reflected in two aspects. The first is the weak recovery of consumption. The recovery of consumption depends on two aspects: the first is the disposable income of residents. In the first quarter, the disposable income of urban residents increased by 4%, which is far lower than the growth rate before the pandemic; the second is the consumption tendency, which refers to spending at a given income level. In the first quarter, the average consumption tendency of urban residents was 57% (57 yuan for 100 yuan in disposable income), which was lower than the pre-pandemic level of 62%, and was not improved significantly than that during the pandemic.
The second is insufficient investment, especially the slower growth rate of private investment, which was only 0.6% in the first quarter. Private investment is the most important engine for creating new jobs and increasing productivity. Economic recovery will be difficult to sustain if private investment does not recover.
How to expand consumption and investment and increase demand? Underconsumption equals oversaving. In other words, how to reduce savings and increase investment?
The market economy should rely on price-based measures to solve problems. The corresponding price-based measure is to lower interest rates to reduce savings and increase investment. By lowering the policy interest rate, the central bank transmits a signal. It drives down various deposit and loan interest rates and bond interest rates, thereby playing the role of encouraging investment and reducing savings.
Lowering interest rates can expand investment and consumption through multiple channels, not only reducing debt costs but also increasing asset valuations, causing appropriate currency depreciation, reducing government debt pressure, and increasing fiscal spending space, etc. Based on historical data, we roughly estimate that a 100 BP reduction in the policy rate can save residents, enterprises and the government 1 trillion yuan in cash flow and bring about 1.2 percentage points of GDP growth.
There is a lot of concern that lowering spending rates will not be effective. From international experience, as long as the interest rate is low enough, it is still useful to expand demand. The United States and Europe have achieved employment goals and desirable economic growth through low-interest rate policies. Japan has emerged from the lost decade with extremely low interest rates. If corporate loan, bond, and mortgage interests in China are reduced by half or more, housing and asset prices will be propped up, and stock prices will rise. Can all these results improve our balance sheet and have any effect on consumption and investment?
Recently, the market has been concerned that the M2 growth rate in the first quarter was very high, but the economy did not seem to perform as well as expected. Is monetary expansion ineffective?
Two clarifications are needed here.
First, monetary policy in the first quarter was not loosened. In the first quarter of this year, the growth rate of M2 was 12.7%, a high point in the past five years, but the growth rate of social financing in the first quarter was 9.9%, which was a low point in the past five years. Social financing data show that borrowing and lending in society don’t increase. Why? Urban investment platform companies used to rely on bond issuance for financing, which would increase social financing, but not M2. Recently, they have relied more on bank loans instead of bond issuance for financing, which will increase M2, which does not produce extra social financing.
Second, the money released at the moment cannot generate sufficient demand expansion. The standard way to create demand through bank loans is to lower interest rates so lenders can afford to borrow money. After receiving the funds, lenders need to consume to generate demand and form the next round of income growth. However, in reality, we have not lowered interest rates universally but let banks lend to some industries at lower interest rates. In contrast, loan interest rates may still be high for other industries. The problem with this approach is that many companies that enjoy preferential loan interest rates may not be willing to expend money after receiving loans. In particular, the expansion of investment in manufacturing companies will not be based on temporary loans but on longer-term considerations. Even some companies that receive low-interest-rate loans will deposit them again to earn interest margins. Meanwhile, many companies and individuals willing to spend are left out due to the price of funds. This credit and monetary growth do not work as effectively as they should for demand expansion.
Another concern is what will happen to the exchange rate after the interest rate is lowered.
First of all, if the interest rate is lowered, will the RMB exchange rate definitely depreciate? Based on past experience, it may not be the case. The China-US interest rate differential is a factor that affects exchange rates and capital flows, but more important than that is the domestic economic fundamentals. The China-US interest rate differential has turned from positive to negative in the past few years, but the RMB exchange rate has not depreciated significantly. This shows that the impact of the China-US interest rate difference on the exchange rate is not that significant. By lowering interest rates and improving the fundamentals of the domestic economy, the RMB may not necessarily depreciate.
Second, even if the RMB depreciates, would it be a small or a large depreciation? A small depreciation would benefit exports and expand demand, which may not be a bad thing. Would it be a large depreciation? China is a trade surplus country without high inflationary pressure. If the RMB faces huge depreciation pressure, it is probably not because of interest rate differentials but because of serious problems in China's economic fundamentals or new issues in China-US relations. Lowering interest rates to improve economic fundamentals is precisely a way to protect the exchange rate without bringing pressure on it.
Monetary authorities often advocate that more price-based measures should be taken to guide the market, which is very important. By taking more price-based measures to solve the problem of insufficient demand, we can reduce the dependence on non-price-based measures, and both policy effects and policy costs will perform better.
