Abstract: The article points out the reason interest rate policy is given such great importance is that adjusting policy interest rates is a highly targeted measure to address the problem of insufficient aggregate demand with tremendous power. The article uses simple scenario analysis to see how powerful policy rate cuts would be and whether the various fears about the policy adjustment are tenable. It is estimated that if the policy rate was reduced to zero, interest expenses for the household, non-financial business, and the broad government sectors would fall by 1.48 trillion, 3.22 trillion, and 2.4 trillion RMB, respectively, totaling 7.1 trillion RMB for the whole society.
The challenge of China’s economy is weak demand. Macroeconomists’ main prescription for addressing this issue, is loose monetary policy. In practice, central banks would lower policy rates and adopt quantitative easing. Based on the outcome of their practice, countries such as the US, Europe, and Japan have gradually emerged from the conundrum of insufficient demand through accommodative monetary policy and realized relatively full employment and robust economic growth.
Interest rate policy is given such great importance because adjusting policy rate is a highly targeted measure to address the problem of insufficient aggregate demand and has tremendous power. Lowering policy rates leads to a decrease in the overall cost of financing in society, a decline in savings deposit rates, and an increase in asset valuation, impacting every economic entity. Enterprises and households with debts, or loans for investment and consumption will benefit from it; savers who are unwilling to spend money and prefer to keep it in banks rather than invest in equity assets will suffer losses. Policy rate adjustments not only use the price lever to encourage investment and consumption while curbing savings but also swiftly increase the leverage of debtors and investors, enabling them to have money for investment and consumption.
However, domestically, interest rate policy receives widespread suspicion and concern. There is skepticism regarding whether interest rate policy can effectively boost demand, and whether the policy can be smoothly transmitted or not, especially considering the weak sentiment of private investors and other structural issues. There is also concern that lowering interest rates may severally weaken the RMB and hit the banking sector.
Perhaps it is these suspicions and concerns that have led to a very limited adjustment in the policy rate over the past three years in response to China’s downward economic pressures. During the period of an economic downturn in 2015, China took ten interest rate cuts, with a cumulative reduction in the policy rate of 185 basis points. Since the outbreak of the Covid-19 pandemic, China has lowered the policy rate a total of three times for a cumulative reduction of 55 basis points. If we look at the real interest rates, despite sharply rising willingness to save and falling willingness to invest since the pandemic, real interest rates are not lower than the pre-pandemic levels. Since real interest rates have not been sufficiently adjusted to help fill the savings and investment gap, weak demand is still a pressing issue.
We can roughly estimate the change in the real interest rate by subtracting the year-over-year growth rate of core CPI from the weighted average interest rate on RMB loans to financial institutions. In the first quarter of 2023, China's real interest rate was 3.64%, only 0.4 percentage points less than in the fourth quarter of 2019.
The article cannot provide answers to these doubts and fears about interest rate policy. The main purpose here is to use simple scenario analysis to see how powerful policy rate cuts would be and whether the fears about the policy adjustment are tenable. The scenario analysis makes some assumptions based on experiences, and in general, takes a conservative side which would allow us to see the least magnitude of impact lowering interest rate would have.
I. INTEREST EXPENSE WOULD DECREASE BY 7.1 TRILLION RMB
According to data by BIS, by the end of Q3 2022, the debt level of China’s non-financial sector reached 335 trillion RMB. By form of debt, RMB loans accounted for the largest share of 64%, equivalent to 224 trillion RMB; government and corporate bonds accounted for about 26%, amounting to 94 trillion RMB. Other forms of debt represented around 10% of the total.
By sector, the debt level of the household sector, non-financial business sector, and government sector reached 74 trillion, 190 trillion, and 91 trillion RMB, respectively. The BIS data significantly underestimate the size of China's government debt in a broad sense because the debt of some local government financing vehicles (LGFVs) was counted in the non-financial business sector, which is widely considered to be the government's hidden debt and falls under the broad government sector. After adjustment, the size of the household, non-financial business (excluding LGFVs), and broad government (including LGFVs) debt was about 74 trillion, 161 trillion, and 120 trillion RMB, accounting for 22%, 45% and 33% of total debt, respectively.
In practice, policy rate refers to the central bank's overnight lending rate to the financial system, which is the 7-day reverse repo rate in China’s system. It is assumed that there is full transmission between the policy rate and the cost of debt, i.e., if the policy rate falls by 1%, the cost of debt will also fall by 1%. The current 7-day reverse repo rate of 2% (editor's note: on June 13, the 7-day reverse repo rate dropped to 1.9%), a drop to 0 is a decrease of 2 percentage points. Combined with the distribution of debt by sector, interest expense for the household, non-financial business, and the broad government sectors will fall by 1.48 trillion, 3.22 trillion, and 2.4 trillion RMB, respectively, totaling 7.1 trillion RMB for the whole society.
From China's past experience of lowering the policy rate, a lower policy rate tends to lead to an even greater decline in lending rate, meaning that a 2% cut of the policy rate would lead to a more than 2% drop in lending rates, further reducing the interest expense of the household, business and the government sectors.
Reducing the policy rate to zero is a very clear and strong signal to expand demand, which will significantly impact the expectations of current market participants and change their consumption and investment behavior. This implies changes in many of the indicators on which our calculations are based. The impact of lower interest rates on the economy and asset prices is likely to be nonlinear. In the case of sharp rate cuts, the conclusions of many of the following calculations may be more conservative than optimistic.
II. BALANCE SHEETS WOULD BE IMPROVED
Lowering the policy interest rate can improve the balance sheets of households and businesses by increasing asset prices. A drop in the risk-free interest rate can directly boost the valuation of risky assets. The decrease in interest due to lower policy interest rates is equivalent to an increase in the net profit of non-financial enterprises, which can also lead to a rise in stock prices.
At the end of 2008, the Fed lowered the benchmark interest rate to zero, and in the following year, the valuation of the S&P 500 rose from 11.5 to 14.5, an increase of 26%. According to the past elasticity relationship of China's stock market index to interest rates, every one percentage point drop in the policy interest rate corresponds to an approximately 8% rise in both the price-earnings ratio and the stock index. Reducing the policy interest rate to zero could push up the stock index by 16%.
As of April 2023, China's stock market value is about 84.8 trillion yuan. Regardless of the boosted stock prices because of cash flow improvement, if decreasing policy interest rates can produce a 26% increase in stock valuation, the corresponding stock market value will increase by about 18.7 trillion yuan. If decreasing policy interest rates can produce a 16% increase in stock valuation, the corresponding stock market value will increase by about 13.6 trillion yuan. If we consider the cash flow improvement, the increase in stock prices will be larger, and the corresponding increase in market value will be even more. The same logic applies to other risky assets (such as real estate), which will also benefit from a significant decrease in the policy interest rate and directly improve the balance sheets of households and businesses.
The household sector as a whole is a net savings sector, but there are significant internal differences. It can be divided into two groups: net savers and net debtors. Net savers are mainly high-income individuals and retirees who are the main holders of fixed deposits, wealth management products, and various funds. Net debtors are mainly young and middle-aged individuals whose main debts are mortgages.
The effect of lowering the policy interest rate on the household sector is differentiated. The main beneficiaries of lower debt costs are middle-aged and young individuals with debts and families with mortgages. At the same time, deposit interest rates, wealth management returns, and money market fund returns will also decrease, and the main sufferer of the loss will be net savers. A considerable proportion of net savers also hold a large amount of risky assets. The rise in the price of these assets will largely offset the loss of interest income.
As of April 2023, the fixed deposit scale held by Chinese households was about 92 trillion yuan, wealth management products about 24 trillion yuan, money market funds about 7 trillion yuan, and directly held stocks about 44 trillion yuan. Assuming the return rate of deposits, wealth management, and money market funds also falls by two percentage points, the interest income of the household sector will decrease by about 2.4 trillion yuan. The main sufferer of the loss will be net savers. However, the increase in stock valuation can increase the value of the stocks held by the household sector by about 7 trillion to 11.4 trillion yuan. This part of the gain is also mainly enjoyed by net savers.
Both businesses and the government are net debt sectors, and a zero interest rate significantly reduces the debt burden for both.
With the zero interest rate, investors and consumers willing to incur debt are positively incentivized, and the risk asset investors are encouraged, while those negatively affected are savers who are unwilling to invest in risky assets. Encouraging investment and restraining savings is precisely the main mechanism of interest rate pricing to expand total demand.
In conclusion, after the policy interest rate drops to zero, the balance sheets of all sectors will improve because of improved cash flows and asset appreciation driven by rising asset prices.
III. THE IMPACTS ON BANKS ARE MIXED
In the first scenario, changes in the benchmark interest rate can be transmitted to both the deposit and loan ends equivalently, so the bank's interest spread will hardly be affected. In this case, we don't need to consider the negative impact on banks.
In the second scenario, as the changes in deposit interest rates are not as flexible as those in loan interest rates, the bank's interest spread will narrow, and bank profits will be affected. But at the same time, we should see that at lower interest rates, the credit demand from private investment will rise, offsetting the decline in bank profits to some extent. Due to the increase in overall demand level and the resulting improvement in the cash flow of enterprises, residents, and the government, the non-performing loan rate of banks will decrease. And the asset valuation held by banks will rise, which is also good news for banks. If the government's debt interest expenditure can decrease by 2.4 trillion yuan due to a significant reduction in interest rates, then the debt pressure in a considerable number of regions will be greatly relieved. The asset quality of small and medium-sized banks will be significantly improved, which enhances rather than weakens the stability of banks and the financial system.
If interest rates drop and the China-U.S. interest rate spread widens, does it mean that the RMB exchange rate will depreciate? Firstly, based on past experience, this may not be the case. The China-U.S. interest rate spread is a factor that affects exchange rates and capital flows, but the domestic economic fundamentals are a more important factor. The influence of the China-U.S. interest rate spread on the exchange rate is not that significant. The experience of the past few years has fully demonstrated this point. As the China-U.S. interest rate spread turned to negative from positive, the RMB exchange rate did not depreciate significantly. By lowering interest rates, improving domestic economic fundamentals, enhancing investor confidence, and increasing the demand for the RMB, RMB may not have to depreciate.
Secondly, even if the RMB depreciates, is it a minor or major depreciation? A minor depreciation is beneficial to exports and expanding demand and may not be a bad thing. Will it be a major depreciation? China has a huge trade surplus and does not have high inflationary pressure. If the RMB faces huge depreciation pressure, it is not because of the interest spread but because of serious problems in China's economic fundamentals or even more serious problems in China-U.S. relations. Cutting interest rates to improve economic fundamentals is precisely to protect the exchange rate, not to put pressure on it.
This article was published on CF40’s WeChat blog on June 13, 2023. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations. It is translated by CF40 and has not been subject to the review of the author himself.
