The People’s Bank of China (PBoC) lowered interest rates on Sunday to 5.1%. The 0.25% cut is the third time they’ve reduced rates in the past six months.
This matters to Australia because the health of the Chinese economy directly impacts our own fortunes. The latest rate cut further cheapens the cost of credit. This in turn will increase business and consumer borrowing — and spending.
That means Chinese consumers will buy more of everything, from cars to houses. It should also lead to businesses investing in more infrastructure projects.
And that’s where Australia comes in. The Australian economy is highly dependent on Chinese demand for our commodities. We specialise in exporting raw materials (like iron ore) that China uses to construct their nation. The more that China invests in infrastructure and housing, the better off we are.
Exports make up a large percentage of the Australian government’s revenues. These revenues then trickle down to the rest of the economy through government spending. In 2014 income tax accounted for 70% of government revenues (and much of it is down to exporters). That makes China’s commodity demands crucial to the health of the Aussie economy.
What the rate cut tells us about the PBoC’s outlook for the Chinese economy
The interest rate cuts are a good indication for how the PBoC see China’s economic future. According to The Daily Reckoning Feature Editor Tim Dohrmann, it provides us with key insights into what China’s powerbrokers are thinking.
The first is that they’re still concerned about the slower GDP growth. Evidently there is a need for the PBoC to increase spending activity in the market. The growth rate for 2015 is projected at 7%. But that’s down on last year’s 7.4% rate. And it’s well below the 10% growth rates seen as recently as 2010.
By any measure the Chinese economy is still growing at a rapid rate. You won’t find 7% growth rates in much of the rest of the world. But even this doesn’t change the fact that the Chinese economy is heading for its worst year in 25 years.
Both the PBoC and the Chinese government have talked about the need for consumers to offset lagging exports to lift the economy. Balance of trade data is the big worry here.
China’s trade surplus has plummeted since the start of the year. The balance of trade for both January and February was above US$600 billion. But in March it was a paltry US$30 billion. April saw a huge improvement (US$341 billion) but the surplus is still well below the start of the year.
The trade data puts even more pressure on consumers to spend. The PBoC is banking that the rate cuts will be enough to prevent the economy from dipping below 7% GDP growth this year. But even if it doesn’t prove to be enough, the interest rates can go much lower.
Why interest rates will continue to fall in China
Tim says that China’s low 1.5% inflation rate will give them breathing room for further interest rate cuts in the future. He expects to see rates lowered further this year. Some economists believe that rates may hit a recent low of 2% again in the coming years.
But the PBoC have lots of room to go lower. The current interest rate is still much higher than the historical average. Even as recently as 2011 China had a negative real interest rate (-1.2%). Negative rates are just a central bank’s desperate way of trying to convince commercial banks to borrow more money. So the PBoC aren’t concerned about lowering it from its current 5.1% level. And they have every good reason to send rates lower.
Central banks around the world have been doing exactly that to boost their national economies. This recent trend is based on the idea that lower rates lead to an increase in exports. Compared to the Eurozone (which has negative interest rates), the PBoC will feel that they have scope to give the economy whatever lift it needs by lowering rates in the next few years.
Why Chinese banks are less upbeat about the interest rate cuts
Interest rate cuts will only achieve their purpose of increasing money in the economy if the banks follow the PBoC’s lead in passing it on to borrowers. A Minsheng Securities economist says the rate cut won’t have as big an effect as expected. Even though the interest rate has been cut by 0.65% in the past six months, the actual borrowing costs are only marginally lower.
Bank profits hit a six year low in the first quarter of 2015. The rate cuts of recent months have only hurt bank profit margins. And there are suggestions that bad loans are piling up at banks. That’s why they’re more hesitant about passing on the full cuts to borrowers. More lending at lower interest rates will only squeeze profits further.
The PBoC knows this. They’ve already admitted that lenders will only partly pass the latest rate cut down to borrowers. But the broader effect of the lower rates should still result in more borrowing and spending. And it’s probably not the last we’ll see of it this year.
All of this is further proof that the PBoC is set to continue its monetary easing program in the future. The Daily Reckoning’s Contributing Editor, Phillip J. Anderson, has been writing for years that China’s boom is only beginning. They have plenty of room to lower rates to boost spending in the economy. That’s why Phil doesn’t share the media’s pessimism about China’s economy.
Phil wants to show how you can profit from the media’s ignorance. He says now is the best time to invest in China, as cheaper money continues pushing up Chinese real estate and equities. To find out how to download his report, ‘The Cassandra Syndrome: After This Report, You Won’t Worry About China Again for Another Decade’, click here.
Contributor, The Daily Reckoning