People’s Bank of China Cuts Interest Rates Sharply -Insights into Chinese Economics

Surprisingly, the Chinese central bank declared a sharp interest rate cut by 40 basis points on Friday, 21th Nov 2014. With the release of this news, a debate began over the prospects this might bring for the second largest economy. Theoretically, the government takes this action to reduce the cost of financing and to increase the liquidity within the market. However, behind the story, many believe that this is a clear signal that the Chinese economy is suffering from economic slow down after a decade of fast development.


The Current Problems with China’s Economy

Recent policy changes on interest rates and lending volumes show a clear indication of when the Chinese economy experienced difficulties. As is well known, economies are subject to highly cyclical evolvement. Together with the world economy, the most recent economic growth cycle started for China in 2003, a year after Hu Jintao became president. The lending volume increased sharply by 23% in 2003, while GDP began double-digit growth. When the financial crisis struck the world in 2008, the Chinese government launched a 4 trillion RMB economic stimulation plan to react to the negative impact from foreign markets. However, due to the incomplete financing system, most of the funds flew into infrastructure and real estate segments, which were mostly on a one-time basis that cannot be repeated. Since 2011, three years after the 4-trillion-plan, the effect of this stimulus has gradually diminished and the challenge of keeping up growth has emerged.


Three pillars support the growth of China’s economy: Export, Consumption, and Investment. By analyzing the current status of these three pillars, we can clearly understand the problems China faces:

  • Export

Similar to the path of many other Asian countries, China’s economic growth is greatly driven by exports. Under the background of “deindustrialization” in US and Western Europe, China gradually took over most low and medium-end manufacturing and became the “World’s factory.” However, this form of development was to some extent unsustainable because China has relied too heavily on low-income human labor and high environmental degradation. Recently, this has led to serious social problems.

Given the financial crisis in 2008 and the European crisis in the past two years, China’s export industry has struggled due to a decrease in external consumption. Another issue has been the gradual appreciation of Chinese RMB, which has appreciated from 8.6187 (to 1 USD) in 1994 to 6.1432 (to 1 USD). This appreciation has hurt the comparative advantage of Chinese manufacturing. As the statistics reveal, China has just experienced an exports slowdown in the third-quarter of this year. This slowdown has led to third-quarter GDP growth of around 7%, which fell behind the annual target of 7.5%.

  • Consumption

After the last financial crisis, changing the GDP growth pattern is the key strategy of the Chinese government. The government has clearly stated that pushing up the internal consumption rate is a top priority. With this clear goal in mind, the Chinese government has constructed many new economic policies, including an agricultural subsidiary, a medical care system reform, a agriculture tax cut, and a salary increase program. However, it takes time to observe how efficient these new policies will be. According to statistical data, the percentage of residential consumption to GDP was 46.4% in the year 2000. The number decreased to 33.8% in 2010 and then stayed in the range of 34%-35% for the following years. This data is telling us that if China wants to expand its domestic market, a reform in industrial structure will be required, and this is difficult accomplishment to make in short period of time. In addition, the country is now lagged by serious corruption and unbalance of income. There is still a long journey ahead for the government to solve all these issues, and push up the consumption.

  • Investment

Since the improvements of these other two pillars are difficult and time consuming, a quicker method of economic growth must be adopted. Investment in China is just that. More than 80% of economic scale is contributed by government related industry, which ensures the government’s ability of raising capital and investing into specific fields. In fact, this investment has been a vital part of China’s economy, especially in the last few years.  To better understand this investment, we divide the government’s investment activities into three main categories: manufacturing investment, infrastructure investment, and real estate investment.

Manufacturing Investment

Beginning in the late 90s with the reformation of state-owned companies, led by Prime Minister Zhu Rongji, China kept investing in the manufacturing industry as a result of demographic benefits. After the big boom for the past 10 years, the entire manufacturing industry is in a situation of overcapacity. The average facility utilization rate among all industries is only 70%. Take the steel industry as an example; the profit margin for each ton of production is only several pennies. It would be difficult to further increase investment in manufacturing.

Infrastructure Investment

As with the practice of the 4 trillion-plan, most of the infrastructure investments depend on government funding. However, the local governments are not money machines with unlimited capacity. In order to meet the huge capital needs for infrastructure investment, the local governments usually rely on issuing a variety of bonds in different forms. Funding the infrastructure investment through government credit seems practical in a short period of time, but it is unsustainable and risky in the long-term. On one hand, the general infrastructure projects, like railways and stadiums, are one-time investments and most of the major facilities have been built so far. Even if a need for infrastructure still exists in second-line or third-line cities, the scale of the investment will not be comparable to previous construction. On the other hand, the government’s credits vary from province to province. Actually, only several local governments like Beijing and Shanghai, which own deep pockets and political priorities, have good credit ratings. However, things seem different within other provinces. The local government of Shanxi Province defaulted earlier this year. The event clearly indicated that even for the government, credit is not unlimited. In conclusion, infrastructure investment seems to be an available way to drive GDP growth, but it is not as powerful as previous years have shown. Also, it is not sustainable enough for the long-term, and brings problems to government finance.

Real Estate Investment

Real estate investment used to be the key engine for China’s GDP growth in the past 5 years. However, this flourishing situation has disappeared. According to a recent industry report, the price of residential houses fell in 67 cities out of 70 in October. The slowdown in real estate has leads to many problems. First, many bank loans are backed with house property pledges. When real estate prices decrease, the bank will tighten the loan policy and decrease the lending. When capital supply decreases, the cost for company financing will increase, which leads to a further depress in industrial business. Second, government revenue will shrink sharply if the real estate industry goes into recession, because there are large portions of government revenue that come from real estate related taxes and land selling. Considering the large amount of the government debt all over the country at this time, if the real estate bubble someday collapses, the government would go bankrupt due to a incapability to accumulate consumption.

Conclusions and the Effect of Cutting Interest Rates

In conclusion, China is facing accumulated problems from exports, consumption, and investment. These difficulties will keep challenging the growth of China’s economy. However, it is still too early to conclude that China’s economy has fell into a predicament. After all, China is still the World’s fastest growing economic power with larger influence in global affairs. There are still many advantages that China could take to overcome these difficulties and lead to further and better development. First, the global crude oil prices keep falling, which China could benefit from by hedging with the increase in human costs. Second, some geographic political incidents that happened earlier this year provided China another choice of investment: resources. In May 2014, China signed a contract with Russia on the trade of natural gas, and the value of this contract was estimated to be nearly $400 billion USD. New input of resources will play a vital role in China’s industrial upgrade. Third, the new Chinese government, led by President Xi Jinping, has declared a war against corruption and dedicated to push the reformation in Chinese society. By optimizing social structure, upgrading the manufacturing industry, and encouraging technological innovation, there is still much confidence for the future development of the Chinese economy.

Though promising, there is still current issues that need to be dealt with. Cutting interest rates will have following positive impacts to the economy and help China to maintain its annual GDP growth target of 7.5%, but more must be done.

  • Restrain RMB appreciation and subsidy export. The value of RMB to dollar depreciated by 200 bp in one day after the announcement. In the long run, if the RMB keeps depreciation, it will definitely benefit the export industry and release pressure to those struggling in export enterprises.
  • Reduce borrowing cost for industrial companies. This is the most direct influence to the economy. With the interest cut, it will partially solve the problem of high borrowing costs to private business sectors and encourage the industrial investment.
  • Incentives for the real estate industry. Lower interest is definitely positive news to the real estate industry. A real estate site transaction achieved a deal at the highest price in local history in Guangzhou soon after the announcement published.



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