In November 2014, China’s central bank declared it will lower the interest by 0.4%. The modification is not large enough to imply a change of policy direction, however; it is still an effort to sour on the financial market and the real estate market, which are both believed to be two important areas to growth. A Xinhuanet journalist Liu (Nov.25, 2014) quotes the explanation from the state council press stating that this reduction may help solve the problem of high-cost financing. According to its statistics, the total financing amount in October 2014 was 2018 billion yuan less than last October. To preserve the growth rate, the central bank believes that it is necessary to increase liquidity and to maintain an active financing market as the year before.
This leaves two questions to be answered: firstly, how does one know in the first place that the financial market and real estate market need help? Secondly, how much can these two markets contribute to the growth rate and for how long? The first question is easier to answer, however, it is the second question that really matters (but ignored by many people). I will argue that the focus on financial markets and real estate market at this time is not a good choice, and it may even bring danger in the future.
To answer the second question, we must look at the big picture first. Since the 2008 crisis, China has lost its double-digit growth rate, with the exception in 2010 when it reached 10.4% (NBSC, 2014). In 2012 and 2013, the growth rate remained at 7.7% (NBSC, 2014). A lower growth rate is nothing bad as a country further develops to reach the existing production possibility frontier. However, the components of GDP imply an uncertain future. Astonishingly, 85% of the first three quarters’ GDP was from investment in 2014. And the data present an increasing trend in investment: in 2007, investment was 44% of GDP, which is still a considerable amount. It reached 60% in 2010, 70% in 2012, and 74% in 2013 (NBSC, 2014). A high investment rate is meaningful if it’s associated with a major economic reform, a technological revolution, or re-building the nation after a disaster. However, there is no major demand which induced these investments. What does this mean? It means that there is misallocation of resources.
Take a closer look: since 2012 about a quarter of the investment has been contributed from State Owned Enterprises (SOE). The nature of SOEs leads to the irresponsibility of investment decisions. If a private entrepreneur makes a bad decision, he suffers the loss; if a SOE makes a bad decision, the country suffers the loss. It is also easier for the SOE to borrow to invest. Hence, malinvestments by SOEs are very likely to happen.
Now, let’s say the financial market is really contributing to growth. Is it sustainable? Malinvestments are not sustainable. According to Roger Garrison (2000), when an intentionally lowered interest rate occurs, it gives false signals to investors. They tend to think that the society has more resources than it really has, and they will invest the money into the earlier production stages. What happens next is that during the middle stage, the projects will fail due to the lack of money. The investment gives an illusion that the society can produce outside the production possibility frontier.
Now it is easier to examine the first question. Chinese people may still remember all kinds of policies implemented during 2010 to 2012 aiming to lower housing prices, and to end the bubble. The consequence is that the real estate sector has not been performing well since then and sales keeps decreasing (NBSC, 2014). This may not be a bad thing as it seems to be: people are suspicious that the housing bubble is still there, and are being cautious. Buyers have their perception of the market, and they may have other plans for their money. The rapid change of housing policies also contribute to the suspicion. To leave the real estate market alone is a better choice for now.
Similarly, to reduce SOE’s involvement in the financial market will be more helpful, or it may send false signals to the market. An inactive market in the short run does not imply the need for intervention. All they need is a bit patience.
Garrison, R. (2000), Time and Money: The Macroeconomics of Capital Structure,
New York: Routledge.
Liu, (2014) “央行降息将对地产构成双重利好”, Xinhuanet, Beijing.
National Bureau of Statistics China (2014), “Macro Data: GDP, Investment,