The Reasons Behind, and Future Impacts of China’s Recent Interest Rate Reform in Layman’s Terms
If you have been following China economic news lately, you have probably noticed a massive quantity of articles referencing China’s credit problems, shadow banks, and recently, interest rate deregulation. This year could very well mark a turning point in China’s economic structuring.
For the past twenty-plus years, China’s economy has been centered around exports, cheap labor, and inexpensive goods. This export market helped to propel China into its position as the number two ranked GDP in the world. However, if one considers China’s GDP per capita, he will find that this ranking is much lower, around eighty-second overall. The reason behind this massive difference in rankings lies in China’s current market structure.
Currently, China’s state owned banks have been offering cheap credit at the government-set rate of around 6 percent to its state owned enterprises (SOEs). This rate allows China’s massive companies to take out loans that are very easy to payback. Therefore, they essentially have more capital than the small and medium sized companies and can allocate this to turning out cheaper goods, as their costs for capital are low. Also affecting the net overall cost is the availability of cheap labor. Over the past twenty-plus years, migrant workers have been flooding major Chinese cities such as Beijing, Shanghai, and Shenzhen to work low paying, labor intensive jobs. While these jobs lack social benefits such as healthcare and a retirement fund, in three months it offers rural Chinese workers a chance to pull in an income equal to a full year’s labor in the countryside. And although the current hukou system (housing registration system in China) restricts these immigrants and their families’ access to a proper apartment or social benefits that come with being a city citizen, the appeal for Chinese migrant workers still exists by means of salary alone. This cheap labor partnered with cheap capital has allowed Chinese SOEs to manufacture incredibly cheap goods that have fueled its export reliant economy for years.
Now, however, the cheap labor is beginning to run out. Most migrant workers have already migrated. These workers are beginning to expect higher wages. A culture of spending has overtaken those at the top of the Chinese economic ladder, as BMWs, expensive watches, and Louis Vuitton bags have become status symbols, even for government officials. The government is beginning to realize it can no longer rely on its export oriented economy, as foreign factories have begun moving to countries with cheaper labor, such as Cambodia, Vietnam, and Myanmar.
China wants to change its economic structuring to focus less on cheap exports and more on domestic consumption. In order to do so, China needs to turn its attention towards fostering small and medium sized business growth and encouraging its citizens to spend, rather than save.
Currently, China’s bank regulations limit its four major government owned banks from extending cheap credit outside of large SOEs. They’ve accomplished this by limiting the amount of loans banks are allowed to grant. Clearly, this puts an impetus on banks to extend loans to companies that have a history of being able to pay them back, and companies that will take out massive loans, basically only SOEs. Small and medium sized enterprises (SMEs) are more often than not forced to go to shadow banks, or what the Chinese call “microcredit” firms to receive loans. Because these loans run on more of a free market (China allows them to extend credit rates to up to four times the government rate), these SMEs are forced to take out loans at rates of up to 24 percent. Clearly, this is not beneficial to fostering private sector business growth, and doesn’t allow for businesses, or generally individuals as well to engage in social mobility.
Furthermore, these SMEs typically offer more service oriented products on which a country with a culture of consumption relies (see the US). Faced with such high interest rates, these companies are forced to offer their products at much higher prices, discouraging consumption.
China’s citizens have another reason for wanting to save money rather than spend it, as the government does not have a strong welfare system in place for retirees. Therefore, China’s working class feels a strong commitment to save money in order to take care of their elderly, retired parents. In fact, this aspect of China’s economic culture has affected their overall culture in general, as male children are preferred to female (due to China’s culture placing male children in charge of taking care of their parents, and the fact that males generally make more money) and more children are preferred to few (a reason behind their rapid population growth and the infamous one child policy).
In addition to the lack of a strong welfare policy for China’s elderly, the largest banks’ interest rates are currently placed at a level that is lower than what some believe to be the actual inflation rate in China. In effect, this means that if Chinese citizens choose to place their extra earnings in a bank deposit, they will actually be losing money. This along with an irregular and still developing stock market that may or may not be a puppet of the government does the opposite of encouraging investment in traditional, safer investments. Instead, Chinese citizens are investing in what their opinion is the next best alternative, real estate. This has forced real estate prices to hit prices so high that even Starbucks has problems with paying rent.
Clearly, China’s interest rate policies have unintentionally spurred many a problem and therefore need to be changed. However, this change will not be accompanied by economic rosiness and cheer, it could also present new problems.
China’s slow deregulation of interest rates will inevitably encourage investors to begin investing in banks again. With this will more than likely come a real estate market crash. Because of the mass amounts of investment in real estate, real estate prices are above what many consider the actual market levels to be. As this investment stops, real estate prices will drop, and many Chinese citizens will see their life saving disappear before their eyes. Although these citizens will also begin to see higher salaries from their jobs in the private sector (as wages can now rise due to capital being cheaper), it could take a while for the difference, between what they lost so quickly and their slowly increasing wages, to disappear. This could usher in social instability, and the government needs to be prepared for this in advance, otherwise the already high number of protests could become higher, and the government’s rule could be on rocky waters. As far as the future and China’s economic and social stability, only time will tell.
Follow me on Twitter: @c_h_wood