Pettis on China Rate Cut: Late, Small, and Precarious

From Michael Pettis this morning on the China rate increase:

This is definitely good news.  It increases household income by raising the return on savings, which is a necessary part of the rebalancing process.  It (very slightly) reduces the incredible incentive to borrow money and splurge on manufacturing capacity, investment and real estate development.  And it signals that the PBoC is concerned about overinvestment.

But it is a pretty small move and very late. The PBoC has been, very unwillingly I think, behind the curve on interest rates.  Most of us believe the PBoC has wanted to slow investment growth and to raise rates for a quite a while now, but it isn’t easy to do so.  One of the problems is that the economy – especially local and provincial governments and SOEs, not to mention the central bank itself – is so dependent on artificially low interest rates to remain profitable or viable, that even a small increase in interest rates can raise put pressure on cash flow and financial distress costs

Beijing hasn’t raised interest rates in nearly three years (December 2007), even though deposit rates are clearly negative and the lending rate may well be close to zero or even negative – depending on what you consider the right measure of inflation.   There have been rumors about a rate hike for the past three weeks.  Earlier this month Chen Long, my assistant at SWS, told me that the there was a lot of talk about a hike in the deposit rate some time this month.

We thought it would be very unlikely that the deposit rate would be hiked without an equivalent hike in the lending rate.  The very wide spread between the two (306 basis points for one-year maturities, which does not take into account the typical maturity mismatch between depositors and borrowers) is the main part of a bank recapitalization process which many believe necessary to protect the system from an anticipated surge in non-performing loans.

But Chinese borrowers are too dependent on artificially low interest rates for their viability, so we felt there really wasn’t much room to raise the lending rate.  Our conclusion: the PBoC might raise both deposit and lending rates by up to 25 basis points, mainly as a way of reversing some of the decline in real lending rates during the past year, but they wouldn’t be able to do anything more aggressive.

More here.