On the 21st, China effectively froze the July loan prime rate (LPR), which is essentially the benchmark interest rate. Amid this, there are mixed claims that the long-term deflation (decline in prices) is raising real interest rates, necessitating additional rate cuts to stimulate the economy, and that a 'zero (0) interest rate' should be approached with caution. Recently, economic indicators have emerged positively, relieving immediate pressure for rate cuts, but the likelihood of a need for a reduction may arise again due to factors such as deflation and sluggish domestic demand.
The People's Bank of China announced that it would maintain the one-year LPR at 3% and the five-year LPR at 3.5%. The LPR is the interest rate applied by banks to clients with high creditworthiness, calculated based on the proposed rates submitted by commercial banks to the People's Bank. The one-year LPR affects household loans, while the five-year LPR impacts home mortgage rates. The People's Bank has been keeping the rates unchanged since it reduced the LPR for the first time in seven months last May.
This interest rate freeze was announced shortly after China's key economic indicators unexpectedly showed strong performance last week. According to China's National Bureau of Statistics, the second quarter gross domestic product (GDP) growth rate was 5.2%, slightly exceeding market expectations. Industrial production also rose 6.8% compared to the previous year, surpassing market estimates of 5.7%.
As the economic situation in the first half of the year, which had been overshadowed by concerns over recession from the tariff war with the United States, performed better than expected, it is analyzed that the People's Bank has alleviated its burden regarding large-scale monetary easing. Lin Song, the chief economist for Greater China at ING, noted to Reuters that "while ongoing price decline pressures and weakened loan demand support the need for additional easing policies, the People's Bank may hold off on monetary easing until a more appropriate time arrives."
◇ The impact of deflation leads to worsening perception of the economy… Pressure for rate cuts increases
However, the actual conditions felt by economic agents are deteriorating, increasing demands for interest rate cuts. The gap between real GDP growth rate and nominal growth rate illustrates this well. According to China's National Bureau of Statistics, the real GDP growth rate in the second quarter was over 5%, yet the nominal growth rate was only 3.9%.
The real growth rate refers to the pure production growth rate excluding price changes, whereas the nominal growth rate reflects the increase rate adjusted for price rises or falls. While the real growth rate alone can imply that the economy is growing rapidly, the nominal growth rate, affected by deflation, is lower, indicating that businesses are experiencing decreased sales and households are facing stagnant incomes.
Because of this, even if the interest rates are maintained at the same level, the rates that each economic agent actually feels can rise, leading to the necessity for rate cuts to alleviate their burdens. According to the Financial Times (FT), there are arguments emerging within China to swiftly reduce interest rates for this reason. The need to ease the fiscal difficulties of local governments and expand investments also supports this claim.
Currently, the People's Bank of China's seven-day reverse repurchase agreement interest rate is at 1.4%. This is a key short-term policy interest rate influencing the LPR, and if this rate decreases, it will provide more room for LPR cuts and alleviate the burden of real interest rates. Jing Ma, the senior representative for China at the Institute of International Finance (IIF), stated that "China can increase its growth potential if interest rates and fiscal expansions are aligned. China still has considerable room to expand public investment," adding that "a zero interest rate is by no means an impossible scenario."
◇ Concerns grow over bubbles and oversupply… Banks' revenue decline is also problematic
However, while interest rate cuts are a means of defending the economy, they simultaneously raise concerns that the declining value of money could cause excessive capital to flow into asset markets, like real estate, creating a 'bubble.' If asset prices rise excessively, it could lead to shocks in the financial markets when the bubble bursts in the future. In particular, China, which has not escaped from real estate stagnation for several years, is wary of long-term stagnation cases following the collapse of the real estate bubble in Japan during the 1990s.
Given the current worsening issue of oversupply, lowering interest rates could provoke increased investment rather than consumption, potentially exacerbating the oversupply. The significant drop in revenue of state-owned banks is also a concern. According to FT, the average net interest margin (NIM) of China's six major state-owned banks had never dropped below 2% until 2021, but it fell to a historic low of 1.48% in the first quarter of this year. Currently, Chinese banks are facing threats to asset soundness due to increased defaults from the real estate market slump, and if interest rates are further lowered, banks could suffer catastrophic losses in revenue.
Experts analyzed that simple interest rate cuts are unlikely to revive domestic demand and investment. According to local media, Ding Shuang, an economist at Standard Chartered, mentioned at a recent forum that "the fiscal capacity in the second half of the year has decreased compared to the first half, and investment recovery is also sluggish," adding that "instruments should be implemented to enhance fiscal mobility and stimulate consumption capacity. Simply reducing interest rates alone is unlikely to yield effective real economic stimulus."