Zero interest rate is unlikely to work in China

By Yi Xianrong
0 Comment(s)Print E-mail Beijing Review, December 22, 2015
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Foreign investment institutions have forecast that the yuan will continue depreciating after its inclusion into the currency basket of the special drawing rights (SDR). The reason behind that logic is that Chinese monetary authorities may try to reduce or even stop interventions--in order to examine the yuan's capability to resist external pressures.

For instance, Citigroup Inc. strategists projected in their 2016 outlook that as the U.S. economy enters its seventh year of expansion following the 2008-09 crisis, the probability of a U.S. recession will reach 65 percent next year. In China, Citi claims that deflationary pressures and downside risks to growth will force Beijing to loosen fiscal policy and let the yuan depreciate. Perhaps China will become the first major emerging market economy to cut interest rates to zero.

Danny Gabay, a director of London-based macro research consultancy Fathom Financial Consulting, said in November that China's central bank will eventually follow its Western counterparts by cutting its benchmark interest rate to zero. Gabay also said the yuan is to slide by an estimated 2-3 percent per quarter for the next two years--ultimately by about 25 percent.

The forecasts and therapies that foreign experts offer are based on the theories and institutions in the European and U.S. markets. However, the market conditions and institutions in China are completely different. Therefore, the financial strategies that serve benefits to Europe and the United States are unlikely to work in China.

In any case, China still faces the imminent challenge of an economic slowdown, and the government must adjust policies in order to maintain economic growth. However, if the central bank is to continue cutting interest rates all the way down to zero, the Chinese economy would find itself in a hard position to make a sound recovery in the future.

The slashing of interest rates down to zero would lower the costs of financing and relieve debt-burdened companies while also stimulating consumption. However, it is important to note that commercial banks absolutely dominate the current financial system in China.

A zero-interest policy will not only drive a large chunk of the 134 trillion yuan ($21.03 trillion) in deposits out of the banks and reduce the available funds for domestic banks to lend, but also thoroughly change the profit pattern and profitability of Chinese commercial banks. A business pattern that is backed by no interest rates spurs and intensifies competition, which may put immature commercial banks into hot water. This could prove to be difficult to reverse, were it to arouse a serious crisis in China's financial sector. In the second half of this year, the profit rates of Chinese commercial banks dropped to a decade low, but non-performing loans were rising. The banking regulatory authority is quite conscious of these potentially dangerous variables.

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