China’s Central Bank Deviates From Course

The People’s Bank of China, the central bank of China, had been tracking the United States’ Federal Reserve when it came to rate adjustments. When the Fed hiked rates, the PBOC hiked rates. But the PBOC didn’t hike rates two weeks ago when the Fed made its latest 0.25% bump to the Fed Funds rate. Why did they deviate from the follow the leader game all of a sudden? The answer is quite simple—they couldn’t afford to.

The PBOC has been trying to curb borrowing as it is concerned that the growing debt levels by corporations and municipalities could eventually choke economic growth. How do you typically slow down borrowing? You raise rates. Unfortunately for China, the latest economic numbers show that the rate hikes are also starting to slow down retail spending.

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You can see on the chart below how China’s external debt has been growing at a rapid pace with the rate of borrowing increasing sharply after the financial crisis. Of course, some of the borrowing was warranted as the country tries to maintain a GDP growth rate that has been over 6% since the early 90’s.

The most recent economic reports out of China show that the rate hikes are starting to impact the borrowing. The investment rate in buildings, factories, and other fixed assets was up 6.1% in the first five months of 2018 over the previous year. That same measure showed an increase of 7% through the end of April, but it is still up considerably from last year.

Retail sales were up 8.5% in May ’18 compared to May ’17, but April retails sales were up 9.4% on a year-over-year basis. As you can see on the chart below, that pace of growth is the lowest rate in the last seven years. Unfortunately, that is as far back as would allow.

It is a tough job the PBOC faces—keep the pace of growth above 6% while curtailing the borrowing levels. And the possible trade war with the United States is also weighing on the economy and the stock market. The combination of the trade war and the PBOC not following suit with the Fed’s rate hike have taken a big toll on the Yuan as it has fallen over 3% in the last two weeks.

A weaker currency is another tough job for the central bank. While it makes China’s exports cheaper and more attractive as exports, it also makes Yuan-backed investments less attractive. In monetary economic theory, you have to raise rates to make your currency more attractive to investors. And that leads us back to the fact that the PBOC couldn’t afford to raise rates this month as the Fed did.

What does all of this mean? Like I said before, the whole scenario puts the PBOC in a tough spot. The long-term trend in debt growth could cause major economic problems for years to come. Raising rates will slow that debt growth, but it will continue to cause declines in retail sales and it could cause China’s GDP growth rate to drop below 6% for the first time in over 25 years.

A lot will depend on what happens with the ongoing trade dispute. If the U.S. and China can come to an agreement and avoid an all out trade war, the confidence toward Chinese investments will grow and the correction in Chinese stocks will likely come to an end. If China goes into a recessionary period, the effects will be felt worldwide, they won’t be the only country affected. If they are the focal point of a worldwide recession, they will likely get hurt worse than others, but European countries and the U.S. will likely enter recessions too.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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