What are the Implications of another Rate Cut in China?

The Econometrics of the Chinese Economy

Policymakers, investors and traders all reacted with concern at the latest economic figures to whittle out of China. It has officially been confirmed that the Chinese economy has contracted at an annual rate of 6.9% in September 2015. This marks the first time in 6 years that the Chinese GDP growth has dropped below the key 7% support level. A graphic representation of China's GDP annual growth rate paints a clear picture of decline from January 2013 through September 2015.

At the start of the said time period, China's annual GDP growth was 8% fueled largely by massive expenditure on infrastructure, easy access to financing and large capital inflows.
The Chinese economy has undergone a paradigm shift in terms of its strategic focus. The process has been underway for many years, but the crises that have plagued the global markets vis-a-vis fears of a Japanese recession, a European recession, dollar strength and emerging market weakness are but several of many factors weighing heavily on the Chinese economy.

‘Ghost Cities’ Pepper the Chinese Urban Landscape

The move towards a consumer-centric economy in China has not come without great cost. While the government has attempted to spend its way out of a hole, China is now peppered with scores of vacant cities known as ghost cities. They simply don't have enough people to take up residence and property prices have plummeted. The real estate bubble is but one of many concerns facing the domestic Chinese market. Coupled with the recent equities rout in China, it is clear why overall demand in the world's second-largest economy is on the decline.

What we are seeing now was described by the Chinese premier Xi Jinping as nothing more than growing pains for China. The euphemism would be apropos were it not for trillions of dollars that have already been wiped out from equities markets around the world. The sharp contractions in Chinese economic performance are indeed cause for concern, especially the manufacturing sector which grew at a rate of 5.7% as opposed to the consensus estimate forecast of 6%. September brought bad tidings with it for the Chinese economy, the Asia-Pacific region and the world at large.

Weak Chinese performance has an immediate impact on the fortunes of emerging market economies – notably Brazil, Russia, India, South Africa, Venezuelan, Zambia, the Democratic Republic of Congo and others. Even developed nations that have large mining and agricultural sectors such as Australia have been hard-hit by the economic slowdown in China. Australia is one of China's biggest trading partners in the region, and declining demand for commodities like metals is hurting the mining sector in Australia. All across the world, slowing demand from China is a bad omen for the economic performance of developing nations.

Commodities Concerns Dog the Market

Just recently we have seen major LSE-listed companies like Glencore PLC announcing the shuttering of several mining operations in the DRC, Zambia and Latin America. This is being done in an attempt to reduce the overall supply of metals like copper on the global stage in the hopes of raising the equilibrium price. Several other mining companies are now considering following suit, such rivals Anglo American, Rio Tinto and BHP Billiton.

Mining companies are now focusing their attention on the most profitable operations, while divesting from poorly performing mining operations. With respect to the global energy supply, two important realities now coexist: OPEC countries are over-supplying the market to maintain market share while WTI crude oil inventories in the US have reached a multi week high, sending the price of crude oil sharply lower.

It appears as if the confluence of multiple factors such as weak demand from China, and continuing oversupply of crude oil will perpetuate low energy prices right through until mid-2016 or later. This is good and bad. Low energy prices mean that the inflation dial will hardly move despite the best efforts of central banks like the ECB, BoE and the PBOC. In Europe, the president of the European Central Bank announced his intention to consider additional monetary stimulus policies at the bank's next meeting in December. In just nine months, the ECB has flooded the Eurozone with €1.1 trillion in bond repurchases – but inflation has barely moved. In fact in September the inflation rate was recorded at -0.1%.

What Does a Rate Cut Mean for China?

That the Chinese economy is the world's second-largest economy should be remembered, since it has tremendous forex reserves, buying power and a burgeoning middle class. The Chinese premier recently announced a multibillion pound initiative with the United Kingdom, which will see the Chinese engaged in massive industry investment and expenditure with the UK. Rate cuts are monetary policy tools that are used to make it easier for people to borrow money. China has also decided to reduce the amount of cash that needs to be held by banks so that they can free up more liquidity by loaning it out to customers and investors.

The goal of course is to stimulate economic activity in order to accelerate the velocity of money flow through the country. This will then increase consumption expenditure and boost GDP growth. Inflation is also positively affected by increased expenditure. A rate cut has the effect of devaluing the Chinese currency, making exports even cheaper for foreign buyers. This too will accelerate economic activity, especially in the manufacturing sector. But more importantly, rate cuts are viewed positively by stock markets. When interest rates are low, long-term loans and corporate debt repayments are also low – this allows companies to generate higher profits, pay bigger dividends and enjoy appreciating stock prices. The Chinese government is less concerned with protecting the exchange rate of the currency than it is with accelerating overall economic activity. This is precisely what the rate cut means for China and the rest of the world.
Published on Nov 10, 2015
By Brett Chatz
Brett Chatz is a graduate of the University of South Africa, and holds a Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. Nowadays Brett contributes from his vast expertise for the globally renowned spread betting company –InterTrader.

Copyrighted 2016. Content published with author's permission.

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