On the horns of a dilemma

China's policymakers earned the respect, and the envy, of their counterparts overseas for the agility with which they were able to turn China's economy around in the dark days of 2008. They started to ease policy once again towards the end of last year, but this time the economy is not responding.

That might just be because stimulus efforts over the last few months have been relatively restrained. Until recently, most officials felt there was no need to do more than push down gently on the economy's accelerator pedal.

But China's economy has changed in the last four years in ways that make the usual policy responses less effective. One difference is that, while banks now say they are willing to lend, few firms want to borrow because they doubt the return on their investment would be enough to cover the cost.

This is a big turnaround from the situation over most of the last decade. Interest rates on bank loans have not changed much, the average one-year loan costs 6.5 percent today, roughly the same as five years ago. But with the economy expanding at a much slower rate, expected returns have fallen. If borrowers think loans are too expensive, the usual approach of loosening policy by relaxing constraints on the amount that banks can lend will not work.

But all is not lost. The People's Bank of China can do what central banks do elsewhere and cut interest rates. Rate cuts were part of the policy package in China too in the past, but they functioned more as signals of the government's priorities than as tools for directly stimulating loan demand. Until recently, most borrowers already thought rates were low. This would be a big shift in how the central bank regulates the Chinese economy, with the implication that interest rates would be adjusted more frequently in the future.

But what if interest rate cuts fail to stimulate demand? There is evidence that, in some sectors at least, investment is being held back not by interest rates being too high as by the fact that rapid investment growth in recent years has resulted in overcapacity. As a result, in some parts of the economy, further investment is a losing proposition, whatever interest rate banks are charging.

Take the automobile industry. Sales have been flat since late-2010 but many of China's more than 100 automakers are still engaged in ambitious plans to expand capacity. Many dealers are now slashing prices. Similarly, the investment boom of the last few years has brought a wave of new housing onto the market that will take a while to sell. Reducing the cost of financing on its own may not be sufficient to convince firms to embark on new projects when they are sitting on unsold stock.

At present half of families in China still live in rural areas, compared with around a fifth in Brazil and in most developed economies. In the long run, China will keep urbanising and demand for new housing and for cars will rise. But the positive long-term outlook doesn't give firms an incentive to invest today if China already has all the apartments and auto production lines it needs for the next couple of years.

Admittedly, the evidence that overcapacity is an economy-wide problem is thin. For all the recent worries about slowing growth, few firms seem to be in serious trouble. The wages of migrant workers, usually the first to be sent home if firms are struggling, were still 17 percent higher in the first quarter of 2012 than a year before. Profit margins in industry have risen in the last year when generalised overcapacity would cause them to fall. Listed firms also report healthy returns on their investments. In other words, more concerted efforts to loosen policy should be enough to stimulate an economic recovery.

But concerns about overcapacity will still affect policymakers' decisions. With investment now accounting for half of all spending, the threat of overcapacity is always around the corner. The government has pledged to give consumer spending a greater role in driving growth. The last thing it wants is for reliance on investment to rise even higher.

Yet that is exactly what would happen if the central bank cut interest rates this year to stimulate demand. Policymakers are faced with a choice. Respond to evidence of an economic slowdown, but bring closer the threat of a future crisis of overinvestment. Or sit back and allow the economy to continue to slow. This is not a choice anyone should envy.

The author is chief Asia Economist at Capital Economics, an independent, global macro-economic consultancy.

(China Daily 05/25/2012 page9)