Deflation has China cutting interest rates

Learn why the People's Bank of China (PBoC) is easing monetary policy when almost every other major central bank is tightening.

Mark Fairbairn

July 10, 2023

Key messages

  • The People’s Bank of China reduced its seven-day reverse repurchase rate to 1.9%.
  • China is facing deflationary pressures.
  • Deflation along with a slowdown in global manufacturing will weigh on China’s near-term outlook.

Last month, we saw the Bank of Canada and the Reserve Bank of Australia resume increasing interest rates after a short pause. The U.S. Federal Reserve decided to pause in order to assess the impact of its cumulative rate hikes but set the expectation for more near-term increases. The Bank of England pushed through a surprise hike and the European Central Bank also increased rates while signalling more to come. 

Meanwhile, the People’s Bank of China (PBoC) is marching to the beat of its own drum – the PBoC cut its seven-day reverse repurchase rate by 0.1% last month (the reverse repurchase rate, commonly called the reverse repo rate, is the interest rate at which central banks borrow money from commercial banks).

Why is the PBoC easing monetary policy when almost every other major central bank is tightening? The answer is simple, inflation, or rather the lack thereof.

China is dealing with deflationary pressures

Most major economies are currently wrestling to contain inflation. However, in China, inflation is low and falling. The most recent reading of headline inflation was 0.2% year-over-year having decelerated from 1.8% at the start of 2023. Similarly, core inflation has fallen below 1.0% to 0.6% year-over-year. But why? 

A fading love for housing

China has long had a fascination with housing. The Chinese public took on more debt to buy more houses (second, third or more in some cases), pushing prices up. Housing was seen as the best investment – as prices seemingly only went up and was without risk since the government would support the sector, or so the belief went.

This unsustainable cycle caught the attention of the government, which enacted policies to help reign in the sector. This is summed up nicely by President Xi Jinping quote, “houses are for living in, not for speculation.”

It’s clear that the love affair is fading. Perhaps it’s the view that the government’s support is no longer there, the realization that China’s population is shrinking, that eventually China will have to transition to land sales taxes to fund local governments, that has changed people’s perception of housing. Not to mention, low consumer confidence and high youth unemployment muddying the situation. It’s likely a combination of the above that has altered the economics of housing – it’s no longer the amazing investment it once was. 

Repaying mortgages 

We are now experiencing mortgage repayments at a rate never before seen in China. Instead of consuming or investing, the Chinese are choosing to repay debts. And, by its nature, debt repayment in aggregate is deflationary.

The vast majority of money in an economy is created in the banking system when loans are created. Each time a new loan is made, the borrower gets cash in exchange for a new liability. This cash can then be used to purchase goods and services, which then flows the cash to whomever sold the goods or provided the services. This increases the money supply in the system. However, the opposite occurs when loans are repaid. This is what we are currently seeing in China.

Once the focus of an economy moves to prioritize debt reduction, lower interest rates are no longer as stimulative. In fact, there are examples in history (Japan in the late ‘80s, the U.S. following the 2008 housing crash and southern Europe following the sovereign debt crisis) where lower rates actually accelerated debt repayments because people used the lower rate to repay debts more cheaply via refinancing. This is what is known as a liquidity trap. 

What does this mean for investing in China?

Deleveraging is often healthy if starting debt levels are too high. However, the process needs to be carefully managed to prevent a hard economic (and market) downturn. While Chinese policy makers want to meet their growth objectives for the year, they are acutely aware of the risks of high debt levels at the local government, corporate and individual levels.

Not to mention, options for stimulus are thin, especially for local governments which have footed the bill for maintaining Zero-COVID policies and have lost much of its revenues from land sales for property development. As such, we don’t see much appetite for massive stimulus, unless the risk of a sharp downturn materializes.

While there is concern that China is about to follow Japan’s example of a lost decade of deleveraging, there is at least one key difference. Japanese equities traded at extreme premiums when its property bubble burst. Chinese equities are currently trading at a large discount. Much of the risks of investing in China are understood (demographics, regulatory, geopolitical), so there is at least compensation for taking the risk.

What does this mean for investing in China? In the near term these deleveraging forces combined with the global manufacturing slowdown will present challenges for China’s export sector. For this reason, we are underweight Chinese equities in portfolio solutions that include exposure to emerging markets.

With that said, China remains a large, globally integrated economy, with a highly educated workforce and large consumer market. It has its challenges, but the opportunity for active investment management to add value remains. 

Mark Fairbairn

Mark Fairbairn, CFA, B.Eng., is a Portfolio Manager with the Multi-Asset Management Team of 1832 Asset Management L.P. He is responsible for the non-North American equity funds and pools, Strategic Asset Allocation and is a member of the Tactical Risk and Allocation Committee.