China's lending engine sputters

The People's Bank of China cut its one-year loan prime rate by ten basis points, to 3.55 per cent, and very little happened. Beijing's usual methods are no longer working. In earlier cycles even a small easing set off a rush of borrowing for local infrastructure and property development. This time credit is stuck, because borrowers already owe too much and are in no mood to add more.

The cut on 20 June was the first to the benchmark since last August. It followed reductions of the same size in the central bank's seven-day reverse repo rate and its one-year medium-term lending facility rate the week before, and the five-year rate, which anchors most mortgages, also fell by ten basis points, to 4.2 per cent. Beijing acted because the rebound that followed the end of zero-covid in December has faded. Industrial output and retail sales have slowed, factory-gate prices are falling, consumer prices are barely rising, and about one in five young people in the cities is out of work.

Nobody wants to borrow

Chinese property developers are fighting to survive, and none is buying land. Local government financing vehicles (LGFVs) are held back by debts they cannot sustain. Households have been burned by unfinished flats and falling property prices, so they are saving cash and paying off their mortgages early instead of taking on new loans. Cheaper rates cannot create loan growth when the private sector is set on reducing its debt.

The savings are piling up in banks. Households added a record amount to their deposits last year and have kept adding this year, which is the mirror image of the weak demand for loans. The big state banks cut their deposit rates in early June, partly to protect lending margins that are already at record lows. That helps the banks pass on cheaper loan rates, but it does little to coax savers into spending when the reason they are saving is fear about property and jobs.

How the property engine stalled

The trouble began with policy. In August 2020 regulators imposed the 'three red lines', limits on developers' debt relative to their assets, equity and cash, to stop the sector borrowing ever more. Developers that had funded themselves by pre-selling flats and borrowing against land were cut off, and Evergrande defaulted at the end of 2021. Last summer buyers of unfinished homes across the country threatened to stop paying their mortgages. Land sales, a main source of local-government revenue, fell sharply, leaving the financing vehicles that borrowed against that income short of cash to service their debts.

The chain explains why a rate cut does so little. A developer with falling sales and no access to bond markets does not borrow more because the loan rate drops by a tenth of a point. A financing vehicle that cannot cover its interest from project income needs restructuring, not cheaper new money. A household that has watched neighbours pay for flats that were never finished treats early repayment as the safest use of its savings.

Japan's lesson

The pattern resembles Japan in the 1990s, when falling property and share prices left companies focused on repaying debt instead of investing. The Bank of Japan cut its discount rate to 0.5 per cent by 1995, and bank lending still contracted for much of the following decade. Real interest rates tell a similar story in China today: with factory-gate prices falling, a nominal cut of ten basis points barely dents the real cost of borrowing. The differences matter. China's banks are state-directed, and Beijing can instruct them to lend or order the central government to borrow in place of the weakened local authorities.

China's own history offers a more hopeful precedent. In 2015 and 2016, with the property market slumping, Beijing combined rate cuts with a large programme to rebuild run-down urban housing, funded by cheap loans from the policy banks and paid partly in cash to displaced residents. That money went straight into new flats in smaller cities, and the market revived within a year or so. The lesson is that the recovery came from fiscal and quasi-fiscal money aimed at buyers, with rate cuts playing a supporting role.

Who feels the slowdown

The effects reach well beyond China. Iron-ore and copper exporters depend on Chinese construction, and a stalled property market caps their demand. Falling factory-gate prices mean China is exporting cheaper goods, which helps Western central banks fighting inflation and hurts manufacturers competing with Chinese producers. A weaker yuan gives Chinese exporters a lift but invites complaints from trading partners, and foreign investors in Chinese shares have watched the reopening rally unwind.

What would change the call

The State Council, chaired by Li Qiang, promised in mid-June to introduce further measures to support growth, without saying what they would be. The government has set a growth target of around 5 per cent this year and a quota of 3.8 trillion yuan for special local-government bonds, so the tools for a larger push already exist. The Politburo's meeting on the economy, usually held at the end of July, is the obvious venue for larger support, such as central government money to finish stalled housing projects, easier purchase rules in big cities or a plan for local-government debt. The central bank's monthly credit figures, particularly medium- and long-term household loans, will show whether early mortgage repayments have eased. The yuan has weakened against the dollar this year, and each further cut widens the gap with American rates, which limits how far the central bank is willing to go.

Beijing is finding out what monetary easing cannot do. Cheaper credit is of no use when households and developers have neither the appetite nor the balance sheets to borrow, and further small rate cuts will probably meet the same response until the July Politburo meeting delivers fiscal money aimed at housing.