Credit expansion in China: Navigating a policy quandary and its deflationary impact

China’s credit expansion poses a potential economic boost, yet careful management is essential to avoid deflationary risks associated with excess capacity and financial instability.

A significant obstacle stands in the way of China’s central bank combating the threat of deflation: a greater amount of credit is going to productive sectors of the economy than to consumption, which is revealing structural weaknesses and lessening the impact of the bank’s monetary policy instruments.

The People’s Bank of China (PBOC) is facing pressure to lower interest rates as declining prices push up the real cost of borrowing for individuals and households, which in turn reduces hiring, investment, and consumer spending.

To mitigate the risk of a funding crunch, central bankers are under pressure to reduce reserve requirements and release liquidity into the banking system due to declining asset quality brought on by the real estate crisis and problems with local government debt.

However, both strategies are beset by a similar issue: China’s credit demand is primarily driven by the manufacturing and infrastructure sectors, whose overcapacity problems are intensifying the country’s deflationary forces.

Beijing has been trying to move its industries up the value chain by rerouting capital flows from its struggling real estate sector towards manufacturing. China’s high investment rates have been caused by infrastructure spending for decades, taking money away from households.

Hong Hao, the chief economist at Grow Investment Group, remarked that a significant portion of the credit is directed towards the infrastructure sector and excess capacity, thereby exacerbating deflationary pressures.

The PBOC’s situation, according to analysts, makes it even more urgent for the government to accelerate structural reforms to increase consumption—a long-standing policy gap that it has promised to close throughout 2023 but has had difficulty achieving.

November saw the greatest annual decline in consumer prices in China in three years, falling by 0.5%, while factory-gate prices plummeted by 3.0%, highlighting the fragility of both domestic and foreign demand in comparison to production capacity.

On Friday, December inflation data is expected, and on January 22, the PBOC may decide its benchmark rate.

Persistently falling prices over an extended period may discourage increased consumer spending and private-sector investment. This could negatively impact jobs and incomes, creating a self-reinforcing cycle that impedes economic growth, akin to the situation experienced in Japan during the 1990s.

November saw a record low in the ratio between the M1 money supply, which is made up of cash in circulation and corporate demand deposits, and the M2 money supply, which is made up of M1, fixed corporate, household, and other deposits.

“Low M1 growth may indicate inadequate policy transmission, be a sign of low private business confidence, or be a consequence of the real estate market downturn.” This is worrying, according to analysts at Citi.

Approximately 20% of the new loans totalling 21.58 trillion yuan ($3.01 trillion) between January and November of 2023 were given to households; the remaining loans were given to corporations.

According to analysts, state-owned businesses, which usually have access to less expensive credit from state banks, are likely the ones who took out the majority of those loans.

Private businesses struggle more, particularly those in industries that aren’t thought to be policy priorities.

After several rate reductions in recent years, the benchmark one-year loan prime rate (LPR) of the PBOC is currently 3.45%, the lowest since August 2019. However, after accounting for factory-gate prices, the rate has increased. It stood at 6.45% in November, up from a multi-year high of 8.95% in June, but it is still higher than China’s projected 5% GDP growth in 2023.

Although experts argue that the PBOC must continue with gradual measures due to structural imbalances, there is justification for further monetary easing given the rise in real borrowing costs.

On December 22, five of the biggest state banks in China cut the interest rates on a portion of their deposits. This could open the door for the PBOC to lower policy rates later this month.

This year, Citi anticipates a cumulative 50 basis points (bps) reduction in the banks’ reserve requirement ratios (RRR) and a total of 20 basis points (bps) in policy rate cuts. Goldman Sachs anticipates one policy rate cut of 10 bps and three RRR cuts of 25 bps each.

OCBC Bank’s Tommy Xie, head of Greater China research, issued a warning, arguing that the current combination of monetary, fiscal, and other policies could worsen deflationary pressures with additional liquidity injections.

Governor of the central bank Pan Gongsheng announced in November that monetary policy will remain “accommodative,” but he also called for changes to lessen the economy’s dependency on real estate and infrastructure.

Stronger demand and economic growth are required to avert the risk of further deflation, according to HSBC chief Asia economist Frederic Neumann.