China’s economic slowdown has become a major concern for policymakers, and the recent decision by the People’s Bank of China (PBOC) to cut interest rates, including those on existing mortgages, signals that authorities are taking steps to address the issue. But while the move provided a temporary boost to mainland Chinese stocks, analysts caution that rate cuts alone may not be enough to kickstart the country’s slowing economy.

China is grappling with weak domestic demand, rising debt levels, and a sluggish housing market. These factors have culminated in a complex economic environment that requires more than just monetary policy adjustments to stimulate growth. As the world’s second-largest economy seeks to regain its footing, economists are increasingly calling for a comprehensive fiscal response, particularly through government spending and housing market reforms.

Interest Rate Cuts: A Short-Term Fix?

The PBOC’s surprise rate cuts were aimed at easing financial conditions for both consumers and businesses, offering some relief to an economy that has been underperforming. Larry Hu, chief China economist at Macquarie, noted that the move could signal “the beginning of the end of China’s longest deflationary streak since 1999.” However, he stressed that additional fiscal support, particularly in the housing market, is necessary to boost domestic demand and ensure long-term economic recovery.

Despite the optimism in equity markets, China’s bond market responded more cautiously to the rate cuts. The 10-year government bond yield initially dropped to a record low of 2%, reflecting investor skepticism about the effectiveness of monetary easing. The yield later stabilized around 2.07%, still far below the U.S. 10-year Treasury yield of 3.74%, indicating a significant divergence in market expectations between the two largest economies.

Edmund Goh, head of China fixed income at abrdn, highlighted the need for broader fiscal policy interventions. “We will need major fiscal policy support to see higher CNY government bond yields,” Goh said, adding that Beijing would likely increase fiscal stimulus despite its current reluctance. The yield gap between Chinese and U.S. government bonds underscores the different paths each country’s economy is on. While the U.S. has been grappling with inflation and higher interest rates, China is dealing with deflationary pressures and slower growth.

Diverging Economic Trajectories: U.S. vs. China

For years, China’s government bond yields were higher than those of the U.S., making it an attractive destination for foreign investment. However, the tide turned in April 2022, when aggressive rate hikes by the U.S. Federal Reserve pushed American yields above their Chinese counterparts for the first time in over a decade. This shift reflected broader concerns about China’s growth prospects and the divergence between the two economies.

The U.S. has been contending with rising inflation and strong economic activity, leading to higher interest rates. Meanwhile, China’s economic recovery from the pandemic has been sluggish, with industrial activity slowing and retail sales barely growing at 2% year-on-year. Analysts worry that China may not achieve its 5% growth target for 2024 unless there is a significant increase in fiscal stimulus.

Yifei Ding, senior fixed income portfolio manager at Invesco, emphasized that U.S. rate cuts alone will not close the yield gap between the two nations. “The market is forming a medium to long-term expectation on the U.S. growth rate, the inflation rate. [The Fed] cutting 50 basis points doesn’t change this outlook much,” Ding said. He expects Chinese bond yields to remain low for the foreseeable future, even if Beijing ramps up stimulus efforts.

The Role of Fiscal Stimulus in Reinvigorating Growth

While monetary policy tools such as rate cuts are designed to stimulate borrowing and investment, they are not always sufficient on their own, especially when an economy faces structural challenges. In China’s case, high debt levels among consumers and businesses have limited the effectiveness of recent monetary easing measures. This is where fiscal policy—direct government spending—can play a crucial role in reigniting growth.

China’s Ministry of Finance has been conservative in its approach to fiscal policy. Although there was a slight increase in the fiscal deficit to 3.8% in 2023, Beijing reverted to a more restrained 3% deficit target in 2024. Analysts from CF40, a prominent Chinese think tank, estimate that the country still faces a 1 trillion yuan shortfall in spending if it is to meet its fiscal target for the year. Without additional government spending, they warn that growth could remain below expectations.

“If general budget revenue growth does not rebound significantly in the second half of the year, it may be necessary to increase the deficit and issue additional treasury bonds in a timely manner to fill the revenue gap,” the CF40 report stated. PBOC Governor Pan Gongsheng acknowledged the slower pace of government bond issuance but maintained that the central bank was collaborating with the Ministry of Finance to manage the process effectively.

The need for fiscal stimulus goes beyond simply increasing government spending. As Haizhong Chang, executive director of Fitch (China) Bohua Credit Ratings, pointed out, monetary easing will only be effective if it is complemented by fiscal policy that addresses the real economy’s needs. “High leverage in Chinese corporates and households makes them unwilling to borrow more,” Chang said, noting that this reduces the impact of looser monetary policy.

Housing Market and Consumer Demand: Key Areas for Fiscal Focus

China’s housing market has long been a critical pillar of its economy, but in recent years, the sector has been struggling. A combination of regulatory crackdowns, overleveraged developers, and waning demand has created significant challenges for both homebuyers and businesses. Analysts like Larry Hu suggest that government spending on housing could be a key driver of economic recovery. By financing housing projects through the PBOC’s balance sheet, Beijing could both stimulate construction activity and alleviate some of the financial pressures facing developers.

However, addressing the housing market is just one piece of the puzzle. Boosting consumer demand will be essential if China is to achieve sustainable long-term growth. With household debt at record levels, consumers have been reluctant to spend, leading to subdued retail sales growth. While rate cuts may reduce the cost of borrowing, they are unlikely to stimulate significant consumer spending without additional government intervention.

Breathing Room from U.S. Rate Cuts

The U.S. Federal Reserve’s recent rate cuts have provided some relief for China, particularly in terms of the foreign exchange market. Lower U.S. interest rates have weakened the dollar against the Chinese yuan, which benefits Chinese exporters by making their goods more competitive in international markets. This has been one of the few bright spots in China’s otherwise sluggish economy.

Louis Kuijs, APAC Chief Economist at S&P Global Ratings, noted that the Fed’s easing policies had reduced some of the external pressures on China. “Lower U.S. interest rates provide relief on China’s FX market and capital flows, thus easing the external constraint that the high U.S. rates have imposed on the PBOC’s monetary policy in recent years,” Kuijs said.

Nevertheless, he emphasized that fiscal stimulus would be necessary to sustain economic growth. “Fiscal expenditure lags the 2024 budget allocation, bond issuance has been slow, and there are no signs of substantial fiscal stimulus plans,” Kuijs warned, highlighting the need for more proactive government spending to address the economy’s deep-rooted issues.

A Complex Path to Recovery

China’s economic challenges cannot be solved with interest rate cuts alone. While the PBOC’s recent moves have provided some short-term relief, analysts agree that a more aggressive fiscal response is required to address the structural issues plaguing the economy. From reviving the housing market to boosting consumer demand, Beijing has a range of policy tools at its disposal, but it will need to act decisively to avoid falling short of its growth targets. As global economic conditions remain uncertain, China’s ability to balance monetary and fiscal policies will be crucial in determining its path to recovery.

(Adapted from CNBC.com)

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