The policies behind China’s recent economic slowdown — including the frugality drive and ongoing tightening measures imposed on the property market — have worked well.

Slow but steady [By Gou Ben/China.org.cn]

Gross domestic product growth has decelerated to a four year low of 7.5 percent in second quarter of 2013. Yet the labor market has remained relatively tight as widespread reports of unemployment are absent.

Naturally, the market is always concerned that the slowdown may go too far, particularly after the central bank recently allowed interbank liquidity to become so tight.

Counterintuitive as it seems, by refraining from injecting liquidity intentionally, authorities are mitigating risks in the banking sector. The gradual ascent of interbank rates occurred after the authorities tightened the governance of wealth management products in March.

The new rules stipulated by China Banking Regulatory Commission required banks to invest not more than 35 percent of funds raised from the sale of wealth management products into non-publicly traded debt. This effectively chokes-off an important source of funding flowing into property developers and local government finance vehicles, which often find it difficult to obtain conventional bank loans. As a result, they must have been relying on non-conventional channels to obtain the necessary funding.

Authorities either know beforehand which banks will be squeezed in the act, or they want to make use of this particular event to expose overextended banks. Judging from authorities’ stance so far, a credible threat has already been made.

Keeping status quo

Against such backdrops, the dominant strategy is to keep the status quo on monetary policy and to inject liquidity through open market operations when needed. Even though interbank rates have already normalized, banks’ lending behavior will likely remain cautious for the remainder of the year.

That said, we should not over-analyze the impact of the liquidity squeeze on the real economy. M2 growth has remained steady at 14.1 percent year-on-year in the first half of 2013 which is still above the 13 percent annual target. New loans in first half 2013 grew by 14.0 percent. These numbers are generally healthy and do not suggest economy-wide illiquidity.

As far as domestic demand is concerned, private consumption has remained resilient as indicated by retail sales data. Fixed asset investment growth, however, has remained subdued at 20.1 percent in the first half of 2013 but the result is consistent with the long term goal of suppressing investment’s contribution to GDP. The good news is that the risk of inflation is reduced as evidenced by benign CPI and PPI readings. It is very clear that China is making serious effort to restructure the economy. The current state of the macro-economy suggests real economic activities will pick up slowly. Cutting interest rates to reduce borrowing costs, as some people are speculating, will only reinforce the root cause of the problem.

That’s because lower rates encourage people to chase higher yields and helps the proliferation of wealth management products. Besides, lowering of benchmark rates may not necessarily translate into lower funding costs for the final borrowers.

Lets’ also not forget the property market is still blistering. As such, interest rate liberalization needs to quicken so that banks have more freedom to determine deposit and lending rates. This is the most challenging part and requires careful planning given the numerous stakeholders involved.

People’s Bank of China mentioned in its 2013 financial stability report that is was ready to set up a deposit insurance system as soon as this year. We envision domestic interest rates to speed up once reform kicks in.

Contrasting objectives

The coexistence of elevated asset prices and slower economic growth will prevail as long as quantitative easing floods the world with liquidity. Striking a balance between two contrasting policy objectives requires in-depth diagnostics within appropriate contexts.

At this juncture, China has clearly chosen to accept “normal” growth relative to “supernormal” growth prior to 2008. In retrospect, China would have much more policy flexibility now if it had allowed its exchange rate to appreciate more and interest rate reform to quicken more when the economy was stronger a few years ago.

It is better late than never to resolve problems. The solutions are clear: (1) Maintain a strong currency in general but periodically allow fluctuations to reflect market forces; (2) Carry on with interest rate reform; and (3) Map out a clear urbanization strategy to stimulate domestic demand.

In the absence of monetary loosening and fiscal stimulus, the strength of subsequent recovery will likely to be tepid. The economy will most likely be just hanging in there. Slower economic growth is natural during a transitional period. As such, the economy will likely grow 7.5 percent in 2013, down from 7.8 percent in 2012.

The down-trend should not be read too negatively because China can easily propel growth by relaxing restrictions in the property market, or by simply following in the footsteps of other central banks to conduct quantitative easing. Yet the authorities have chosen to walk a difficult path of structural reforms. This is an encouraging development.