China’s policy dilemma: is boosting credit deflationary?

China’s central bank faces a major hurdle in quelling the threat of deflation: more credit is flowing to productive forces than into consumption, exposing structural flaws in the economy and reducing the effectiveness of its monetary policy tools.

The People’s Bank of China (PBOC) is under pressure to cut interest rates as falling prices raise real borrowing costs for private businesses and households, curbing investment, hiring and consumer spending.

Deteriorating asset quality from the property crisis and local government debt woes is also pressuring central bankers to release liquidity into the banking system by cutting reserve requirements to fend off any risks of a funding crunch.

But both moves share a common problem: demand for credit in China mainly comes from the manufacturing and the infrastructure sectors, whose overcapacity issues are exacerbating deflationary forces in the economy.

Beijing has been redirecting money flows from its ailing property sector towards manufacturing in a bid to move its industries up the value chain. Infrastructure spending has been responsible for China’s high investment rates for decades, diverting economic resources away from households.

“Much of the credit is going to the infrastructure sector and also into some of the excess capacity,” said Hong Hao, chief economist at Grow Investment Group. “That way, it actually creates further deflationary pressures. That’s the problem.”

The PBOC “will continue to ease, but I think monetary policy at this juncture is less effective than it should be,” he said.

Analysts say the PBOC’s predicament increases the urgency for the government to speed up structural reforms to boost consumption, a long-standing deficit in policies it has vowed to address throughout 2023, but struggled to make significant progress on.

China’s consumer prices fell by 0.5% year-on-year in November, the fastest in three years, while factory-gate prices tumbled by a whopping 3.0%, underscoring the weakness of both external and domestic demand relative to production capacity.

December inflation data is due on Friday, while the PBOC could decide its next move on its benchmark rate on Jan. 22.

A sustained period of falling prices may discourage further private sector investment and consumer spending, which in turn can hurt jobs and incomes and become a self-feeding mechanism that weighs on growth, as seen in Japan in the 1990s.

Weak private sector demand for credit shows up in China’s money supply.

The ratio between M1 money supply – which consists of cash in circulation and corporate demand deposits – and M2 money supply – which includes M1, fixed corporate, household and other deposits – fell to a record low in November.

“Low M1 growth could be an indicator of weak private business confidence, or a byproduct of the property downturn, or both, suggesting less satisfactory policy transmission. This is really concerning,” Citi analysts wrote.

Of the 21.58 trillion yuan ($3.01 trillion) in new loans in January-November 2023, about 20% went to households, while corporate loans made up for the rest.

Analysts said most of those loans were probably taken by state-owned enterprises, which typically have access to cheaper credit from state banks.

Private companies, especially from sectors not deemed to be policy priorities, have a harder time.

The PBOC’s benchmark one-year loan prime rate (LPR) stands at 3.45%, the lowest since August 2019, after a series of rate cuts in recent years.