Monetary policy won't save China; economic reform will

The People's Bank of China, China's central bank, recently cut interest rates twice in one month after nearly three years with no such reduction. The latest rate cuts have triggered public concern over the future of China's economic development. There is now a need to discern whether the central bank will continue to tighten its monetary policy going forward, and what effect this could have on the economy.
Since December 2011, the central bank has lowered commercial banks' required reserve ratio three times. It cut interest rates for the second time on June 8. Market experts were predicting that the central bank will focus on liquidity control measures in the short term, such as reserve ratio cuts and debt buybacks, rather than continuing with interest rate cuts. The bank nevertheless announced surprise interest rate cuts last week.

The risk of a decline in the Chinese economy is higher than most believe. GDP growth in the second quarter of this year has been estimated to fall by 7.6%, approaching the 7.5% target set by Chinese authorities. What is more, the purchasing managers index — a measure of the manufacturing sector — touched a record low in June. The annual growth rate of the consumer price index fell to 2.2%, indicating a slowdown in the economy. And foreign institutions maintain a grim outlook on China's economy, with a Citibank China report even warning that the country is at its most critical economic moment in 30 years.

Since the beginning of this year, Beijing has adopted various measures to stimulate domestic demand. It has encouraged the consumption of energy-efficient automobiles and home appliances, and approved investments in infrastructure projects worth several hundreds of billions of yuan. These measures have been far less effective than expected.
There is now a need to introduce more effective monetary policies to stimulate investment, consumption and demand.

Beijing has demonstrated its resolve to stabilize China's economy to ensure social stability and a smooth transfer of power before the 18th National Congress of the Chinese Communist Party in October, during which a leadership changeover is expected to take place.
Compared with the policies adopted by the United States, Europe and Japan — which have promised to keep interest rates near zero — there is ample room for China to alter policies in order to meet its goals.

But China's current economic problems are the result of an overly relaxed monetary policy that begun in the wake of the recent financial crisis. Problems could arise if the central bank tries to adopt an expansionary monetary policy to reverse the economic decline.
China's currency supply has grown greatly. The broad money supply, or M2, has increased to 90 trillion yuan (US$), more than that of the United States. The enormous resulting liquidity was the root cause of China's property bubble and rising commodity prices. If the central bank continues to cut interest rates, this could revive the housing bubble that the country has expended much political capital to combat.

Restructuring the economy has become Beijing's major goal. The government has said several times that it will reduce GDP growth to allow restructuring. It has again resorted to interest rate cuts to maintain economic growth. This means that China's economic transformation could stall, as maintaining stable growth is deemed the top policy target.
The central bank adopted asymmetric interest rate cuts mainly to reduce corporate borrowing costs and increase the flexibility of rates. Yet under China's dual financial structure, the main beneficiaries of regular financial institutions' loans are state-owned enterprises. State firms may invest too heavily, proving detrimental to reforms.

Although China maintains a trade surplus and its currency is stable compared to those of other emerging countries, leading to low import prices and inflationary pressure, Beijing should be cautious in adopting measures to maintain stable growth and not rely too heavily on monetary policy. It should instead implement systemic reforms and relax regulations to increase private investment, allowing private firms to borrow more easily and at lower rates. Only these kinds of reforms will bring about stable economic growth.