China Cuts Interest Rates

News from China continues to dominate financial headlines and to upend the stability of domestic markets here in the U.S. We've blogged multiple times before about the ongoing issues China is facing, but this past Monday saw such a sharp decline in Chinese equities that Xinhua (the government’s official news agency) dubbed it "Black Monday." Domestic equity markets reacted to the massive sell-off in China by following them downward. Big names were not insulated from the big moves: Apple Inc. opened Monday down 10%, hitting a low 13% below Friday's close, before recovering to a loss of about 2.5% to end the day. The fall in equity markets pushed safe-haven Treasury yields down considerably, with the yield on 10 year debt falling below 2%. By Thursday, both U.S. and European markets had largely recovered, perhaps thanks to China's latest intervention tactics.

China announced at the end of the day Monday that they would try traditional monetary policy (rather than some of the more unique solutions they had tried previously) to help stabilize the economy, dropping interest rates by 0.25% and the required reserve ratio by 0.50%. For the year to date, China has now dropped interest rates by 1.4% down from a steady rate of 6% where interest rates had remained for over the past two years (see chart below).

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Emerging markets also seem to have stabilized themselves somewhat from China's fall. Where they had previously seemed anchored to the fall in Chinese markets (via the ties of exports and commodities), emerging market countries broke a seven-day slide with their largest gain in two years.

Ultimately, the real question that is puzzling markets and creating such big swings with every new tidbit of information is whether or not this is simply an equity bubble correction in China, or the first signs of something more. While some market participants think that this is merely a revaluation of overvalued Chinese equities and not a full-on financial crisis, others are not so sure. They point to signs of a slowing Chinese economy that is over-reliant on fixed investment for growth, and that has largely exhausted the gains to be had as labor switches from agriculture to manufacturing.

Of course, it could also be both, something emphasized by noted macroeconomist Barry Eichgreen who told Slate.com's Alison Griswold, "I think we are seeing two separate things. The growth of the economy has slowed from 10 percent a few years ago to somewhere in the 6 to 7 percent range, and that’s what we talk about in the paper. And then there’s a second, largely separate phenomenon where the stock market more than doubled since between last December and the beginning of the summer, and now it’s given back about half of what it gained, and you know all kinds of people are nonplussed, all kinds of small investors and local investors and others took steps on the stock market. They were encouraged to do so by authorities to juice the economy a bit. But now those efforts have unraveled.”

Gavyn Davies of the Financial Times seems to agree, noting in a recent article that "...China’s economic problems are deep seated, stemming from an unbalanced economy that is far too dependent on investment, and on inherent contradictions between the need to introduce market forces in the long term, and the need to retain state control to deflate the leverage bubble in the short term."

If China is facing both problems simultaneously, which one should be more concerning, and which should China be focusing on? All parties seem to agree that the underlying economic imbalances are far more troubling than the equity market correction, with some suggesting that they are the root cause of the market declines. Policymakers in China face a difficult task in addressing both.