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Order from Chaos

Why China cut interest rates

The People’s Bank of China cut interest rates and the required reserve ratio after Chinese markets closed Tuesday. I have three quick reactions to this news:

First, it was appropriate to provide some monetary stimulus in this uncertain environment. The move was aimed at the real economy, making sure that the growth slowdown is not too severe. But it may ultimately have the side benefit of stabilizing the stock market. Nevertheless, the Shanghai market brushed off the central bank’s easing and closed down 1.3 percent in its first day of trading after the announcement.

Second, China is undergoing a transformation of its economy away from industry, exports, and investment towards services and consumption. Most of China’s high frequency data monitor the old economy and it’s not surprising that these data are weak. Through the first half of the year, services were growing rapidly, as were household income and consumption. But it is hard to know if that is still true in mid-August. China lacks the broad range of real-time data that the U.S. Federal Reserve relies on. China should produce more data related to the new economy.

Third, it would be prudent to provide some fiscal stimulus aimed at consumption to make sure that it continues to grow well. Tax cuts, even temporary ones, and more public spending on health, education, and the environment are good candidates. China can afford fiscal stimulus and should aim it at consumption to support the ongoing transformation of the economy.

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