Interest rates have risen as China's better-than-expected second quarter GDP lifted markets. At the same time, underlying inflation keeps falling, causing an even larger rise in real rates. S&P Global Ratings believes a climb in real interest rates may throw China's recovery off course just as it should be gathering steam.

China's economic data for July provide more indication the recovery remains unbalanced and reliant on extraordinary policy support. China's industrial sector has been remarkably resilient, largely aided by rising global demand for technology and medical equipment arising from the global pandemic. Stimulus spending has lifted infrastructure investment and the upstream industries that feed it. Finally, rising household savings and a desire for assets perceived as a reliable store of wealth have lifted China's property market (see chart 1).

Chart 1

China's consumers are lagging behind in this recovery (see chart 1). Five months after COVID-19 cases peaked, retail sales are still below the levels for the same period last year. Until COVID-19, monthly retail sales had been growing at close to 8%, year on year.

Consumers are spending, of course. Online food sales have boomed but this likely reflects higher food prices and a change in how people shop, not how much they are spending (see chart 2). Sales of autos have picked up, perhaps lifted by incentives, and demand for cellphones remains strong. Still, many other categories stay weak, from clothes to furniture and household appliances, especially compared with recent years.

Chart 2

The other soft spot is investment in the manufacturing sector, which private firms have dominated in recent years. Compared with the same month a year ago, manufacturing investment fell about 1% in July. The good news is that investment in the electronics and medical-related sectors is strong, reflecting robust global demand for these types of goods.

Policy support in these areas also partly explains the resilience. State-owned enterprises (SOEs) raised investment in all sectors 14% in July (year on year) compared with 3% for private firms. Indeed, SOEs have been investing at a faster pace than private firms for some time now, stretching back to 2019.

The dynamics behind this unbalanced recovery remain the same, in our view. Social distancing--enforced or voluntary--suppresses demand for business and consumer services, holding back jobs. The purchasing managers' index (PMI) for services indicate most firms asked are still reporting fewer jobs.

The service sector and private firms are the engines of job growth in normal times. Households are reacting to an income shock and jobs uncertainty by cutting spending and saving more. The U.S.-China trade and technology fight adds to challenges, mostly by hitting already fragile confidence, but this is still mostly a domestic story.

So it seems too early for China's economy to have to deal with rising real interest rates, a more onerous debt-servicing burden, and tightening financial conditions--but that is exactly what is happening. This reflects higher nominal interest rates and lower inflation.

Investors have turned to equities and shunned government bonds, often seen as a safe haven, causing their yields to rise and also pushing up yields on corporate bonds. At the same time, markets have interpreted the recent rise in short-term repo rates--which are heavily influenced by People's Bank of China (PBOC) policies--as a sign that policymakers are comfortable pulling back some monetary stimulus.

The one-year swap rate is a good measure of what the market expects for the average level of the repo rate over the next 12 months. The rate has risen by 100 basis points (or 1 percentage point) since May (see chart 3). The result has been a rise in interest rates across all maturities from overnight to 10 years.

Chart 3

At the same time, inflation continues to fall as supply outruns demand. Focus on core inflation, which excludes food and energy. The core rate is less sensitive to supply shocks and better represents cyclical economic conditions.

In July, core consumer prices were just 0.5% higher than a year ago. Remember that core inflation started 2020 at about 1.5%. Producer prices are already in deflation. As inflation falls or deflation intensifies, wages and corporate revenues will experience less upward pressure. In turn, this increases real interest rates and makes debt servicing harder but also discourages new borrowing.

Corporate borrowers are particularly exposed, as reflected in the one-year loan prime rate (LPR), the representative lending rate to prime corporate borrowers. The LPR is anchored to the rate offered by the PBOC's medium-term lending facility, or MLF. Since COVID-19 broke, the PBOC has kept the MLF broadly stable, surprising many market participants who expected steep cuts. In turn, since the start of 2020, the LPR has fallen by just 30 basis points, to 3.85%. Over the same period, core inflation has fallen by 100 basis points, so the real LPR interest rate has risen by 70 basis points.

Chart 4 shows the real LPR and the effective lending rate on general loans offered by banks to corporate customers. (The LPR is extended back before its introduction using the benchmark lending rate.) The PBOC discloses the effective lending rate quarterly, but we can roughly predict where it will be every month because it closely tracks the LPR and corporate bond yields. The effective rate reflects the pricing of new loans so the effect will not be felt on many borrowers until the interest rate resets. In China, for both corporate and mortgage borrowers, this typically happens annually, either on January 1 or the date on which the initial contract was signed.

Chart 4

What does this tell us about current policies? In a recent interview, the governor of the central bank, Yi Gang, suggested that actions taken since COVID-19 can be summarized in 18 characters, just three of which were "cut interest rates." The governor highlighted declines in three key rates in June 2020, from the end of 2019: the weighted average repo (down 21 basis points), the 10-year government bond yield (down 32 basis points), and the inclusive finance rate for small and midsize enterprises (down 80 basis points).

The governor was referring to interest rates in June in his remarks. Since then, at least two of these rates have risen in nominal terms. The repo is up 35 basis points and the 10-year government bond yield has risen 10 basis points. Given the likely rise in the effective loan rate, we would expect some upward pressure on inclusive loan rates also, even if the central bank is providing moral suasion to keep them low. Of course, as we have noted and because core inflation is falling, in real terms, the increase in rates will be larger.

As well as market optimism, rising rates also reflect an abiding tension in the central bank's wish to lower borrowing costs while guarding against financial risks. Can it be done? The central bank is trying by developing tools that increase access to credit for the real economy, especially small and midsize enterprises, while keeping credit on a tight rein.

The overall credit impulse is measured as the change in net credit to the nonfinancial sector as a share of trend GDP. This indicator rose sharply in the second quarter as policies were eased, especially fiscal and credit policies. But the impulse is now turning sharply negative at the same time that real interest rates are rising--surely not a coincidence. We estimate a negative impulse of about 3 percentage points of GDP over recent months. The central bank governor noted that his focus in the second half is to ensure monetary policy becomes more "precise." China may pull this off but history suggests that monetary policy is a blunt tool rather than a scalpel.

Overall, emerging downside risks to growth from financial conditions are attributable to an abundance of policymaker prudence, over-optimism in financial markets that pushes interest rates higher, and a recovery that remains unconvincing. Our forecast for Chinese GDP growth in 2020 and 2021 remains at 1.2% and 7.4%, respectively.

Second-quarter growth of 3.2% suggests we should be thinking about revising our full-year forecast higher, and mechanically that makes sense (we had expected something between 1% and 2% for the quarter). But until China's consumers start spending and private firms pick up investment, it's too early to say the recovery is self-sustaining and can live with much less stimulus, including higher real interest rates.

Related Research

• China's Deflating Recovery Still Needs Stimulus, July 21, 2020
• Hong Kong's Trend Growth To More Than Halve By 2030, July 20, 2020
• Asia-Pacific Losses Near $3 Trillion As Balance Sheet Recession Looms, June 26, 2020
• The China Confidence Game, June 17, 2020
• The Refinancing Clock Is Ticking Louder For China's Issuers, April 16, 2020