Why interest rates policy can have opposite effect in China?

April 22nd, 2010

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In highly indebted countries such as ours, we associate lower interest rates with higher consumer expenditure and higher interest rates with lower consumer spending. The reason is simple. Since it is the norm for people to be indebted, lower interest rates implies lower debt servicing obligations, which implies greater borrowing capacity for spending.

Indeed, this was what happened in Australia when the Reserve Bank cut interest rates in 2008 to pre-empt any potential fallout from the GFC. The whole point of the interest rate cut was to help families repay their debt faster, which many did. But when the government dangled the higher First Home Owners? Grant (FHOG), many young people took this opportunity to borrow more. Lower interest rates certainly made it easier for these people to do so (which flowed on to the rest of the economy as increased consumer spending).

In countries like China, where the savings mentality is highly ingrained, lower interest rates have the opposite effect. To understand why, consider a typical Mr Wang who is saving for his son?s university education in say, 20 years time. Also, Mr Wang already has a substantial cash balance at the bank. When interest rates go up, Mr Wang will be earning greater returns on his cash at bank. With that, he can put aside less of his wages for savings, which implies that his spending can increase. When interest rates go down,  his returns on cash at bank reduces. Mr Wang will then feel that he needs to put aside more of his wages for savings, which implies that his spending have to decrease.

That explains why the Chinese consumers (especially the older generations) are so reluctant to spend. In fact, higher price inflation pushed many of the older folks to spend less in order to counter higher prices.

Remember, this is just our theory- that due to cultural differences, the demand for money in China is much higher than in Western countries (see Demand for money, inflation/deflation & its implication).