The world’s No.2 economy is near the point where lower rates make matters worse—a deflationary black hole

(Originally published Aug. 28 in “What in the World“) Profits at China’s big manufacturers continue to tumble.

The National Bureau of Statistics said Sunday that industrial profits fell 6.7% in July, the seventh consecutive monthly decline. Industrial earnings fell 16.8% in the first half of 2023 compared with the first half of 2022 and dropped 15.5% in the first seven months of the year.

With the job and housing markets weak, the stock market falling, and little available in the way of a socialist safety net, it’s little wonder that China’s heavily indebted households are gripped with a deepening feeling of despair. The gloom threatens not only President Xi Jinping’s efforts to deliver prosperity, but perhaps his grip on power.

But as he tries to arrest China’s economic downturn, Xi may discover that policies devised in Beijing may not have the intended effect in the provinces.

One problem: local government officials may simply not execute them. Shanghai, for example, may not fully implement new measures designed to revive property demand. Officials there, still under the influence of Beijing’s campaign in recent year to rein in the property market’s excesses, don’t want to risk reviving the kind of frenzied over-investment that they’ve been battling so hard to quell. Even if the orders to reverse course are coming down from Beijing.

The other problem: efforts to stimulate the economy can sometimes do just the opposite. Take China’s banks and their depositors. While the government has directed banks to boost property lending, the central bank raised eyebrows last week by cutting the one-year prime rate used as a benchmark for loans to businesses to 3.45% from 3.55%. But it left its five-year loan prime rate, the benchmark for mortgages at 4.2%. The idea was reportedly to avoid any further cuts in commercial banks’ interest margins, which had dropped by July to 1.74%, lower than the 1.8% level the central bank considers a safe minimum.

Economists now expect that banks may soon cut deposit rates. By cutting what they pay their depositors, banks may then be able to lower what they charge for mortgage loans.

But that’s not what ordinarily happens. Banks faced with the prospect of weak loan growth, low margins and increasing defaults on existing loans often become even more reluctant to make new loans. Instead of seeking to preserve their margins, they try to boost them for new loans to offset expected losses on existing assets. Banks also tend to beef up their cash reserves in hard times to preserve their own liquidity and so lend less—even if margins are the same or higher.

Regulatory efforts in recent years to make banks safer can accentuate this effect. While in the past banks were governed primarily by reserve requirements, they now face strict prudential rules on how much capital they must hold, how much they can borrow against that capital to lend and how much liquidity they must maintain. All these ratios are determined by how much they have lent and how much of that money is, in turn, at risk. When the risk of default goes up, these regulatory guardrails force banks to become more conservative. That helps safeguard the banks but can exacerbate a credit crunch and make it harder for policymakers to translate monetary policies into real credit to consumers and businesses that need it.

Their depositors can behave the same way. Central banks facing low inflation, or in China’s case deflation, like to see deposit rates go down because it ostensibly discourages savers and prompts them to spend.

But not always. In a weak economy with fearful consumers already saving for a rainy day, lowering deposit rates when it’s already raining sometimes prompts fearful consumers to save even more.

Both these phenomena are corollaries of a phenomenon economists call “pushing on a string.” In a weak economy, you can offer borrowers lower rates, but you can’t make them borrow. You can lower costs for banks, but you can’t make them lend. And you can punish consumers with lower deposit rates, but you can’t make them spend.