Zero Interest Rate Traps

Foreign investment institutions have forecast that the yuan will continue depreciating after its inclusion into the currency basket of the special drawing rights （SDR）. The reason behind that logic is that Chinese monetary authorities may try to reduce or even stop interventions—in order to examine the yuans capability to resist external pressures.

For instance， Citigroup Inc. strategists projected in their 2016 outlook that as the U.S. economy enters its seventh year of expansion following the 2008-09 crisis， the probability of a U.S. recession will reach 65 percent next year. In China， Citi claims that deflationary pressures and downside risks to growth will force Beijing to loosen fiscal policy and let the yuan depreciate. Perhaps China will become the first major emerging market economy to cut interest rates to zero.

Danny Gabay， a director of Londonbased macro research consultancy Fathom Financial Consulting， said in November that Chinas central bank will eventually follow its Western counterparts by cutting its benchmark interest rate to zero. Gabay also said the yuan is to slide by an estimated 2-3 percent per quarter for the next two years—ultimately by about 25 percent.

The forecasts and therapies that foreign experts offer are based on the theories and institutions in the European and U.S. markets. However， the market conditions and institutions in China are completely different. Therefore， the financial strategies that serve benefits to Europe and the United States are unlikely to work in China.

In any case， China still faces the imminent challenge of an economic slowdown， and the government must adjust policies in order to maintain economic growth. However， if the central bank is to continue cutting interest rates all the way down to zero， the Chinese economy would find itself in a hard position to make a sound recovery in the future.

The slashing of interest rates down to zero would lower the costs of financing and relieve debt-burdened companies while also stimulating consumption. However， it is important to note that commercial banks absolutely dominate the current financial system in China.

A zero-interest policy will not only drive a large chunk of the 134 trillion yuan （$21.03 trillion） in deposits out of the banks and reduce the available funds for domestic banks to lend， but also thoroughly change the profit pattern and profitability of Chinese commercial banks. A business pattern that is backed by no interest rates spurs and intensifies competition， which may put immature commercial banks into hot water. This could prove to be difficult to reverse， were it to arouse a serious crisis in Chinas financial sector. In the second half of this year， the profit rates of Chinese commercial banks dropped to a decade low， but non-performing loans were rising. The banking regulatory authority is quite conscious of these potentially dangerous variables.

According to a report by McKinsey & Co.， by the first half of 2014， the debt of Chinese government， companies and families had totaled 2.82 times that of the countrys GDP. The debt issue is now a major focus point for the Chinese Government. If China cuts the interest rates to zero， the corporate debt load will be greatly relieved， but this will also seriously eat away at the value of the yuan， which will cause a massive depreciation of the currency. A 25-percent depreciation would bring immeasurable stress to the yuan that was recently added into the SDR basket. The yuans internationalization would also be impeded， because the huge capital flow out of China could arouse expectations of depreciation.

Under current circumstances， any further depreciation of the yuan would cause a negative feed-back loop， wherein expectations of the devaluation could lead toward the decreased value of the yuan. The Chinese Government should stay vigilant against any crises that could stem from such negative speculation.

Since the mere 3-percent depreciation of the currency， following the central banks announcement to improve the yuans exchange rate formation system on August 11， had caused such global turmoil， what would a 25-percent fall in the value of the currency arouse？ Would the global and Chinese markets be capable of surviving such a torturous scenario？

As for the conditions of Chinas real economy and financial market structure， even if the interest rates are slashed to zero， it wont be easy to alleviate corporate debt burdens. That is because many of those companies borrow a great amount of money from private lenders. Under a zero-interest policy， those most affected would mainly be in the real estate industry， since a huge amount of capital could be expected to flow into that market. Such an influx of capital would only serve to further inflate the housing bubble again， making it more difficult to reduce the number of unsold homes.

The market is now pessimistic while the yuan is facing severe depreciation pressure， but in the middle and long term， the huge demand encouraged by the yuans internationalization， the new economic impetus stimulated by the 13th Five-Year Plan （2016-20） and the multiple government pro-growth policies will all support the yuan in remaining strong.

The tendency of moderate-to-high speed economic growth has not changed， the trade surplus in goods is still large， and both foreign and outbound direct investment are growing， which means there is no logical basis for the yuan to continue depreciating.