Two weeks ago the People’s Bank of China announced this year’s sixth interest-rate cut. Each announcement has brought limited relief to the many corporate and local-government borrowers struggling with a phenomenon China hasn’t seen in nearly two decades: high real interest rates.

Up until 2012, Beijing practiced a development policy known as financial repression. Through the PBOC, it directed the banks that held a rapidly growing pool of household savings to lend at interest rates far below the country’s growth rate, and often below the inflation rate, and to pay depositors even less. This benefited borrowers at the expense of savers.

Michael Pettis
Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
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More than any other factor, this unleashed China’s investment-driven growth “miracle.” But artificially low interest rates make it difficult to judge the quality of investment. After many years of healthy growth, Chinese banks began to misallocate capital on an unprecedented scale. And because the same low interest rates depressed household income, it depressed consumption, further unbalancing China’s economy.

When the lending rate is in line with nominal GDP growth, savers and borrowers share the benefits of growth evenly. This wasn’t the case in China. While nominal growth averaged in the high teens for most of this century, China’s benchmark one-year lending rate averaged between 7% and 8%. This was painful for household savers, who typically received at least three percentage points less on their deposits.

But conditions began to change dramatically in 2012. Nominal growth dropped to 11.3% in 2012 from 17.4% in 2011. Now it’s fallen to 6.2%. This was matched by rapidly declining inflation; the broadest measure dropped sharply to just under 3% in 2012 from nearly 8% in 2011. It is slightly negative today.

Interest rates didn’t fall nearly as quickly. They began to decline in 2013, and by late October the benchmark one-year lending and deposit rates were lowered to 4.4% and 1.5%, respectively. Even if producer-price deflation is substantially less next year than the nearly 6% of the past 12 months, borrowing costs will still feel painfully high and borrowers will continue clamoring for relief.

If consumer prices keep increasing at last year’s levels of 1.6%, depositors will finally break even on their savings in real terms. But this comes after decades in which the real value of their savings declined by several percentage points each year.

This is why the PBOC was right to resist lowering interest rates in line with falling nominal GDP growth and inflation, and is right to continue resisting further reductions in interest rates. Thanks to years of repressed rates, China’s households saw their share of GDP drop sharply, while Chinese borrowers developed a very cavalier attitude to risk-taking.

And for all the wailing among borrowers, the benchmark one-year lending rate is still well below nominal GDP growth of 6.2%; government borrowing rates are even lower. Even if growth continues to drop on average by more than one percentage point every year until 2020, as I expect it will, borrowing costs are still low.

In spite of short-term pain, China is better off in the medium term by holding the line on interest rates. Beijing is working hard to reform the management of state-owned businesses, but their terrible investment record was caused less by incompetent management than by rational responses to excessively low interest rates. Higher interest rates will do more to fix this problem than any reorganization or changes in ownership structure.

More importantly, the longer the PBOC holds off lowering the deposit rate, the faster household income will grow. That will stimulate consumption, which must rise quickly if investment is to decline without causing job loss.

China must rapidly reduce investment growth if it hopes to control its burgeoning debt. Because high interest rates support consumption growth, the less aggressively the PBOC lowers them, the less likely it is that debt will soar to unmanageable levels.

The administration of Party Secretary Xi Jinping inherited a terribly unbalanced economy with burgeoning debt. Beijing doesn’t have easy options to control that debt before it reaches dangerous levels in three or four years. The PBOC will almost certainly lower interest rates further, but by delaying as much as possible it can promote needed restructuring. Higher rates will be painful, but much less so than allowing debt to spiral out of control.

This article was originally published in the Wall Street Journal.