Even though the central bank will likely cut interest rates further in small steps in the near term, China is probably not entering a rate-cut cycle, given the macro and microeconomic constraints.
- Easing policy bit by bit reflects Beijing’s concerns over slowing GDP growth momentum
- Tweaking money market rates should have only a limited impact
- Chinese bond yields may be approaching a bottom in the coming months
Monetary policy easing: gently does it
To strike a balance between easing policy and containing potential inflationary pressures, the People’s Bank of China (PBoC) has, in my view, opted for a low-profile approach by adjusting liquidity and interest rates via the money market (i.e. the reverse repo rate) and the lending facility (MLF injection and MLF interest rate) in the face of rising inflation due mainly to soaring pork prices.
Policy easing in small steps has been in evidence lately: the MLF interest rate was cut by just 5bp and RMB 200 billion of liquidity was injected via the MLF on 5 November and 15 November, respectively. These steps were followed by a cut in the 7-day reverse repo rate and the loan prime rate (LPR) by 5bp on 18 November and 20 November.
The reverse repo rate is a proxy for the PBoC’s policy stance, while the MLF rate is the benchmark for pricing commercial banks’ LPR. The cuts in these two crucial rates clearly show policy easing as the authorities become more concerned over weak GDP growth momentum.
Limited systemic effect
Money market rates have not so far become an important channel affecting system-wide credit because banks source the bulk of their funding from retail deposits. Meanwhile, not all banks benefit from central bank MLF injections and rate cuts as the PBoC controls the allocation of liquidity via the MLF to only a designated group of banks, and directs banks that do receive MLF liquidity injections to use the money for specific investments.
Thus, policy easing via adjustments in the reverse repo rate and the MLF are easing efforts without significant systemic effects. They also signal to the market that Beijing is not implementing massive reflation.
However, selective easing is inherently unstable because it is insufficient to revive a cyclical upturn and the authorities have to reassure the market constantly that no wholesale bailout would be needed. Selective easing also runs a policy risk of overestimating the strength of an economy that is under pressure from domestic debt control and a trade war.
Is the central bank entering a rate-cut cycle?
There will likely be more easing in the short term through lending facilities rate cuts and injections and LPR cuts, but not a high-profile liquidity injection. Some market players are wondering whether China has entered a rate-cut cycle. Perhaps not, in my view.
- Firstly, inflation has risen to above the PBoC’s target threshold of 3% thanks to soaring pork prices due to the African swine flu. Granted, core inflation has remained below 2%. But as the economy is likely to stabilise soon and even recover slightly, concern over broadening inflationary pressures will likely become more prominent on the PBoC’s radar.
- Secondly, the central bank faces a systemic stability constraint on rate cuts. It has become a top priority for Chinese banks to raise capital, especially for small and medium-sized banks which are under-capitalised. There have already been a few cases of small bank failures since May this year. It would be hard for them to attract capital if their earnings are hit by declining lending rates.
- Lastly, from a long-term reform perspective, the real lending rate is already low. For example, with nominal GDP growing at 7.6% currently, the prevailing LPR of 4.15% means that the prime lending rate is 3.45% below the nominal GDP growth rate. Few countries have a prime lending rate that is some 350bp lower than nominal growth. Furthermore, the real LPR is approaching zero with inflation rising to above 3%. If the real lending rate is too low, it could backfire on the government’s debt reduction and structural reform objectives by allowing the ‘zombie firms’ to survive.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
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