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I don’t mind telling a dark side.
Clint Eastwood

While the PBoC will likely cut rates in a few more small steps in the short-term, China is probably not entering a rate-cut cycle, in my view, due to both macroeconomic and microeconomic constraints. In a broader sense, this underscores my view that Chinese yields may be approaching a bottom in the coming months.

Easing timidly

To strike a balance between easing policy and containing potential inflationary pressures, the PBoC has, in my view, opted for a low-profile easing approach by adjusting liquidity and interest rates via the money market (reverse repo rate) and lending facility (MLF injection and interest rate) in the face of rising CPI inflation due mainly to soaring pork price. Following the cut in the MLF interest rate by 5bps and the RMB200 bn liquidity injection via the MLF on 5 November and 15 November, respectively, the PBoC cut its 7-day reverse repo interest rate and the Loan Prime Rate (LPR) by 5 bps on 18 November and 20 November, respectively, discerning a series of small step policy easing. The reverse repo rate is a proxy to the PBoC’s policy stance while the MLF rate is the benchmark for pricing the commercial banks’ LPR. Thus, the cuts in these two crucial interest rates show clearly a policy easing move, as the authorities become more concerned about the weak growth momentum.

Limited systemic effect

At the present stage of development, money market rates in China are not yet an important channel affecting system-wide credit as Chinese banks source the bulk of their funding from retail deposits. Meanwhile, not all banks in the system benefit from MLF injection and rate cut as the PBoC controls the liquidity allocation in the MLF to only a designated group of banks and directs the MLF liquidity recipient banks to fund 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, the selective easing mode is inherently unstable because it is not enough 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 the economy under the weights of domestic debt control and an external trade war.

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 high profile liquidity injection. Some market players are wondering if China has entered a rate-cut cycle.

Perhaps not, in my view.

Firstly, CPI inflation has risen to over 3%, above the PBoC’s inflation target threshold of 3%, thanks to soaring pork price due to the African swine flu. Granted, core CPI has remained below 2%. But as the economy is likely to stabilise and even recover a bit soon, the concern about broadening inflationary pressures will become more prominent on the PBoC’s radar screen. Secondly, the PBoC faces a systemic stability constraint on rate cuts. It has become a top priority for Chinese banks to raise capital, especially for the 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, China’s real lending rate is already low. For example, with nominal GDP growing at 7.6% currently, the prevailing LPR of 4.15% means that China’s prime lending rate is 3.45% below the nominal GDP growth rate. Few countries have the prime lending rate that is 350bps lower than nominal GDP growth. Furthermore, China’s real LPR is approaching zero with CPI rising 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.

Chi Lo, Senior Economist


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