China’s surprise rate cut may be just the beginning

Tuesday’s surprise People’s Bank of China (PBOC) interest rate cut signaled the depths of Beijing’s concerns about the slowdown in Asia’s biggest economy. Governor Yi Gang’s team lowered its seven-day reverse repurchase rate by 10 basis points to 1.9%, the first such move since August 2022. The swift reaction in global markets is a reminder that the global spotlight is on the PBOC as rarely before as three data points converge. One is a slowing economy with factory-gate inflation trends falling even faster. Two, a cratering property sector crying out for monetary support. Three, news in the last five days that six state-owned banks cut their deposit rates under policymakers’ guidance. Put it all together and traders can begin to understand why the PBOC cut rates so unexpectedly. Already, the debate is shifting to when might the PBOC ease again. It could be a while. There are two different arguments here. One is that, sure, China’s financial system could possibly do with another official rate cut. The other is that, no, Governor Yi doesn’t want to go there if he can avoid opening the monetary floodgates anew. It’s true that demand for credit is low and unevenly distributed. It’s true, too, that there are concerns as disinflationary trends might morph into full-blown deflation. As a weaker-than-expected Covid-19 reopening trade weighs on manufacturing, China’s factory gate prices plunged 4.6% in May, the most precipitous decline in seven years. Yet strategist Alvin Tan at RBC Capital Markets speaks for many when he warns that rate cuts alone won’t solve the biggest headwind — a “troubled property sector” that’s keeping households “under pressure.” Goldman Sachs economist Wang Lisheng says a stumbling real estate sector is an increasing drag on China’s 2023, not least its ability to reach the government’s 5% gross domestic product (GDP) growth target. The trouble, Wang says, is “falling demographic demand, a shift in policy focus to support strategically important sectors, and weaker housing affordability.” The problem, in other words, is of a long-term structural nature, not something that adding yuan to the system can fix. This puts the onus less on Yi’s PBOC than Premier Li Qiang’s reform team, which is reportedly gearing up to recalibrate growth engines. China’s Premier Li Qiang takes an oath after being elected during the fourth plenary session of the National People’s Congress (NPC) at the Great Hall of the People in Beijing, China on March 11, 2023. Image: Pool / Twitter / Screengrab One important pivot that Li set in motion since March is stepping away from Beijing’s draconian tech crackdown. The fallout from President Xi Jinping’s maneuver, one that started with sidelining Alibaba Group founder Jack Ma, continues to cast a cloud over China’s appeal as an investment destination. Look no further than the yuan trading well past 7 to the US dollar. It’s a sign, in part, that global investors are taking a trust-but-verify approach to Li’s insistence that China is once again open for business. As Li said in late March: “We will align with international economic and trade rules that are of very high standards, expand our opening-up in a steady and systematic way, and strive to create a first-class business environment that is market-oriented, rule-of-law-based and internationalized. No matter how the international situation changes, China will unswervingly keep expanding our opening up.” One example of that opening: the new “Swap Connect” program between China and Hong Kong. On top of earlier stock and bond connect arrangements, this new framework opens the way for overseas funds to access derivatives vital to hedging bets in China’s bond market. The dearth of hedging tools has long turned off the biggest of the big money. That scheme also enables traders to deal in key money-market rates tied closely to PBOC policies. It deepens institutional investors’ involvement in China markets. And it’s a notable step toward fulfilling a pledge to open mainland capital markets to international funds. Rose Zhu, chief China country officer at Deutsche Bank, calls it “a huge leap forward in developing the domestic derivatives and bond markets.” If executed well, the capital pulled in via such connect dynamics could help to turn the page, to some extent, from the regulatory crackdowns of 2020 and 2021. It reminds top investment banks that the geopolitical turbulence and dueling sanctions between Beijing and Washington isn’t completely derailing market reforms. However, that doesn’t mean the PBOC won’t be adding liquidity in the short-to-medium term. After all, as economists at Maybank warned last week, “there’s immense concern for the country’s economy especially given there appears to be limited sources of growth.” As strategist Kelvin Wong at OANDA points out, the recent move by six state-owned banks to cut deposit rates proved the point. “These measures,” Wo

China’s surprise rate cut may be just the beginning

Tuesday’s surprise People’s Bank of China (PBOC) interest rate cut signaled the depths of Beijing’s concerns about the slowdown in Asia’s biggest economy.

Governor Yi Gang’s team lowered its seven-day reverse repurchase rate by 10 basis points to 1.9%, the first such move since August 2022. The swift reaction in global markets is a reminder that the global spotlight is on the PBOC as rarely before as three data points converge.

One is a slowing economy with factory-gate inflation trends falling even faster. Two, a cratering property sector crying out for monetary support. Three, news in the last five days that six state-owned banks cut their deposit rates under policymakers’ guidance. Put it all together and traders can begin to understand why the PBOC cut rates so unexpectedly.

Already, the debate is shifting to when might the PBOC ease again. It could be a while.

There are two different arguments here. One is that, sure, China’s financial system could possibly do with another official rate cut. The other is that, no, Governor Yi doesn’t want to go there if he can avoid opening the monetary floodgates anew.

It’s true that demand for credit is low and unevenly distributed. It’s true, too, that there are concerns as disinflationary trends might morph into full-blown deflation.

As a weaker-than-expected Covid-19 reopening trade weighs on manufacturing, China’s factory gate prices plunged 4.6% in May, the most precipitous decline in seven years.

Yet strategist Alvin Tan at RBC Capital Markets speaks for many when he warns that rate cuts alone won’t solve the biggest headwind — a “troubled property sector” that’s keeping households “under pressure.”

Goldman Sachs economist Wang Lisheng says a stumbling real estate sector is an increasing drag on China’s 2023, not least its ability to reach the government’s 5% gross domestic product (GDP) growth target.

The trouble, Wang says, is “falling demographic demand, a shift in policy focus to support strategically important sectors, and weaker housing affordability.”

The problem, in other words, is of a long-term structural nature, not something that adding yuan to the system can fix. This puts the onus less on Yi’s PBOC than Premier Li Qiang’s reform team, which is reportedly gearing up to recalibrate growth engines.

China’s Premier Li Qiang takes an oath after being elected during the fourth plenary session of the National People’s Congress (NPC) at the Great Hall of the People in Beijing, China on March 11, 2023. Image: Pool / Twitter / Screengrab

One important pivot that Li set in motion since March is stepping away from Beijing’s draconian tech crackdown. The fallout from President Xi Jinping’s maneuver, one that started with sidelining Alibaba Group founder Jack Ma, continues to cast a cloud over China’s appeal as an investment destination.

Look no further than the yuan trading well past 7 to the US dollar. It’s a sign, in part, that global investors are taking a trust-but-verify approach to Li’s insistence that China is once again open for business.

As Li said in late March: “We will align with international economic and trade rules that are of very high standards, expand our opening-up in a steady and systematic way, and strive to create a first-class business environment that is market-oriented, rule-of-law-based and internationalized. No matter how the international situation changes, China will unswervingly keep expanding our opening up.”

One example of that opening: the new “Swap Connect” program between China and Hong Kong. On top of earlier stock and bond connect arrangements, this new framework opens the way for overseas funds to access derivatives vital to hedging bets in China’s bond market. The dearth of hedging tools has long turned off the biggest of the big money.

That scheme also enables traders to deal in key money-market rates tied closely to PBOC policies. It deepens institutional investors’ involvement in China markets. And it’s a notable step toward fulfilling a pledge to open mainland capital markets to international funds.

Rose Zhu, chief China country officer at Deutsche Bank, calls it “a huge leap forward in developing the domestic derivatives and bond markets.”

If executed well, the capital pulled in via such connect dynamics could help to turn the page, to some extent, from the regulatory crackdowns of 2020 and 2021. It reminds top investment banks that the geopolitical turbulence and dueling sanctions between Beijing and Washington isn’t completely derailing market reforms.

However, that doesn’t mean the PBOC won’t be adding liquidity in the short-to-medium term. After all, as economists at Maybank warned last week, “there’s immense concern for the country’s economy especially given there appears to be limited sources of growth.”

As strategist Kelvin Wong at OANDA points out, the recent move by six state-owned banks to cut deposit rates proved the point. “These measures,” Wong says, “are made to stimulate consumer confidence and increased credit supply so that there will be lesser funds inflow into the banks’ fixed deposit products and lower the cost of funding for banks, which in turn can incentivize a reduction in lending rates.”

Economist Carlos Casanova at Union Bancaire Privée is in the camp that has been expecting stronger PBOC actions. “Weak May inflation reinforces the case for stronger policy support,” he says, adding that “although subdued inflation is good news for consumption, excessive deflation is also problematic, as it entails smaller profits for companies and slower job creation.”

Casanova says “we think the PBOC could also consider additional reserve requirement ratio cuts as well as continued support via liquidity operations and faster credit growth.” Monetary support, he adds, “will have to be accompanied by bottom-up policies” to boost demand for, say, electric vehicles and other big-ticket items like household appliances.

“Macroprudential support for the housing sector,” Casanova says, “is already underway on a province-by-province basis and could be expanded. We also expect measures to address youth unemployment over the summer months.”

Residential buildings in Beijing. The average price last year for second-hand housing in China's capital was 60,925 yuan per square meter, down 3.3% from a year earlier. Photo: iStock
Residential buildings in Beijing. Photo: iStock

Casanova views large state-owned domestic banks trimming deposit rates as a step in the right direction. “This should help to improve profit margins,” he says, “allowing more room to extend credit to key sectors” such as small-and-medium-sized enterprises.

Economist Li Chao at Zheshang Securities also sees good odds that the PBOC will be more active in the second half of the year — both through rate cuts and RRR reductions.

Add analyst Ming Ming at Citic Securities Co to the China-needs-a-rate-cut camp. “June is a key window of policy to stabilize economic growth,” Ming notes. “That, combined with some recent activity and financial indicators as well as market sentiment, has led to a clear increase in the necessity for an interest rate cut.”

Economist Zhiwei Zhang at Pinpoint Asset Management worries that the “risk of deflation is still weighing on the economy. Recent economic indicators send consistent signals that the economy is cooling.”

Yet things on the ground in China are rather complicated. Case in point: don’t rule out a rebound in consumer prices.

“We still think a tightening labor market will put some upward pressure on inflation later this year,” says economist Julian Evans-Pritchard at Capital Economics. Odds are, he says, mainland inflation “will remain well within policymakers’ comfort zone.”

Evans-Pritchard adds that the “government’s ceiling of around 3% for the headline rate is unlikely to be tested and we doubt inflation will become a barrier to increased policy support.”

Yet easier PBOC policies won’t easily resurrect China’s property sector. Though a cornerstone generator of mainland GDP didn’t collapse amid three years of Covid pain, it’s displaying telltale signs of stress. In May, for example, its post-pandemic resurgence slowed to just 6.7% from a 29%-plus pace in the previous two months.

Goldman’s Wang notes that Beijing policymakers are likely to loosen the availability of credit to new homebuyers. That could take the form of targeted lowering of mortgage rates and down-payment ratios and easing up on curbs on home purchases.

Yet Wang doesn’t expect to see Beijing moving to “engineer an up-cycle” that kicks off a “repeat of the 2015-2018 cash-backed shantytown renovation program.”

Rather, Wang sees Premier Li’s team favoring a non-PBOC “endgame for the property sector policy” that lowers the sector’s pivotal role in driving growth.

Along with fixing cracks in the property sector, Li’s team also must accelerate efforts to build wider and deeper social safety nets. Economists agree this is the key to prodding mainland households to save less and spend more over time to increase the role of domestic demand-led growth.

The “prioritization of spending on households over investment would also deliver larger stabilization benefits,” notes International Monetary Fund economist Thomas Helbling.

“For example, means-tested transfers to households would boost aggregate demand 50% more than an equivalent amount of public investment. To ensure consistency across policies, fiscal policy should be undertaken within a medium-term fiscal framework.”

China needs more domestic spending and less savings to stimulate growth. Photo: Facebook

Helbling argues for “an ambitious but feasible set of reforms [that] can improve these prospects, importantly in a way that is inclusive by raising the role of household consumption in demand.”

“Reforms such as gradually lifting the retirement age to increase labor supply, strengthening unemployment and health insurance benefits, and reforming state-owned enterprises to close their productivity gap with private firms would significantly boost growth in coming years,” he says.

Even so, the PPOC has limited ability to counter headwinds bearing down on China’s economy. Tuesday’s surprise rate move could be a confidence booster for global investors. But it also seems the central bank’s way of signaling that it’s time for the government to take the lead in safeguarding and stimulating growth.

Follow William Pesek on Twitter at @WilliamPesek