By Ana Swanson
China’s central bank carried out one of its famous surprise moves last Friday. At 6:30 p.m. local time, three-and-a-half hours after the markets closed, the central bank announced it was cutting interest rates, the first time it has done so in more than two years.
In a move widely viewed as a recognition of the need to return to a more expansionary monetary policy to stimulate growth, the Chinese central bank, or People’s Bank of China (PBOC), cut the benchmark lending rate by 0.40 percentage points, to 5.6% from 6%. It also cut the benchmark deposit rate by 0.25 percentage points, from 3% to 2.75%.
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My firm, JL Warren Capital, sees the rate cut in a different context. In contrast to the market view, we believe the rate cut is a largely symbolic move with limited practical effect.
Rate cuts should theoretically lower the cost of borrowing and spur the economy. China’s growth dipped to 7.3% in the third quarter, while economic metrics such as consumer-price inflation also lost steam.
But while the PBOC lowered the ceiling that banks can set on their deposit rates to 2.75% from 3%, it simultaneously made an offsetting move. It also said that banks can now pay depositors 1.2 times the benchmark rate for one-year deposits, up from 1.1 times previously. This in fact leaves the effective ceiling on the one-year deposit rate unchanged at 3.3% (3 x 1.1% = 3.3%, and 2.75% x 1.2 = 3.3%).
Rate cuts are unlikely to have more than a limited practical impact.
Meanwhile, unlike the ceiling on deposit rates, the floor on the lending rate is not actually a binding constraint for banks in China. China eliminated the lower limit on lending rates in July 2013, as a partial step toward liberalizing interest rates. So while the central bank still issues the benchmark lending rate as guidance, Chinese banks can issue loans as cheaply as they wish.
So, other than their symbolic value, the rate cuts are unlikely to have more than a limited practical impact. In sum, both the deposit and lending rates were effectively unchanged: The deposit rate is unchanged because the cut in the benchmark rate is fully offset by the rise in the deposit rate ceiling, while lending rates are not subject to lower limits.
Why would the PBOC go through these gymnastics in order to leave the benchmark rate unchanged? First, the central bank may see this is a desirable structural reform. It is a small step toward liberalizing interest rates (which are still controlled by the government in China), in that the move gives banks more discretion, at least nominally, in setting deposit rates. And in the same announcement, the PBOC also scrapped limits on interest rates for long-term deposits of five years, and simplified the system of benchmark rates for loans.
Perhaps more importantly in the near term, the cut gives the appearance of an expansionary move without the broad expansionary effect that a substantial cut in interest rates, a cut in the reserve requirement ratio, or large-scale repos or open market purchases would have.
The PBOC is the most pro-reform body in the government, and it does not favor a highly expansionary policy in the midst of ballooning credit bubble. It is usually more conservative than the central government on stimulus, and the two often compromise somewhere in the middle. So the PBOC did something that looks expansionary but will have a minimal expansionary effect.
What does the PBOC hope could change in the Chinese economy while it buys some time with this measure? It could be looking for a global recovery to spur Chinese exports, or a pickup in domestic business confidence that increases corporate investments. It could also be hoping that increased mortgage lending and home purchases stimulate demand in the housing market, so that new housing starts do not collapse next year.
No easy fix
Will this work? JL Warren Capital spoke with half a dozen senior loan officers at Bank of China /zigman2/quotes/209359942/delayed CN:601988 -0.30% /zigman2/quotes/204682472/delayed HK:3988 +0.96% , Industrial & Commercial Bank of China /zigman2/quotes/202525815/delayed CN:601398 -0.92% /zigman2/quotes/201401473/delayed HK:1398 +0.55% and China Minsheng Banking Corp. /zigman2/quotes/203910009/delayed CN:600016 -0.20% /zigman2/quotes/208095167/delayed HK:1988 +2.03% to see whether they were planning to reduce rates on loans to property developers after the PBOC’s announcement. All of the officers said loan rates to developers were unlikely to change, since China’s benchmark lending rate is not binding or mandatory.
The effect on individual homebuyers seems likely to be mixed. The rate cut will lower monthly mortgage payments for homebuyers (the mortgage rate for first-time homebuyers is currently priced at the benchmark rate discounted by 5%), and will probably cause some people to buy houses earlier than they otherwise would. However, some homebuyers view the rate cut as the first of a succession of cuts yet to come, meaning they are likely to take a wait-and-see approach.
Most of the loan officers we spoke with believe that the impact of Friday’s policy change is likely to be short-lived, similar to the policy change on September 30 that aimed to spur mortgage lending. In that case, the increase in transaction volume in the real estate market lasted less than a month.
The loan officers also said that almost all the banks will use the opportunity to raise deposit ceilings from 10% to 20% above the limit, as competition for deposits is currently intense. The asymmetric cut between the deposit and lending rates (lending rates were cut by substantially more than deposit rates) suggest the government is trying to break the banking monopoly and establish a more competitive and market-driven financial environment.
One beneficiary could be highly levered companies. Rate cuts also are positive for bonds that are priced on benchmark rates.
For investors in China, the negative and cautionary signals from this rate cut outweigh any positive signals. Even though the practical effects of the rate cut are limited, the fact that the PBOC made any move shows that the macro risks are now greater than previously thought. Third-quarter earnings for the companies that JL Warren Capital tracks, including e-commerce companies, budget hotels, and consumer retain chains, were weaker across the board than Wall Street analysts anticipated.
Ana Swanson is an analyst at JL Warren Capital LLC, a China-focused, New York-based research firm.