Why the PBOC's Surprise Rate Cut Matters

I know we usually focus on major central banks’ monetary policy biases in predicting longer-term price trends, but we also gotta zoom in on the PBOC’s surprise rate cut to see its implications on the forex market. While most forex traders were out enjoying the weekend, the Chinese central bank decided to slash its one-year deposit and lending rates by 0.25% each to 2.5% and 5.35% respectively in an effort to boost lending activity in the country.

As it turns out, PBOC officials are admitting that economic growth is losing momentum and that falling inflation is becoming a huge concern. After all, China’s annual GDP dropped from 7.7% in 2013 to 7.4% last year – its slowest pace of growth in more than 20 years. Inflation has tumbled to 0.8% in January 2015 from 2.5% a year ago, dragged down mostly by falling oil prices.

Leading indicators seem to suggest that further economic weakness is in the cards, as declining import levels hint at a prolonged downturn in domestic demand. Export activity has also tanked since China’s trade partners are also slowing down, potentially leading to lower factory output and business production later on.

PBOC policymakers also explained that the ongoing property market slowdown is another main reason for their rate cuts. As it is, China’s real estate developers are suffering huge debt burdens, and it doesn’t help that home prices have been posting steep declines lately. This is a big deal for the country since the real estate market, along with related industries such as construction and furniture, accounts for a fourth of China’s overall economic growth.

Given all these economic woes, it’s no wonder that several market analysts predicted that China definitely had these rate cuts coming. In fact, some predict that more PBOC easing moves are likely to be announced in the coming months, as the country struggles to meet its growth targets for this year. After previously announcing a lending rate cut back in November last year and cutting the reserve requirement ratio (RRR) last month, the Chinese central bank might be gearing up for an actual reduction in its benchmark interest rate before the second half of 2015.

This implies that not even the world’s second largest economy is immune from the troubles plaguing most major economies these days, particularly that of weaker inflation. Yep, that’s a long way off its glory days of double-digit GDP growth and outpacing its peers!

This also suggests that the global economy might be in for darker days, as a potential downturn in China could spill over to the rest of the world. This could set off a prolonged period of risk aversion, which might lead to more capital outflows from China towards the better-performing U.S. economy, supporting the safe-haven U.S. dollar.