China: Financial markets force PBoC to ease

Peoples Bank of China (PBoC) today cut its leading interest rate by 25bp and the reserve requirement ratio (RRR) for commercial banks by 50bp. This was the fifth interest rate cut since November last year. The one-year benchmark lending rate and the one-year benchmark deposit rate were both cut by 25bp to 4.6% and 1.75%, respectively. The reserve requirement ratio for large commercial banks was cut by 50bp to 18.0%. Notably, the RRR cut will not be effective until 6 September, hence the RRR-cut will not immediately inject liquidity in the money market.

PBoC also announced a substantial liberalisation of banks’ deposit rates in connection with the easing measures. The cap on deposit rates with maturities exceeding one year was abolished and for deposits with maturities with one year or less banks will now be allowed to charge 150% of the benchmark deposit rates. The floor on lending rates has already been abolished, meaning that interest rates are now close to completely liberalised. The implication is that PBoC’s leading interest rates have now become largely symbolic and the stance of monetary policy should now instead be judged by the development in the interbank money market rates.

Cutting the interest rate and reserve requirement simultaneously is a relatively strong easing move. That said, we regard it as a reluctant easing move forced by the sharp decline in the stock market today and yesterday. In that sense it is reactive rather than proactive and this could eventually reduce its effectiveness. In the Q&A document published on PBoC’s web page, the cut in the interest rate and the RRR was explained with “global financial market being highly volatile” and the economy remaining “under downward pressure. Regarding the stock market today’s easing move also suggests that the Chinese government has returned to a more marketbased approach instead of using non-conventional measures (mainly purchases of stocks by government institutions).

Policy-wise, PBoC in our view is in a very difficult balancing act. On the one hand, financial markets want monetary easing, on the other hand financial markets do not want CNY to depreciate too fast. It might be difficult for PBoC to deliver both simultaneously. Recently PBoC’s intervention in the FX market has reduced liquidity in the interbank market and tended to push money market rates higher. Hence, if PBoC really wants to ease monetary policy and push money market rates lower, it might have to accept more flexibility in the USD/CNY exchange rate and allow CNY to weaken a bit. This might already be happening with PBOC increasing the USD/CNY fixing by 0.2% (largest increase since 13 August). Today’s market close for USD/CNY suggests that tomorrow’s USD/CNY fixing could be raised by another 0.2%. If this trend continues in the coming days, concern about “China joining the global currency war” could return to the market.