In Views on China’s Surprise Rate Cut (Part 1) – Rationale and Notable Features, we explained the reasons behind China’s most recent rate cut and the mechanism of broadening the float¬ing range of the deposit and lending rates. In this article, we take a look at the implications of China’s interest rate cut to the overall economy.
Given that all the major economic indicators published in May disappointed markets, it is probably widely agreed upon that the recent interest rate cut was necessary to support China’s economy. Although an interest rate cut will likely be more effective than the previous RRR cuts, we nonetheless view the cut as "good, but not good enough". Will there be further monetary easing? Yes, but at the same time, the central government will cautiously monitor economic conditions which includes inflationary trends and so when and what comes next will be highly sensitive to data releases in the upcoming months. But what’s certain is that China still has a lot of room to manoeuvre and we believe that fiscal policy is definitely not excluded from the equation.
Not Just an RRR-Cut
Since the end of last year, the People’s Bank of China (PBoC) has cut its RRR three times, with the most recent cut effective just three weeks ago. However, as mentioned in our previous article, alongside the RRR-cuts were also indications of a worsening economic environment, which highlights that monetary easing implemented thus far has had little effect in boosting the economy through lending. It has become clear that RRR-cuts are simply insufficient to boost lending and subsequent growth. This is because the problem does not solely rest on credit supply but on credit demand. Declining medium-to-long-term loans to businesses were clear signs of weakening investment sentiment. So no matter how much money is freed up in the banking system, with no willing borrowers, the excess supply of loans will still do nothing to stimulate the economy.
This is why an interest rate cut is "good". Though they are both tools of easing monetary policy, an interest rate cut’s function differs materially from an RRR-cut. Interest rate cuts effectively lower the cost of credit but RRR cuts merely increases the quantity of credit. So we can see that an increase in credit quantity can only be effective in stimulating growth if demand for credit is already present, but credit quantity and demand do not bear a causal relation. On the other hand, cheaper credit can induce credit demand and subsequently stimulate growth. Consequently, we do think that the unexpected interest rate cut will help China’s weakening economy, but investors should also keep in mind that this one-time cut alone cannot accomplish a lot.
Steps to Financial Reform and Implications to the Banking System
As mentioned previously, one notable feature of the recent interest rate cut is its asymmetry, which also has important implications. In addition to cutting the benchmark interest rate by 25 bps, PBoC also liberalised banks’ ability to set lending and deposit rates, allowing banks to set lending rates as low as 20% below the benchmark rate (increased from 10% previously) and deposit rates as high as 10% above the benchmark rate. This increases the policy moves effectiveness because the lowest lending interest rate has effectively been lowered by an additional 63 bps due to the lending discount rate doubling.
The move to increase flexibility marks one of the starting steps for China to implement reforms to its financial system. This move allows rates to be more market-determined, albeit only to a limited extent. This move also has implications on Chinese banks. Not only does an interest rate cut compress bank’s profitability by lowering their net interest margins, but increased flexibility also means increased competition. The bad news is that banks’ profitability may lower, but the good news is that this market-based approach will help filter out the low quality and inefficient banks.
What’s Ahead for the Economy?
A surprise interest rate cut is not all good news. Given that inflationary risks have not vanished, the rate cut was evidently implemented in order to ease mounting economic stress. It is also a sign that the economic conditions are worse-than-expected. The timing of the interest rate cut is also interesting as it was done just a couple of days before a range of critical data releases for May, including industrial production and trade figures for the weekend and new loans for the following week. Once again, we witness the PBoC’s policy fine-tuning in action as it implements more drastic measures in order to preemptively offset the upcoming weak data releases.
Recent publications of weak economic data have demonstrated high levels of uncertainty surrounding China’s economic outlook in the short term. As mentioned earlier, this one-time rate cut is not going to ensure a rebound in these economic indicators for the following months but it does remind us that the central bank still has room to manoeuvre and is equipped with a range of policy tools to utilise in face of potentially deteriorating conditions. Therefore, we do expect further policy moves to come, which will involve both RRR-cuts and further interest rate cuts. At the same time, the timing of these policies will be difficult to predict and highly dependent and sensitive to the upcoming economic trends. It is also worth noting that, although it appears as though the government has shifted its focus away from inflation towards growth considerations, we believe the headline CPI figure will still continue to be a determinant factor for monetary policy.
Any Chance for Another 4 trillion Yuan Stimulus?
Not a chance. Though faced with another period of weak economic growth with stock markets plummeting and resembling that of 2008’s, China’s economy faces different challenges today, making a fiscal stimulus package, with the size of 4 trillion yuan, highly infeasible. Faced with the financial crisis, the central government implemented a fiscal stimulus package three and a half years ago, the size of approximately 10% of GDP. The stimulus helped the nation avert a marked economic slowdown but the negative consequences proved to be large and to this date still present. The lending spree by banks and overinvestments by local governments left the former with piling non-performing loans and the latter with piles of debt. Another major consequence was soaring property prices the government is still on a mission to control. Given that the toxic consequences still persist, we do not see any possibility for the government to make such bold moves again.
Even if China tried to avoid the real estate realm and directed investments towards other projects, there are two other obstacles we think the nation will unlikely overcome. First, any large scale fiscal stimulus will require funding from local governments. It is unlikely the local governments will have the willingness or ability to embark on the funding size similar to that of 2008’s. Secondly, the government has emphasised multiple times its commitment to economic reforms to becoming a consumption-driven economy; this is the fundamental goal under the 12th Five-year plan. Introducing a large-scale fiscal stimulus would direct funds towards investments and push the nation off-track to its reform goals, which we believe the government will try to avoid.
That said, although we do not think China will implement a large scale fiscal stimulus, some sort of expansionary fiscal policy is highly likely especially if economic growth continues to show signs of deterioration. Unfortunately, the size and timing of any fiscal stimulus is still difficult to predict given that the state of the economy has not proved to be detrimental as yet. The data releases and developments in the upcoming months will be critical to policymakers; meanwhile, we will continue to closely monitor China’s economic growth trends and how any further policy moves will impact the economy.
What Should Investors Do?
China’s economic situation has turned out to be worse-than-expected and the economy may only bottom out closer to the end of the year. However, in line with our expectations, the PBoC continues to react sensitively to the apparent economic trends and "fine-tune" policy. The surprise rate cut is evidence of the central bank’s commitment to defend economic growth and thus our positive outlook for Chinese equities continues to be supported. Nonetheless, as we have mentioned earlier, this one-time rate cut itself will not be enough to spur economic demand in China; instead, this will highly depend on future policy moves.
Despite a weak economic environment, investors should closely look at the fundamentals in the long run. After the sell-off in May, we have seen valuations dip to extremely attractive levels once again, declining to below the levels seen at the worst of the financial crisis in 2008. Hence we continue to favour the Chinese equity markets and maintain a 5-star or "Very Attractive" rating on the market.
Chart 1: Market Valuation of the Hang Seng Mainland 100 (HSML100) index
Views on China’s Surprise Rate Cut (Part 1) – Rationale and Notable Features
Prepare for a Chinese Rally!
China: What are the implications of a 7.5% Growth Target?