China Slashes Rates but is it the Cure All?

Friday, the People’s Bank of China (PBOC) surprised the markets, in a good way, with an interest rate cut. However, this is no magic pill and while we saw a nice global stock rally on Friday, do not expect much from this move.

For sure, it will lower the downside risks for the world’s second largest economy. However, it will do nothing to impact the baseline growth for 2014 and will not change the forecast for a slower growth in 2015. The PBOC has been resisting cutting rates or initiating a broad based monetary easing program for some time now. On Friday, the cut their main rate reducing their 12 month benchmark lending rate by 0.40 basis points to 5.6 percent. They also reduced their 12 month deposit rate to 2.75 percent. This was 0.25 percentage point cut.

This came after the PBOC made a small move to change the rates banks pay customers. They moved this up to 1.2 times the benchmark, up from the previous 1.1.

This marks the first time the PBOC has cut rates since 2012 and indicated policymakers are becoming worried about the slowing economic growth. This also suggests that they are losing some confidence in the recent bout of targeted easing. However, they are not too convinced this will spur faster growth. This rate cut is asymmetric. So why are they injecting more money into the economy at this time? We will get little acceleration in growth, which is very low by historical standards.

Right now, we are seeing a sharp slowdown in credit growth which just came in at $89 billion last month. This is the third lowest raise on record since 2012.

This means there is a call for more liquidity.

In other words, the success of this interest rate cut will be dependent on whether or not Beijing will inject more cash into the economy. This rate cut will help borrowers of medium to long term debt cut their expenses but the real boost for China’s economy will come from more cash injections. So we would now like to see a reserve requirement ratio (RRR) cut to help support this latest policy move. We could see this RRR cut by the end of December.

This is the beginning of an easing cycle from the PBOC.

These cuts are needed to support the economy. Lowering the benchmark rate will also relieve some of the debt burden. It will support businesses and support private demand. We should see another rate cut in the first half of 2015. We also feel that Beijing will enact fiscal measures going forward. Why? The rate cuts, by themselves, will have little impact on economic growth but its intent will be helpful as this move signals to investors that growth is still a major driver towards future economic policy. It always has been and now we should expect future cash injections as well as policy decisions over the next year.