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China to cut banks’ reserve to boost liquidity
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China’s central bank delivered its first interest rate cut in 2015, following the reserve requirement ratio (RRR) cut on February 5. It was a cut of 25 basis points to both the benchmark deposit and lending rates, effective March 1.
Meanwhile, the ceiling on the deposit rate was increased to 1.3 times the benchmark rate from 1.2 times, a further push in interest rate liberalisation. Looking ahead, we expect the People’s Bank of China to continue its use of both quantity-based and price-based tools, including RRR and interest rate cuts, to inject liquidity and lower real interest rates.
We maintain our view of two more RRR cuts in the first half, and one remaining 25-basis-point benchmark interest rate cut in the quarter. We also expect the central bank to accommodate more yuan weakness against the US dollar. While the central bank continues to put emphasis on a “prudent” monetary stance, downside surprises to inflation and growth will induce additional easing.
Why now and what’s next? The rate cut is response to the rising deflation risks and continued subdued economic activities as seen in the past month so the move was as widely expected and, thus, considered just a matter of time.
The central bank appears to have decided to pull the trigger now rather than wait for the incoming data February inflation and Jan-Feb activity data. Our observations have been that the central bank tends to move tactically ahead of China’s annual National People’s Congress meeting as we recall the sharp drop in the interbank rate and the currency last February. If the February data disappoint and capital outflows accelerate, in our view, another broad-based RRR cut is likely to be delivered in March.
The latest interest rate cut is more a signal than real given the de facto “asymmetric” nature. The move appears to be symmetric with 25-basis-point cuts in the benchmark lending and deposit rates to 5.35 percent and 2.5 percent respectively, and is in line with our forecast.
But it is actually asymmetric in nature. The central bank has pushed forward reforms with a second 10 percent increase in the deposit rate ceiling since November, exceeding our and market expectations. This means the cap on the 1-year deposit rate is broadly unchanged, 3.25 percent now vs 3.3 percent previously. With banks facing the same funding costs, they will have less incentive to pass on the benchmark lending rate cut to avoid further margin squeeze, given more demand than supply in credit and a liberalized lending rate.
More RRR cuts are needed to increase the supply of liquidity and lower interest rates. There have been increasing signs of capital outflows and rising yuan deprecation expectations on the back of the strong dollar and a confirmed easing cycle by the Chinese central bank since November. That has tightened domestic liquidity conditions and resulted in elevated interbank interest rates.
Our view has been that RRR cuts are more effective at lowering financing costs than benchmark interest rate cuts. The RRR cuts will also increase the money multiplier and support money and total financing growth. Our bias has been for more RRR cuts in 2015 than interest rate cuts. We have noted groups of indicators to watch, including the yuan’s depreciation; the central bank’s open market operations; M1 and M2 growth rates; inflation; and PPI deflation.
The central bank continues to be behind the curve from a cyclical perspective, in our view, given its priority of “adjusting economic structure” and “pushing for reforms” to achieve medium-term sustainability.
Real interest rates have risen by 300 basis points since 2011 if deflated by the CPI, and monetary and financing conditions have been tightening significantly. Despite the interest rate and RRR cuts since November, the central bank continues to highlight to the market that these moves do not represent the start of strong stimulus or a shift of the “prudent” monetary policy stance.
The latest move doesn’t change our 2015 growth and inflation views. We continue to see risks to our 7 percent growth forecast tilted to the downside and maintain our below-consensus 1.2 percent inflation forecast for 2015.
We have argued that such monetary easing is necessary to neutralize capital outflows and rising real interest rates as well as to prevent downward growth and a deflation spiral. But the expected easing would unlikely lift growth significantly.
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