THE interest rate cut is first move after July 2012. The rate cut is logical by itself, given the weak growth momentum and low inflation environment.

However, this policy announcement is a big surprise as the central bank has been focused on monetary easing in unconventional ways.

This reflects the government concern about near-term growth outlook, and the desperate efforts to lower the funding cost for the corporate sector (earlier in November the State Council issued 10 measures to address the high funding cost issue, but without hinting adjustment in the monetary policy). In recent months, the efforts to bring down lending rates have not been very effective.

The asymmetric interest rate cut could put significant pressure on bank profitability.

If banks will offer 20 percent deposit rate premium and new benchmark lending rate (using one-year benchmark rates), the interest margin could be narrowed by 40 basis points. This may raise the question whether banks will maintain the distribution of lending rates around the benchmark rates, or will choose to float up the range.

We interpret the announcement as a signal of policy shift toward more aggressive monetary easing (although the central bank stated in its official release that it is a neutral policy action and does not represent any shift in monetary policy).

We expect at least one more rate cuts in the coming quarters. In addition, possible quantitative measures include reserve requirement ratio cuts (which is in our 2015 forecast), targeted quantitative measures such as pledged supplementary lending, standard lending facility, medium-lending facility and open market operations, and possible adjustment in the loan-to-deposit calculation. We will also review our forecast of growth trajectory accordingly.

Liu Linan, senior strategist, Deutsche Bank

The policy announcement came after the regular State Council meeting on November 19 when Premier Li Keqiang proposed 10 measures to address issues with elevated funding cost for corporate. As we have discussed in our recent reports, the key task for the government in the second half has been to effectively lowering corporate financing cost.

Monetary policy transmission so far has begun to be more evident in the bond market and corporate direct financing, however, financing conditions for corporate borrowers, particularly small and medium-sized enterprises has not improved materially, this is largely due to a lack of market-based funding channel and banks’ credit risk control. As such, we believe the policy announcement confirms that the central bank is committed to alleviating corporate funding difficulties and to tackling structural issues with accelerating interest rate reforms.

The above measures on interest rate reforms and the timing of the widening of the deposit rate ceiling are in line with the roadmap of interest rate reforms that we envisioned, and combining deposit rate cuts with the ceiling widening is also in line with our policy outlook. However the simplification of the policy rate term structure came as a surprise to us as it takes place about six months earlier than our prior forecast (in the middle of 2015).

We continue to expect China to establish a deposit insurance scheme before the end of this year. We believe the above measures will pave the way for the People’s Bank of China to eventually abolish the policy deposit rate curve and policy lending rate curve which we expect in late 2015. By then, the prime rate curve will develop into a marketbased lending rates curve, and the policy deposit rate curve will be replaced with a short term policy rate target, either the overnight rate or the seven-day rate.

Open market operations

This rate would be the uncollateralized funding rate between financial institutions, similarly to the Fed fund target rate, and it would be likely to come from the SHIBOR market. The central bank could then actively engage in more frequent intraday open market operations to keep this short-dated SHIBOR rate close to its target.

The introduction of a short-term monetary policy rate could form the basis of a new monetary policy framework for China. We envision the new monetary policy framework will significantly improve monetary policy transmission in the domestic financial market (from the money market, the bond market and the bank loan market) which improves the efficient capital allocation in the aggregate economy.

Although the cost of capital in the economy would in such a scenario be increasingly market-oriented, we think keeping a quantitative target would remain critical to China’s monetary policy framework especially in maintaining medium to long term monetary price stability.

In the foreseeable future, we believe China’s monetary policy will rely on a short-term monetary policy rate as the operating target to maintain price stability in the short-term, while at the same time using a broader monetary aggregate measure, the M3, as the quantitative target to manage medium to longer term balances between money aggregate and prices. We envision such a new framework as being similar to European Central Bank’s two-pillar approach of monetary policy and China is likely to complete its interest rate liberalization reform towards the end of 2016.

Chang Jian, chief China
economist, Barclays

We believe the banks will fully utilize the upward flexibility so the one-year benchmark deposit rate will rise to 3.3 percent, the same as currently.

It remains to be seen how much of the cut in the lending rate will get passed on to the borrower as banks face a squeeze in the interest rate margin from this announcement.

China’s bank lending rates are fully liberalized and as of September, banks were charging 71.3 percent of their loans above the benchmark rate, 20.4 percent equal with the benchmark and 8.3 percent below the benchmark.

While banks are unwilling to pass on all the cuts in the benchmark rates, we note that many loans are with long-term customers. We think banks are likely to deliver more than 50 percent of the reduction in the benchmark lending rate.

We think the 40 basis-point cut is a brave move and probably necessary for the lending rate cut to be effectively passed on to the real economy to support demand.

‘Rate cuts unavoidable’

We have long been arguing “cuts in the benchmark rate are unavoidable” and “a lower interest rate environment will help to facilitate the transition of the Chinese economy”. We officially forecast two benchmark interest rate cuts since late June, given our judgment of: 1) targeted easing measures will be ineffective to lower the financing costs; 2) risks to growth are on the downside amid the property market downturn; 3) real interest rates have been too high and are rising amid falling inflation; and 4) the economy’s high debt/GDP of 250 percent.

The market will likely read this as a positive signal that the Chinese government is responding to worsening private demand and rising deflation risks and is finally willing to send a strong signal to the market. We think the disappointing traffic in the first week of the Shanghai-Hong Kong Stock Connect may have been a driving factor.

The Chinese economy continues to face many challenges: deflating of the property bubble, industrial overcapacity, significant financial risks in the official and shadow banking sector to name a few, plus the urgent need to deliver market-oriented  reforms. We have argued that lowering the interest rate will help to reduce the debt burden, lower financial risks, support business sentiment, and sustain private demand.

Our call had been two cuts in the benchmark rates of 25 basis points each in the fourth quarter of 2014 and the first quarter of 2015.

After evaluating the effect of the asymmetric move, we are now looking for another two symmetric cuts in benchmark interest rates, 25 basis points each in the first half of 2015.