China's Rate Cut Is More Panic than Reform

An Interesting Twist in Largely Unexpected Cut

The People's Bank of China (PBoC) cut benchmark interest rates yesterday (7 June) for the first time since 2008. One-year deposit and lending rates were cut by 25 basis points apiece. Interestingly, the PBoC also announced a tweak to how banks are allowed to set interest rates: the deposit rate ceiling has been raised to 110% of the benchmark (from 100%), while the lending rate floor has been lowered to 80% of the benchmark (from 90%). This means that, in effect, it is possible for the one-year deposit to actually rise above its previous level. While the one-year benchmark was cut from 3.5% to 3.25%, the 10% premium afforded to banks allows rates to rise to 3.58%. Indeed, all of the "Big Four" banks have already announced plans to maintain rates at 3.5%, while smaller banks like Bank of Ningbo have offered the maximum of 3.58%.

Sly Solution to a Pressing Problem

In essence, this is a sly solution to a pressing problem. It is a de facto asymmetric interest-rate cut—deposit rates have been held steady (or increased at shorter maturities) while lending rates have been reduced. Keeping deposit rates steady helps to combat deposit flight. Negative real interest rates have been a primary driver behind the flight from deposits, as has the emergence of higher-yielding wealth-management products (WMPs) and a sharp reduction in capital inflows through the current and capital accounts. Household deposits shrunk over CNY600 billion (USD78.66 billion) in April, and deposits at the "Big Four" are reported to have shrunk nearly CNY300 billion in the first 20 days of May. Shrinking deposits have a direct impact on banks' ability to meet their mandated 75% loan-to-deposit ratios (LDRs). As banks bump up against their LDRs, they are less able to extend credit, reducing the role they can play in stimulating demand. Allowing banks to hold deposit rates steady prevents further outflow pressure, and as inflation continues to subside, deposits should start to return at the margins.

Reform?

As well as stemming some deposit flight, it appears that steps have been taken towards interest rate liberalisation. Over the medium term, China needs to liberalise interest rates in order to allow for the more effective pricing, and thus better allocation, of capital. Deposit rates need to rise to allow depositors a healthier return on their savings—inflation-adjusted deposit rates have been negative for most of the last two years. A greater return on savings is necessary to begin to reverse the systematic wealth transfer from households to state firms, driving up household income growth and thus boosting consumption. Yesterday's policy move allows more rate flexibility, so it is an important step, but it has not increased deposit rates—it has merely prevented them from falling alongside the benchmark rates. As such, it does little to improve returns on savings.

What has been accomplished is the squeezing of net interest margins (NIMs)—the guaranteed spread between the deposit and lending rate that forms around 80% of banks' profitability. This should force greater competition amongst banks (as automatic profits are reduced), and, in theory, push them to make capital-allocation decisions based on the merits of a loan itself, rather than government guarantees, political connections and collateral. This should reduce misallocated capital and help to stem over-investment; a boon for rebalancing.

Over shorter maturities, banks' NIMs have been squeezed. The NIM on one-year loans/deposits is now around 2.8 percentage points, down from 3 percentage points. This is a small change, but significant, and will adversely affect profitability. Bank stocks reacted accordingly in today's trading. However, NIMs have actually been increased over longer maturities. There was a 40-basis-point reduction in the rate for 5-year deposits, but only a 25-basis-point reduction in the rate on loans above 5 years. The move was probably undertaken with an eye towards compensating banks for profit losses over shorter maturities.

What's the Real Impact of the Rate Cut?

As a result, the "reform" credentials of this move should be questioned. Lending rates have been reduced, deposit rates have been held steady, and bank profitability losses from shorter maturities have been compensated by longer maturities. This is hardly an ambitious drive towards interest rate liberalisation or rebalancing. The "reform" item merely allows authorities to cut rates without forcing more savings out of deposit accounts, further constraining the ability of banks to lend to the real economy.

The rate cut, then, is a simply a bold signal from a government now willing to battle the economic slowdown. In many respects, it is an admission of failure regarding its previous policy strategy. It appears policymakers had hoped that the economy would stabilise with minimal policy action. Indeed, they quite rightly fear the consequences of a policy over-reaction, and have erred on the side of caution.

Unfortunately, an interest rate cut alone is unlikely to spur much additional activity in the real economy. The price of credit has never really been a problem in China, given suppressed interest rates and a reliance on quantitative tools to steer the economy. Through the end of 2011, the problem was the availability of credit (hence the proliferation of shadow financing), and now the problem is the demand for credit. A drop of 25 basis points may help at the margins, but with pessimism about the outlook spreading and corporate profitability in contraction, it is unlikely to spur factories to expand capacity or developers to kick-start construction.

Consequently, our forecasted revival of economic activity in the second half will come largely through the impact of the "mini-stimulus". The National Development and Reform Commission (NDRC) has presided over a surge of fast-tracked project approvals—with the number approved in May over double that approved in April. Fiscal policy looks to be more pro-active. Cash-for-clunkers car rebate schemes have been mooted, and consumer incentives unveiled. The cut provides a nice boost to sentiment, which should provide a spur to private investment, to complement the large imminent ramp-up in public investment. In combination with a lighter hand on the property market and some luck out of Europe, growth will pick-up through the end of the summer.

Outlook and Implications

Yesterday's interest rate cuts signal a government increasingly panicked by the domestic slowdown and rocky external environment. China is able revitalise its economy, but the more the government leans on the tried-and-tested tools of investment spending and credit issuance, the more they complicate the medium-term rebalancing picture. The government's loosening to date has been extremely cautious for precisely this reason—the implications of over stimulating once again are severe. Unfortunately, it seems increasingly likely that more aggressive policy is needed to reverse the slowdown.