China Cuts Key Interest Rates to Boost Economy After Disappointing Party Meeting

China's central bank has cut key interest rates to support the economy after a major Communist Party meeting disappointed investors by not announcing short-term stimulus measures. The rate cuts aim to bolster borrowing and spending as the economy grows at its slowest pace in over a year.

China Cuts Interest Rates After Investor Disappointment, Aims to Bolster Slowing Economy

In response to investors' disappointment with the absence of short-term stimulus at a significant Communist Party meeting, China implemented unexpected interest rate reductions to bolster the economy, per Bloomberg.

The seven-day reverse repo rate, a critical short-term policy rate, was reduced by the People's Bank of China on July 22, marking the first decrease in nearly a year. The Chinese banks responded by lowering their primary benchmark lending rates approximately one hour later, reducing the cost of borrowing for mortgages and other loans.

Despite their modest nature, the concerted efforts underscored the authorities' urgency to support an economy expanding at its weakest rate in over a year. They were released just one day after the party released a comprehensive document that affirmed President Xi Jinping's strategy to prioritize technology in China's economic future even though it will allow for slower development in the short term.

“It’s a good sign that the government is trying to support the economy, though the fundamental impact is likely to be limited,” said Vey-Sern Ling, a managing director at Union Bancaire Privee.

To redirect growth generators away from debt-fueled sectors such as property, Beijing's twice-a-decade Third Plenum last week reiterated its intention to refrain from implementing excessive stimulus. Xi disclosed strategies to assist local governments that were in debt. Still, officials demonstrated a need for more urgency to stimulate demand or halt a property downturn affecting the world's second-largest economy.

“Neither the Plenum reforms nor the 10-bp reductions are the big bang the market wants. Still, the moves push in the right direction and the fact they have arrived together is a sign of urgency,” Bloomberg Economics said in a report on July 22, calling the combination of policy and rate announcements a “little bang.”

The CSI 300 Index has lost up to 1.1% in response to the rate cutbacks, while the Hang Seng China Enterprises Index has gained 0.8% after declining to 0.6%. Chinese stock investors have responded with a mixed response.

“While today’s rate cuts offer some reassurance that policymakers are being responsive to the recent loss of economic momentum, the heavy lifting will need to come from fiscal, not monetary, policy,” said Julian Evans-Pritchard, head of China economics at Capital Economics.

PBOC Reduces Rates Amid Deflation and Economic Strain, Aiming to Meet 2024 Growth Target

In August, the PBOC reduced the one-year benchmark and seven-day rates by ten basis points. Since then, the currency depreciation pressure has limited the central bank's ability to pressure from a lower interest rate reduction, from 1.8% to 1.7%, on July 22, which is expected to affect borrowing demand minimally. Morgan Stanley economists, including Robin Xing, wrote in a note on July 22 that it reflects the "reactive nature of easing." They also noted that this entails risks to their full-year growth forecast of 4.8%.

According to Yahoo Finance, in a communique issued on July 18, following the conclusion of the Third Plenum, China reiterated its dedication to achieving its 2024 growth target of approximately 5%. However, upon opening the markets the following day, stock purchasers disapproved of the absence of stimulus signals.

On July 21, a more comprehensive document was released that outlined the party's strategy for bolstering the finances of China's local administrations. This strategy included transferring additional revenue from the central to local coffers. This could incentivize officials to increase consumer expenditures, although any impact on consumption will likely be gradual.

China has been experiencing the most extended period of deflation since 1999, as prices have decreased across the entire economy for five consecutive quarters. This implies that actual interest rates, adjusted for price fluctuations, have remained elevated, diminishing the effect of any moderate easing.

The Federal Reserve is anticipated to initiate its rate-cut cycle in September, prompting an increase in expectations for further monetary relief in the months ahead. This would reduce the interest rate disparity between the two nations and reduce the burden on the yuan, thereby providing China with additional policy flexibility.

Analysts anticipate additional rate reductions and a decrease in the reserve requirement ratio, which denotes the quantity of currency banks are required to maintain in reserve. A potential window is anticipated in August and September, as many one-year policy loans will mature and may be replaced by the liquidity that an RRR reduction could unleash.

PBOC Faces Challenges as Rate Cuts Pressure Yuan and Government Bond Yields Decline

The PBOC's months-long struggle to prevent the decline of government bond yields could be further exacerbated by the reduction in the seven-day rate. The PBOC has expressed financial stability concerns, which have weighed on the yuan and reflected a pessimistic view of China's long-term development prospects due to the unrelenting government bond rally.

The offshore yuan edged lower, while China's 10-year government bond yield declined two basis points to 2.24% following the announcement of rate cuts.

Societe Generale SA economists, including Wei Yao, have suggested that the PBOC's decision to permit banks to apply for a reduction or exemption of collaterals required for receiving its one-year policy loans on July 22 could potentially reduce the demand for long-term government bonds from commercial banks and dampen any bond rally that may occur in the wake of the rate cut.

The PBOC has committed to borrowing and selling sovereign notes if yields continue to decline. Traders will closely monitor the bond market for potential movements from the central bank. A Bloomberg survey indicated that the PBOC had a red line of 2.25% for the 10-year yield, which had reached a record low of 2.18% earlier this month.

The prospective benchmark policy rate is seen as the seven-day rate. In recent weeks, the PBOC has indicated a trend toward using the short-term rate to guide markets, which could result in it operating more similarly to other major central banks, such as the Fed.

This will diminish the significance of the medium-term lending facility rate, which is a one-year benchmark. Banks have quoted the LPR as a spread over the MLF rate, and the barrage of cuts on July 22 could indicate a weakening of the link between the two in the future.

The reduction is expected to increase pressure on the yuan, as the Federal Reserve has yet to initiate its rate-cutting path. Serena Zhou, senior China economist at Mizuho Securities Asia Ltd., anticipates that the PBOC will be required to implement measures to stabilize the renminbi exchange rate.

With the help of James Mayger, Shulun Huang, Iris Ouyang, Tania Chen, Helen Sun, Zhu Lin, and Cormac Mullen.