When the Chinese Cut Rates It's Time to Worry

The central bank cuts rates and allows the banks more flexibility
Photograph by Nelson Ching/Bloomberg

The surprise decision by China’s central bank to cut interest rates on June 7 shows increasing nervousness about the state of the economy. While most economists were predicting a rate reduction sometime this year, the suddenness of this latest move reveals just how antsy China’s officials are getting.

“As the first rate cut since Dec 2008, the surprise move sends a strong signal that the government will be more active in supporting demand and stabilizing growth,” wrote Citi Investment Research & Analysis Hong Kong analysts Shuang Ding, Minggao Shen, and Serena Wang in a June 7 note. “We see this as a shift of monetary policy tone that would help lower borrowing costs and improve confidence, increasing the chance for the economy to bottom in Q2 and rebound in Q3.” (Citi Investment Research & Analysis is part of Citigroup Global Markets.)

The People’s Bank of China, China’s central bank, announced it was cutting its benchmark interest rates by 25 basis points, with 12-month lending rates falling from 6.56 percent to 6.31 percent and deposit rates dropping from 3.5 percent to 3.25 percent. Although reserve ratio requirements for Chinese banks have already been reduced three times since last November, today’s cut is the first time China has moved interest rates since raising them (also by 25 basis points) last July.

“The interest rate cut came in as a surprise to the market. Most people were expecting more [bank reserve ratio] cuts” before a move on interest rates, wrote Shanghai-based Standard Chartered economist Wei Li in a June 7 note. “Economic growth and new loan extension data (due this Saturday) must have remained very weak in May, triggering the PBoC to front-load interest rate cuts.”

And while before banks were allowed to lend at a 10 percent discount to the benchmark rate, now they will be able to offer a 20 percent discount. Banks now can also offer savers up to 1.1 times the benchmark savings rate. “The symmetric cuts to both lending and saving benchmark interest rates indicate that the authorities still care to protect banks’ profitability,” wrote Wei Li. “However, the increased flexibilities for banks to decide on actual rates they offer to customers suggest that the PBoC wants to make a step forward toward a more market-oriented interest rate system.”

Don’t expect today’s surprise move to be the last interest rate action. Despite recent announcements that Beijing intends to boost the economy by subsidizing consumer purchases of energy-efficient appliances and speeding up approval of infrastructure projects in steel, energy, water treatment, and other areas, most economists predict more moves by China’s central bank later this year.

London’s Capital Economics, for example, expects one more interest rate cut of 25 basis points before the end of 2012, while Standard Chartered is predicting that the PBOC will reduce rates twice. The Citi analysts expect one or two more rate cuts in 2012.

“The [latest] move is clearly a response to a string of disappointing economic data and, in particular, the weakness of credit growth in the wake of government stimulus calls,” wrote London-based chief Asia economist Mark Williams of Capital Economics in a June 7 note. “Many harbour doubts about the wisdom of another credit-fuelled stimulus, but the government’s overriding objective is to ensure that the economy is not too fragile in the final months before the leadership transition.”

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