PBOC Expanding Reserve Cuts Signaled by Negative Spread

China’s interest-rate swaps are trading below sovereign bond yields, reflecting expectations that this week’s targeted reserve-requirement ratio cuts will be followed by broader monetary easing.

The spread between two-year yields and the interbank swap rate narrowed 94 basis points this quarter and slid below zero on May 22, an unusual phenomenon as swaps bear counterparty default risks. The last time the gap was negative was on the eve of comprehensive RRR reductions in early 2012. The People’s Bank of China announced on June 9 that it will cut the ratio only for city commercial banks and small rural lenders.

Forecasts for the slowest economic growth since 1990 are putting pressure on the PBOC to reverse tightening policies aimed at cooling the property market that drove benchmark money market rates to a record a year ago. An RRR cut for all banks could unlock about 500 billion yuan ($80 billion) of financing, five times more than this week’s targeted measures, Everbright Securities Co. estimates.

“A universal RRR cut will convince the market that liquidity conditions will be stable in the long term, pushing down long-term rates,” said Xu Gao, a Beijing-based economist at Everbright. “If China still can’t reach its target of stable growth, there’ll be more pressure from the State Council on the PBOC.”

Long-End Rates

In its statement this week announcing the targeted RRR lowering, the PBOC reiterated it will continue with prudent monetary policy and that it will promote stable economic operations. Ten of 18 economists in a May 15-20 Bloomberg survey predicted the ratio will be below the current 20 percent by the year-end, with 19.6 percent as the median estimate.

The State Council, or cabinet, is looking to spur credit growth that eased to the slowest pace in more than eight years in April. Long-end rates have remained elevated, curbing loan demand, while higher returns offered by wealth-management products and online funds have pushed up banks’ financing costs, Xu said. China’s 10-year sovereign bond yield averaged 4.40 percent this year, compared with 3.83 percent in 2013.

In the last two months, the PBOC cut reserve requirements for some rural lenders and called on the nation’s biggest banks to accelerate the granting of home mortgages as residential sales and property construction slowed. It will also set up a re-lending facility for smaller companies and has set this year’s quota at 50 billion yuan, state broadcaster China Central Television reported May 31.

Property Prices

Home prices fell for the first time on a monthly basis in May since June 2012, according to SouFun Holdings Ltd., China’s biggest real-estate website owner. Property prices will drop 5 percent this year as developers cut prices to meet sales targets, Standard & Poor’s said this week.

As the PBOC loosened policy and regulators told lenders to limit interbank borrowing, the seven-day repurchase rate, a gauge of the supply of cash among lenders, tumbled 205 basis points from the start of this year to 3.2 percent today. It reached a record 10.77 percent in June last year.

China’s two-, three- and five-year swap spreads all fell below zero in May on speculation the central bank will carry out further easing. The last two times this happened were during the 2008 global financial crisis, and between late 2011 and early 2012, when concerns over Europe’s sovereign debt roiled global markets. In the U.S., swap spreads of those tenors have never slipped below zero.

Growth Concerns

In China, “the negative swap spreads are an indication of growth concerns, flush liquidity conditions and the expectation that cash supply will remain flush and easing measures will continue to be carried out if growth doesn’t pick up,” Yii Hui Wong, a Singapore-based strategist at BNP Paribas SA, said in an e-mail.

Asia’s largest economy showed signs of improvement last month, with a 7 percent increase in exports beating the 6.7 percent forecast from economists. An official gauge of manufacturing rose to a five-month high in May, while the yuan gained 0.3 percent this week, paring its 2014 loss to 2.8 percent. A Bloomberg survey of economists estimates the economy will expand 7.3 percent in 2014, the least in 24 years.

“China learned a big lesson” from its past stimulus measures, Pu Yonghao, chief investment officer for north Asia Pacific at UBS Wealth Management, said in Taipei. “A universal RRR cut may fuel asset-price bubbles when what China needs is to deleverage.”

Cash Supply

“The PBOC will ensure there is ample supply of funds, but that’s not the same as cutting policy rates,” said Albert Leung, a Hong Kong-based strategist at Bank of America Corp. “The manufacturing data has stabilized a bit. I think the bond market is at the right level, but the swap rate is too low to me.”

Instead of a universal RRR cut, China may take steps such as changing the way in which loan-to-deposit ratios are calculated and promoting direct financing such as bond issuance so as to decrease corporate funding costs, according to Linan Liu, a Hong Kong-based strategist at Deutsche Bank AG.

“The high corporate funding costs in the bank loan market threaten a much sharper deceleration of credit, which will translate into weaker economic growth,” Liu said. “It’s important to maintain an easing bias to make sure growth bottoms out over the next three months.”

The PBOC’s best lending rate for one- to three-year money is 6.15 percent. It was reduced from 6.4 percent in July 2012 and was 6.65 percent in June of that year. The rate rose to as as high as 7.56 percent in 2007 before plunging to 5.4 percent during the global financial crisis.

Interest Rate

The targeted easing measures are unlikely to have the same effect as a possible 25-basis-point reduction in the PBOC’s benchmark interest rate, Morgan Stanley economists Helen Qiao and Yin Zhang wrote in a June 9 note, adding that they expect a rate cut in the third quarter.

The PBOC’s decision to make limited adjustments to the RRR fall short of the mandate laid out by the State Council, which first announced the measure on May 30, according to Everbright’s Xu. Policy makers will “appropriately” lower the RRR for banks that have extended a certain amount of loans to rural borrowers and smaller companies, the cabinet had said then.

“The State Council gave the PBOC steps to walk on, but the PBOC didn’t go down those steps,” said Xu. “This shows the central bank still doesn’t want to loosen monetary policy. What you need now is to push down long-term funding costs, so banks will have the incentive to lend.”

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