PBoC delivered asymmetric rate cuts, what’s next?

So what to expect next:
·      Little impact on the 1y deposit rate. We believe the banks will fully utilize the upward flexibility so the 1y benchmark deposit rate will rise to 3.3% (2.75%*1.2 with 20% upward floating), the same as currently (3%*1.1 with 10% upward floating).

·      Public Housing Fund mortgage rates were reduced by 25bp (Figure 2).

·      Incomplete pass-through to the other lending rates. 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% of their loans above the benchmark rate, 20.4% equal with the benchmark and 8.3% below the benchmark (Figure 3).

·      40bp cut is probably necessary for the move to be effective. 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% of the reduction in the benchmark lending rate. We think the 40bp 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.

·      Consistent with our long-held call (see links to notes below). 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 (Figure 4); and 4) the economy’s high debt/GDP of 250%.

·      Near-term hard landing risk reduced. 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.

·      We maintain our 7% growth forecast in 2015. 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.

·      We look for two more symmetric cuts. Our call had been two cuts in the benchmark rates of 25bp each in Q4 14 and Q1 15. After evaluating the effect of the PBoC’s asymmetric move, we are now looking for another two symmetric cuts in benchmark interest rates, 25bp each in H1 15. So the 1y deposit rate would be lowered to 2.25% and the 1y lending rate would be to 5.1%.

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