The People’s Bank of China’s recent (PBoC) move to cut interest rate came as no surprise, following the particularly weak readings of January inflation and another expected soft reading for February. More monetary easing is still needed and could materialize during the second quarter, according to a research report by UBS AG.
The PBoC cut benchmark rates by another 25 basis points, bringing one-year benchmark lending rate to 5.35% and one-year benchmark deposit rate to 2.5%, effective from March 1.
Meanwhile, as another move towards interest rate liberalization, the Chinese central bank lifted China’s deposit rate ceiling further from 1.2 times of benchmark to 1.3 times.
The move came after both China’s consumer price index (CPI) and producers price index (PPI) slipped to a five-year low in January, to 0.8% year-on-year and a decline of 4.3% year-on-year, respectively.
Although the shifting timing of Chinese New Year was to blame, underlying sequential momentum of core inflation did sink to the slowest pace since the global financial crisis. UBS expects February inflation to have not rebounded above 1% either, adding further deflationary concerns.
The decline in inflation has rapidly pushed up real interest rate. The average of CPI and PPI has dropped substantially by 170 basis points since the fourth quarter 2014, and 250 basis points during the past six months, while nominal interest rate has remained sticky despite the November rate cut, with average bank lending rate edging down only around 20 basis points and our estimated overall financial cost barely moving.
As a result, real rate has moved up by 100 basis points since the fourth quarter of 2014, according to UBS estimates. Rapid increase in real interest rate means a tightening of monetary conditions, which stands in sharp contrast with softening real activity growth.
Moreover, financial burden on corporate sector has been aggravated. With industrial profit growth already mired in recession with total profit declining 6% year-on-year, and principal business profit down 9% year-on-year in the fourth quarter 2014. Risks are quickly building up at China’s financial system, prompting more monetary accommodation to mitigate massive tightening and contain financial risk.
The PBoC has clearly become more concerned about deflationary pressure in recent weeks, as reflected in the latest monetary policy report and two PBoC research articles warning against deflationary pressures.
This cut in benchmark rate should help lower the lending rate charged by banks, though the 25 basis points cut may not be passed through entirely since the ceiling on deposit rates are raised again, which effectively mean an asymmetric rate cut and could squeeze banks’ interest margin.
The rate move can also help anchor inflation expectation before deflationary forces become entrenched. The resulting drop in real interest rates should help mitigate the worsening financial burden for the real economy and reduce the negative pressure on banks’ asset quality, thereby containing financial risks.
Although one rate cut is helpful at the margin, it is insufficient to offset the passive tightening of monetary conditions so far, says UBS. The PBoC should cut benchmark lending rates by 100 basis points this year to keep real rates from rising, but the bank expects the central bank to only cut 50 to 75 basis points. The next rate cut could come in the second quarter, following persistent deflationary pressure and weak activity data.
In addition to the rate cut, UBS also believes the central bank need to cut banks’ reserve requirement ratio (RRR), and use liquidity operations to help offset the drop in forex related liquidity, and ease loan quota and other lending restrictions.
Fiscal easing, relaxation of property policies, and pro-growth reforms are also likely in 2015, says UBS. The bank sees these measures to be more effective than monetary easing.
