China rate cuts aim to hold line against deflation

China's third interest-rate cut in six months signalled the central bank's commitment to pushing back against deflation and its impact on real borrowing costs.

But what is less clear to analysts is the extent to which lower rates - and a host of other easing measures - can solve the conumdrum that has bedevilled many a central bank: how to ensure that looser monetary policy translates into a greater flow of funds into the real economy.

The Communist party's Politburo noted in an April 30 meeting that while money-market interest rates have fallen since the latest cut in banks' reserve requirement rations in mid-April, this increased liquidity has largely not filtered through to the real economy.

Economists, noting that rate cuts alone do little to address this concern, expect to see further easing in the form of targeted measures to channel credit to desired sectors of the economy.

The PBoC granted Rmb132bn in "pledged supplementary lending" to China Development Bank, the largest of the country's non-commercial "policy banks" in the first quarter, following Rmb383bn in such lending in 2014. These loans are earmarked for infrastructure and slum redevelopment.

Authorities are also considering policies to encourage banks to buy local-government bonds by accepting them as collateral for loans from the central bank.

The 25 basis point rate cut announced on Sunday, in comparison, is more about staying above water as the tide of deflation rises.

Inflation data released one day ahead of the rate cut showed producer prices falling 4.6 per cent annually in April, slightly better than the five-year low hit in February. Consumer prices also remain stubbornly flat at 1.5 per cent, half of the government's official target of 3 per cent.

"The weighted-average (nominal) loan rate dropped by 22 basis points in the first quarter, while CPI inflation fell more by 33bps during the same period," wrote Larry Hu, head of China economics at Macquarie.

"As a result, the real interest rate was even higher in the first quarter. No wonder we saw the rate cut over the weekend."

Equity markets appear to agree that the latest rate cut was not a dramatic easing signal. The Shanghai Composite index was up a modest 1 per cent on Monday morning, far from reversing the 7 per cent fall from a seven-year intraday high touched on April 28.

The rearguard flavour of the latest rate cut may also help explain why the People's Bank of China continued to describe its monetary policy stance as "prudent" in official statements, in spite of the shift towards loosening. The PBoC first adopted the "prudent" descriptive in early 2011, as it moved to tighten policy in the aftermath of the 2008-09 stimulus plan.

Another factor mitigating the impact of the latest rate cut is the PBoC's parallel move granting banks' greater flexibility to set their deposit rates above the official benchmark.

The latest move towards full deregulation of interest rates allows banks to offer deposit rates up to 50 per cent above the benchmark, up from 30 per cent previously and only 10 per cent prior to November's rate cut.

As a result, though the benchmark one-year deposit rate is now 2.25 per cent, down from 3 per cent before November, the effective ceiling on the one-year deposit rate has actually risen to 3.375 per cent from 3.3 per cent before November.

The central bank has used informal "window guidance" to discourage banks from raising rates, but such pressure is only a stopgap measure.

"For the rest of this year, we expect the PBoC will use a mixture of traditional and innovative targeted measures. As such, targeted, quantitative policy tools will likely play a more important role than before," said Zhu Haibin, chief China economist at JPMorgan.

Additional reporting by Ma Nan

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