China Macro:The PBoC cut interest rate and RRR for financial and economic stability

After the market close, the PBoC cut interest rates by 25bp today, the fifthinterest rate cut since last Nov. After the cut, benchmark 1-yr deposit rates willbe reduced to 1.75% and the 1-yr lending rate to 4.60%. Meanwhile, the PBoCalso cut RRR by 50bp to 18%, which could release RMB700bn to the bankingsystem. Overall, we see it’s modestly positive for the market and the economy. Itmight not enough revive the animal spirits for domestic investors, but could helpalleviate the hard-landing fears for international investors.

Why did the PBoC cut?

In short, it’s for financial and economic stability. First, A-shares slumped 15% inthe past two days, after the miss of the expectation of RRR cut over theweekend. To stop the panic in the stock market, the PBoC reacted to shore upconfidence. Second, we estimate capital outflows and the PBoC’s intervention indefending the RMB could have drained RMB600bn from China’s banking systemfrom June to August. Therefore, the PBoC needs to cut RRR to offset the impact.

Third, it’s also a response to the weak economy, evidenced by PPI deflationworsened on weak demand and plunging commodity prices.

Will the cut drive capital outflows and RMB depreciation?

It could have some negative, but manageable, impact. After all, the main driverfor capital outflows is the concern on China’s economy and expectations onRMB movement, not the differential on bank deposits. Compared to the lowinterest rate environment globally, one could easily get 5% annualized risk-freereturn in China through 3-month Wealth Management Product. Lastly, the PBoCcould still intervene to maintain RMB stability and cut RRR to sterilize capitaloutflows. Indeed, we expect one more RRR cut in 4Q. Meanwhile, we arecomfortable with our call that RMB deprecation by the year end will be less than5% (Implications of the CNY fixing mechanism adjustment, 11 Aug 2015).

What’s the impact on the economy?

The impact is more symbolic than real. To be sure, the rate cut could helpreduce mortgage rate and corporate funding costs. More importantly, it signalledthat China’s policy makers are serious about the 7% growth target for this year.

Notably, the PBoC dropped the phrase ‘prudent monetary policy’ which it used inthe previous rate cuts, indicating that the monetary easing cycle continues. Assuch, we maintain the view in our 2H outlook that China’s economy will have aU-shaped recovery from 2Q15 to 4Q15 (GDP: 7.0%, 6.8% and 7.2% in yoyterms). We believe the current fears on a China hard landing are overdone andexpect some modest improvement in 4Q15, driven by accelerated property andinfrastructure investment from Sept.

Last but not least, China is closer to full interest rate liberalization.

Encouragingly, today the PBoC also removed the rate ceiling for deposits over ayear, marking another step towards interest rate liberalization. The ceiling fordeposits of 1-yr and below remains at 1.5x. Put differently, deposits are movingcloser to Wealth Management Products. In the next cut, interest rateliberalization in China could be finished.