First Take on China’s “Surprise” Rate Cut

Chinese policymakers finally delivered the interest rate cut markets have been clamouring for. As usual, the timing was not as expected. Similar to previous episodes, such as the credit crunch in local rates of 2013, the PBOC let the market volatility reach extreme levels before acting.

This helps to create some degree of separation between the price action and the reaction function of the central bank, though certainly not enough to eliminate the sense of moral hazard.

Surely policymakers are not oblivious to the positive impact on sentiment and equity markets, but it would be myopic to see the move simply as what some have called the “Zhou put.” In other words: bailing out equity investors. In this regard, note that the last interest rate cut by China, on Saturday June 27, also followed some sharp declines in equity markets, but it didn’t reverse the trend.

We think the rate cut is at least as much (if not more) important for liquidity management than for equity market sentiment, from a perspective of the PBOC. The roughly RMB 650 bln it will release is necessary to make up for draining of funds from the PBOC’s intervention policy – i.e. sterilization. With capital outflows already elevated, and likely to have increased after the mini-devaluation last week, the PBOC has to sell dollars and buy yuan to keep supply and demand of money balanced when money flows out. Here is a graph of the CNY spot vs the 12-month NDF over the last 5 years. The spread continues to widen, suggesting that investors are pricing in the risk of further depreciation down the line.

Another reason is China’s push towards continued reform of its financial system, in this case, liberalization of local rates. The PBOC also removed the ceiling for deposit rates with maturity longer than one year. The cut plus liberalization is similar to the min-depreciation of the yuan last week, which came accompanied with a reform of how the fixing is set. Both are important, and they represent different, albeit connected, policy objectives.