China made an unexpected decision on Monday to lower its key policy rates and benchmark lending rate in an effort to boost growth.
The action follows a second quarter economic report that was weaker than expected and an important meeting between top Chinese leaders.
China reduces reverse repo rates to 1.7%
In an effort to enhance the open market operation mechanism, the People’s Bank of China has reduced its reverse repo seven-day rate from 1,8% to just 1.7%.
The government has acknowledged the downward pressures on the economy by making this first cut since almost a full year.
The Central Bank also reduced the 5-year Loan Prime Rate (LPR), from 3.95%, to 3.85% and the 1-year LPR to 3.35%.
Economic challenges prompt decisive rate cuts
Rate cuts were made in response to various economic challenges that China faces, such as the deflation threat, an extended property crisis, rising debt and a weakening consumer and business confidence.
The recent Third Plenum was a significant event that takes place every five years in order to determine the direction of economic policy.
China’s leadership has pledged that they will meet the 5% growth goal for this year despite these difficulties.
Yields on Yuan bonds are affected
After the rate cut, the Chinese Yuan dropped to an almost two-week low at 7.2750 against the dollar. It recovered some of its losses.
The yields on sovereign bonds also fell across the curve. They dropped by up to 3 basis points for both 10-year and 30 year yields before they stabilized at 2.4% and 2.45% respectively.
Investors anticipate that further measures of easing will be taken and the monetary environment will become more accommodating.
In early trading on Monday, China’s 30-year Treasury futures, for delivery in September 2024, rose roughly 0.3%, indicating a positive sentiment among investors towards government securities with a long term.
The PBOC has made a move to use the reverse repo rate of seven days as its main policy instrument, which is more in line with major central banks such as the U.S. Federal Reserve.
What was the reaction of stock and commodities markets?
Stock markets had a mixed reaction. Although the initial reaction was positive with certain sectors showing gains, overall sentiment is cautious.
Investors worry about the economic outlook in general and whether the recent rate reductions will have a significant impact on economic growth. Investors were skeptical about the ability of rate reductions to boost consumer and business confidence due to their modest size.
The response on the commodities markets was moderate. Although China’s policies have a significant impact on global commodities demand, modest rate reductions did not result in any major price changes.
Andreas Steno Larsen, CEO at Steno Research, said:
You could say that the PBoC is giving the banks a marginal increase by imposing the 7D Repo Rate. It is a good one to keep an eye on for any metals shorts and to confirm our general thesis that USD is at its peak (ish) against JPY, but that there is still a lot of domestic demand. This will result in a flood of copper due to the massive increase of Chinese excess capacity.
The rate cut is modest; a stronger fiscal/policy stimuli needed
China’s interest rate reductions are part of larger efforts to boost the economy and combat deflationary forces. Since 1999, the country is experiencing its longest deflationary streak. Prices across the economy have been falling for five quarters in a row.
The PBOC aims at lowering real interest rates by lowering the rates. This will make borrowing attractive, and stimulate economic activity.
Analysts warn, however, that the modest impact of these measures on borrowing by households and businesses may be limited.
Shane Oliver of AMP, the head of investment strategies and chief economist said that the reduction in the 7 day policy rate is “modest”. He also suggested future policy stimuli will be incremental.
Economic experts suggest that a stronger fiscal stimulus could be required to boost economic activity.
The global implications of the road ahead
Rate cuts will likely add to the pressure on the Yuan. This is especially true as the Federal Reserve still hasn’t begun its path of rate reductions. The currency market could become more volatile and trade relationships may be affected by other countries’ reactions to China’s changes.
The rate cut may also affect the global bond market, as traders are closely monitoring any future actions taken by the PBOC in order to control bond yields.
Expectations are growing for further monetary ease in China. This includes rate reductions and a decrease in the Reserve Requirement Ratio (RRR).
As a significant amount of policy loans that are due to mature in the next few months (August and September), these potential actions could be taken.
Additional easing could support the economy, but it also poses risks to the financial stability of the currency and its value.
The post China’s Surprise Rate Cuts Aim to Boost Economy Despite Slowing Growth, Deflation Risks may be updated as new information unfolds
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