China Insights: The full liberalization of interest rate to underpin SDR bid

The People&lqquot&s Bank of China (PBoC) announced to cut both benchmark interest rate and reserve requirement ratio again on 23 Oct, the third double cuts in 2015. 1-year benchmark lending and deposit rates will be lowered by 25bps to 4.35% and 1.5% respectively, the sixth interest rate cuts since November 2014. Meanwhile, reserve requirement ratio will be lowered by 50bps broad-based with RRR for large financial institutions will be lowered to 17.5%. On top of that, qualified financial institutions supporting agriculture and micro and small businesses will be entitled to additional 50bps cut of RRR. What’s more important, PBoC also removed the remaining interest rate ceiling on the shorter tenor deposit. Technically speaking, China’s interest rate has been fully liberalized.

We think the full scale RRR cut is widely expected given capital outflows have accelerated in the past two months. Nevertheless, the sixth interest rate cut is sooner than our expectation given China’s previous monetary easing is taking effects and growth is not running out of control.

Why did PBoC cut interest rate again when previous easing is taking effect?

China has cut interest rates for six times since last November while still keeping its "prudent" monetary policy tone unchanged. Frankly speaking, the context of prudent monetary policy, we think it is less convincing for the latest interest rate cut from growth perspective. One may argue the latest interest rate cut is in reaction to the deceleration of Chinese economy. Indeed, Chinese economy has slowed down for the past four years. Nevertheless, there is no sign of loss of speed. In fact, there is rising speculation that China’s growth may recover slightly on the back of easing monetary and fiscal policies after 3Q growth beat market expectation at 6.9%.

In fact, we have seen signs of turnaround of some monetary indicators following the previous monetary easing. First, demand for medium to long term loans recovered in both household and corporate sectors. Medium to long term loan to corporate sector, for example, increased by CNY357 billion in September after shrinking to about CNY100 billion in July and August. Second, China’s monetary condition index has also improved since August, showing loosening monetary policy is taking effect. Third, funding costs continued to trend down. 

As such, we think inflation rather than growth could be one of the triggers to the latest interest rate cut. China’s CPI moderated to 1.6% in September, turning real interest rate to positive again before the latest interest rate cut. Meanwhile, as a result of recent falling pork and food prices, inflation is expected to fall further in October. As such, the latest interest rate cut is able to help PBoC keep real interest rate in check. Meanwhile, the 43 month consecutive decline of PPI and the 0.3% fall of GDP deflator in the first three quarters may also fuel concerns about deflation risk.

One stone kills two birds

In addition to contain deflation risk, the latest interest rate cut may also be brought forward to support China’s bid for RMB’s inclusion into SDR basket. The most important announcement last Friday, in our view, is China’s decision to fully liberalize its interest rate. Although the removal of remaining interest rate ceiling is unlikely to have imminent impact on China’s deposit rate given flush onshore liquidity and possible window guidance from policy makers, the move clearly shows to the world that China’s financial reform is well on track. The move towards market driven interest rate system will reinforce China’s bid for SDR.

In August, IMF listed a number of operational issues regarding RMB’s inclusion into SDR basket including 1) a suitable USDCNY exchange rate needed in London and New York, 2) deviation of daily fixing from market rate, 3) divergence between onshore and offshore rate, 4) availability of an appropriate interest rate instrument for the SDR basket and 5) ability to hedge.

Since then, China has launched a number of reforms to tick the box and fulfil the requirement including the reform of fixing mechanism on 11 August, which sparked the huge market volatility. On interest rate front, the move towards fully liberalized interest rate will help IMF find an appropriate short end interest rate instrument to decide SDR valuation. As such, we think the latest interest rate cut together with interest rate liberalization may be also part of packages to fulfil IMF’s requirement for SDR inclusion in addition to contain deflation risk.

The impact on RMB may be limited before November’s SDR decision

Theoretically, the double cuts should create more pressure for RMB to weaken further. However, given the choice of the latest interest rate cut timing may be partially driven by SDR review, we believe, China’s policy makers are likely to keep RMB stable in both onshore and offshore markets at least before the November SDR decision. As such, we see limited impact on RMB in the short run.

Unintended consequence

Since China has already cut both rates again, is it necessary to figure the motivations behind double cuts? Yes, we think it is important to asset the possible impact on the market. The disinflation and SDR driven easing is likely to create more risk of asset bubble compared with growth driven easing.

Since the burst of equity bubble, China’s bond market has rallied strongly on the back of easing expectation and lack of investible assets. The rapid decline of bond yields has led to increasing usage of leverage to enhance investors’ return. The latest interest rate cut may result in more leveraged buying spree in bond market, which in turn may raise concern about potential bond market. As such, we need to be vigilance to monitor the development of China’s onshore bond market.

To conclude, we think the RRR cut is widely expected to counter the negative impact of capital outflows. The timing of interest rate cut is still debatable in our view. Given previous easing policy is taking effect and signs of turnaround in monetary indicators emerged, the latest cut is probably not the result of growth. Rising disinflationary pressure could be one of the triggers to the latest interest rate cut. Meanwhile, the full liberalization of interest rate may be part of the package to support RMB’s inclusion into IMF’s SDR basket. The choice of interest rate liberalization timing may be partially driven by SDR review. Therefore, we believe the impact on RMB could be limited before November’s review. Nevertheless, the latest easing may add fuel into already hot bond market. We need to guard against the potential asset bubble risk in China’s bond market. 

The author is an economist at OCBC Bank in Singapore.

Views and opinions expressed in this article are those of the author.