The People’s Bank of China (PBOC) has been busy of late, re-setting the benchmark lending rate in August and cutting the reserve requirement ratio (RRR) by 50 basis points (bps) in early September. This isn’t a big surprise because the central bank is laying the groundwork for shifting the burden of stimulus from fiscal to monetary policy, as forecast in our 3Q2019 outlook.
The main question remains whether monetary stimulus will take the form of interest rate cuts or credit growth. I continue to believe that interest rate cuts, rather than credit, will be the PBOC’s tool of choice.
Weak Credit Environment Will Persist Amid Property Slump
Although observers have declared that China is returning to stimulus mode with the latest RRR cut, it’s actually less than meets the eye. The answer lies in what’s happening to the property sector.
As I noted in the previous Macro Outlook, top policymakers are not interested in engineering another property bubble to boost the economy. In fact, they appear to double down on property tightening. On June 13, Guo Shuqing, the head of China’s finance regulator, issued a draconian warning about the risk of property lending growth and the need to contain it, a message later reinforced at the July Politburo meeting.
This will have a notable impact on credit growth, since the property sector accounts for around one- third of new bank lending. The numbers bear this out—property lending growth has swung dramatically from 20% in May to -8% in July, while the banking sector’s total assets contracted by 0.5 % in July.
The protracted property slump implies that even if demand rises among other types of borrowers, such as corporates and local governments, it isn’t likely to make up for the property sector slowdown. As a result, the RRR cut will largely serve to offset weak credit demand rather than generate more credit, as new lending growth for the rest of 2019 will likely be zero.
At the same time, the bank lending rate has considerable room to fall, making it the PBOC’s primary tool for stimulus in the coming months. Despite a more than 100 bps fall in inflation and all the monetary easing since early 2018, the bank lending rate has remained stubbornly high and has further diverged from the market lending rate.
For instance, the most creditworthy borrowers need to pay an interest of 3.9% to borrow from banks, but can borrow from the bond market at 3.1% (see Figure 1). The same also applies to less creditworthy borrowers. As a result, the average bank lending rate can fall by at least 50 basis points from their current level, which should happen by 1Q2020.
Figure 1. Widening Gap between Loan and Bond Borrowing Rate (%)Source: Wind.
How Will the Interest Rate Cut Be Achieved?
Reducing the lending rate means banks will earn less from loans. This naturally leads to the question of whether the PBOC will compensate the banks for this loss. One way to do this, for example, would be to also cut the deposit interest rate to bolster deposits. Whether the PBOC will pursue this course is consequential because it will have broader implications for capital flows and the currency.
For one thing, to drive down the deposit interest rate, the PBOC will likely provide banks with more liquidity so they have less need to compete for deposits. However, some of the new liquidity will likely end up as capital outflows.
Lowering the deposit rate will also inevitably lead to a reduction in the market interest rate (e.g. bond yield), which could precipitate a dramatic drop in capital inflows. That’s because the higher yield on Chinese bonds relative to other major economies has continued to attract foreign capital despite trade war uncertainties. Foreign investment in Chinese bonds has totaled more than $100 billion since 2018, which has helped to stem capital outflows. But if bond yields were to drop because of a lower market interest rate, the situation could be reversed.
Capital outflows and inflows mismatch will compromise the PBOC’s ability to defend the yuan, which is already under downward pressure because of the trade war. So in order to perform the delicate balancing act of a rate cut while stabilizing the currency, the PBOC will likely do a much larger lending rate cut and keep the deposit or market interest rate cut limited. That means the PBOC is expecting the banks to absorb the lending rate cut at the expense of their profits.This is essentially a transfer from the banking sector to corporates.
Since the lending rate cut will be the primary tool for stimulus, the question is how large it will be, especially now that the Chinese economy has come under renewed growth pressures. Although there is widespread concern about whether Beijing has enough policy room to stabilize growth, I believe Beijing can, and will likely, cut the lending rate by up to 50 bps by the end of 1Q2020, with 60% of the cost financed by a drop in bank profits.
The banks should be able to tolerate it, as the direct effect of a 50 bps cut translates into a reduction of 15% in bank profits. This isn’t great, but some of that can be offset by the stimulative effects of the rate cut and by alleviating the debt burden of borrowers, both of which can help improve asset quality and reduce non-performing loans. So the net effect of a 50 bps lending rate cut on bank profits is likely to be smaller than the banks’ losses on interest income. As a result, if more stimulus is required, Beijing is prepared to lower the lending rate by more than 50 bps.
 Factors such as the Baoshang takeover and the growth slowdown are unlikely the main culprits for the banking sector contraction. The impact of the Baoshang takeover is overwhelmingly on smaller banks. But in July, total assets of large state banks declined at a similar rate as the overall banking sector, which can only be explained by a contraction in mortgage lending since large state banks account for two-thirds of total property lending. And since the lending contraction happened before the trade war escalation in early August, that can also be ruled out as an explanation.
 To prevent another property bubble, the PBOC has explicitly excluded mortgage and property-related lending from benefitting from the lending rate cut. In addition, paper financing is already at the market rate and does not need to be cut. As a result, only about 95 trillion yuan ($13.5 trillion), or two-thirds of bank loans, will be affected by the lending rate cut. This means bank losses as a result of the 50 bps cut will total around 450 billion yuan ($64 billion).
Houze Song is our research fellow focusing on macroeconomics and financial markets. You can read his latest Macro Outlook for 3Q2019 here.
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