Saturday 27 December 2008

Aggressive Rate Cuts Unlikely as Fears of Yuan Decline Mount

The mainland is unlikely to slash interest rates next year as aggressively as it did this year, because rising expectations of yuan depreciation, a by-product of rate cuts, could undermine Beijing’s efforts to shore up the economy.

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Aggressive Rate Cuts Unlikely as Fears of Yuan Decline Mount

Jane Cai
24 December 2008

The mainland is unlikely to slash interest rates next year as aggressively as it did this year, because rising expectations of yuan depreciation, a by-product of rate cuts, could undermine Beijing’s efforts to shore up the economy.

The People’s Bank of China lowered the benchmark one-year deposit rate and lending rates 27 basis points from yesterday. It will cut the required reserve ratio for banks 50 basis points from tomorrow.

After five rate cuts since mid-September, the one-year lending rate has now been slashed a cumulative 216 basis points from 7.47 per cent to 5.31 per cent and the one-year deposit rate lowered a total of 189 points from 4.14 per cent to 2.25 per cent.

“Policymakers are now faced with a dilemma, which makes further substantial rate cuts unlikely next year,” said Ha Jiming, an economist at China International Capital Corp.

CICC has predicted that Beijing will cut the rates 81 basis points by the middle of next year, while Morgan Stanley, JP Morgan and Standard Chartered Bank have forecast a 135 basis point reduction.

The latest rate cut was half the 54 basis points many economists had expected in the past week, when November data showed consumer inflation cooled fast in the economic downturn and the United States slashed rates to almost zero.

“Although big rate cuts can help stem the rapid economic plunge, they will pose challenges to China realising its target of 17 per cent monetary supply growth next year,” Mr. Ha said.

Earlier this month, Beijing set the target for M2 - money supply including cash and all deposits - next year to ensure sufficient liquidity in the banking system to finance the 4 trillion yuan (HK$4.53 trillion) fiscal stimulus plan. A big interest rate cut can spark hopes of further yuan depreciation, raise the risk of capital flight, reduce foreign reserves and slacken money supply growth, as the rise in foreign reserves makes up 75 per cent of the nation’s money supply expansion.

Economic data in the past few months has already sounded the alarm bells. Foreign direct investment contracted more than 33 per cent last month, prompting worries about a retreat in speculative money betting on a yuan appreciation and booming stock and property markets and entering under the guise of foreign direct investment.

In addition, the mainland’s foreign exchange reserves had dropped for the first time in five years after hitting the US$1.9 trillion peak at the end of September, an official of the State Administration of Foreign Exchange said on Monday.

Yi Xianrong, a researcher at the Chinese Academy of Social Sciences, said Beijing had no need to make big cuts in interest rates next year, as the economy would grow 8 to 9 per cent in the second half.

Beijing is pinning its hopes on looser monetary policy to bolster its massive spending on infrastructure through 2010. But economists worry whether the flood of liquidity will translate into expanded funding for companies in need of cash.

“The interest rate cuts could help reduce financing costs for corporates and households with outstanding mortgage loans,” said Peng Wensheng, an economist at Barclays Capital Research.

“This would help to support demand for bank credit, now depressed by weak economic activity and squeezed margins of enterprises.

“Moreover, banks are seen to be reluctant to lend amid increasing concerns about credit risks. It remains to be seen whether Beijing’s policies would help promote bank credit.”