Coronavirus: why is China keeping its powder dry on interest rates as economic contagion grows?

Zhou Xin

China’s central bank kept its main policy interest rate unchanged on Friday, dashing expectations that it would join widespread interest rate cuts in other countries and sending a clear sign that Beijing is taking a more conservative approach in aiding its coronavirus-battered economy than other major nations.

Beijing’s refusal to lower the loan prime rate (LPR) – the new benchmark for the country’s lending rates that it rolled out late last year – comes as major central banks are rushing to slash interest rates and boost asset purchases to cushion the economic shock from the global Covid-19 pandemic that has killed nearly 10,000 people worldwide.

Central banks in the United States, Canada, Britain, Australia, South Korea, Taiwan and Brazil have all cut rates in March, while the European Central Bank and Bank of Japan have expanded their quantitative easing as their interest rates were already in negative territory.

The People’s Bank of China (PBOC), on the other hand, is following a different policy trajectory in supporting the country’s economy, which is on track to suffer its first contraction this quarter since 1976.

Instead of cutting rates, China’s central bank has been pumping vast sums of money into the banking system in an effort to get banks to expand their lending to the country’s factories and workshops.

Last Friday, the PBOC announced a selective cut in required reserve ratio, or the percentage of deposits a bank must hold in reserve at the central bank, to unleash 550 billion yuan (US$77 billion) for banks to lend, adding to the 800 billion yuan added to the market in February.

Ma Jun, a member of the PBOC’s monetary policy committee, an advisory body, said China would continue to cut the required reserve ratio as its main policy tool to pump credit into the banking system.

“The central bank still has a fairly large amount of room to slash the required reserve ratio,” Ma was quoted as saying by the official Shanghai Securities News on Friday.

China’s average reserve ratio is now about 10 per cent, a sharp decline from a peak of over 20 per cent in late 2011. Given Chinese bank deposits now total nearly 200 trillion yuan (US$28.1 trillion), a one percentage point cut in the ratio can, in theory, release around 2 trillion yuan (US$281.8 billion) in funds for banks to lend. The PBOC could release 20 trillion yuan if it slashed the required reserve ratio to zero.

Such a move would not be unprecedented. The US Federal Reserve announced earlier this week that it would reduce its reserve requirement ratio to zero, encouraging US banks to lend as much as possible to help offset the economic damage being caused by the coronavirus.

Before that, the US central bank required banks with more than US$127.5 million on deposit to maintain a reserve ratio of 10 per cent.

The fact that China’s LPR did not change on Friday also showed that the rate, which is based on the average of rates at 18 banks and used as the basis for banks to calculate their rates on loans to corporate and household borrowers, is not yet a true nationwide benchmark.

The LPR would change only when the average quotes from the 18 banks showed a change larger than 5 basis points, according to Ma. For now, despite the extra liquidity in the market, banks are not lowering the rates they charge their clients, Ma said.

At the same time, analysts say that China’s central bank had no other option but to keep cutting the LPR or even the one-year deposit rate – the traditional benchmark policy rate – before long.

The PBOC has not touched the one-year benchmark deposit rate, which is now 1.5 per cent, in more than over four years, as it is reluctant to send a strong signal, Wei He, an analyst at research firm Gavekal wrote in a note.

The bureaucrats within the central bank under governor Yi Gang are trying to use the new LPR interest rate system to adjust borrowing costs without changing the benchmark, which would require the approval of China’s State Council, the government cabinet.

“Yi Gang has articulated a conservative philosophy in which maintaining positive nominal interest rates is an important long-term goal … therefore every rate cut is viewed as scarce ammunition that must be hoarded for emergencies,” Wei wrote. “This is the opposite approach to the US Federal Reserve, which has tried to do as much as possible, as early as possible.”

This is the opposite approach to the US Federal Reserve, which has tried to do as much as possible, as early as possible

Wei He

Larry Hu, China economist at Macquarie Capital in Hong Kong, said that the PBOC believes the market sees the recent cuts by other major central banks as a sign of weakness rather than strength.

“Given such a mindset among investors, why not save the ammo for the future?” Hu wrote.

Hu said China’s central bank “remains firmly in an easing cycle for the remainder of this year” and predicted it would cut the LPR five times by 5 basis points each time.

Hua Changchun, an economist at Guotai Junan Securities, a brokerage, said the downward pressure on China’s economy is expected to grow along with the global economic recession, forcing the PBOC to lower its benchmark deposit rate.

“The next window for China [to cut the deposit rate] is April,” he said.

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