China’s rate cut – killing many birds with one stone

There is a lot happening in China these days – global expansion of RQFII country quotas – Australia and Canada are the latest recipient countries, the Hong Kong-Shanghai mutual market access (MMA), ramping up QFII/ RQFII licencing, money market liquidity injections, targeted QE and more.

By now, everyone has got used to the speed of changes in China that we have come to expect more of the “same” until Friday’s rate cut. This cut has been touted for so long that many have given up on the idea. I for one was the first to say there will “not” be any formal rate cut because I questioned where is the “policy rate” that the PBOC could use. Indeed, I still question what will this rate cut directly translate into? This move is to cut the official 1y lending rate (the rate that commercial banks charge their non bank customers) by 40bp to 5.6% and the 1y deposit rate by 25bp to 2.75% – but banks have already been freed up from pegging their loan rates to this official rate and the pegging to the official deposit rate was also semi-liberalised for certain categories of bank customers. Besides the asymmetric cuts (larger on the lending rate than the deposit rate), the cap for banks’ commercial rate pegged to the official deposit rate has also been lifted from 1.1x to 1.2x, effectively nullifying the 25bp cut (from 3% to 2.75%, the effective cap stays unchanged at 3.3% with the lifting of the cap ratio).

Most importantly, these official lending and deposit rates are guidance for the non-bank sectors and not referenced to the interbank rates. Hence, for the banking system as a whole, there is no boost to overall liquidity or monetary condition. The truth is the PBOC’s effective tool right now are all quantitative tools (not price tools such as an interest rate reference).

Bird #1 – a reassurance to domestic market participants

So the rate cut is symbolic – a reassurance to domestic market participants that the PBOC has been easing monetary policy over the past six months. Going forward, we should feel keep up our expectation for more of the “past” China-style QE measures – i.e. injections via the standing liquidity facility (SLF), medium-term liquidity facility (MLF) and pledged supplementary lending (PSL) and ultimately, the cut on required reserve ratio (RRR).

Bird #2 – to raise the global stage for PBOC

Actually, one can see the rate cut as an open acknowledgement to China’s global partners that China is easing monetary policy to countenance the US’ exit from its ultra-easing monetary policy. This is also a chance for China to gauge how influential its PBOC policy is for global markets given its position as the world’s second largest economy.

Bird #3 – making the CNY market more interest rate sensitive

It is interesting to see that the instantaneous reaction to CNH after the announcement was to trade stronger. It gradually weakened after most analysts published notes warning the rate cut as a sign of a switch to weak exchange rate policy. We will soon find out as the “good thing” about China’s FX policy is – it is totally transparent through its daily fixing upon which virtually all the banks have created statistical or econometric models to forecast these daily predictions. My own model showed hardly any directional bias in the daily fixing these days – i.e. the USDCNY fixing is indeed responding to the market. The relevance here is how big is the USD weight in the PBOC’s fixing basket? Well, it is as big as 90% of the basket. Hence, one cannot exactly say China has been manipulating its currency to make it stronger or weaker – it is merely tracking the USD quite closely. Now, more pertinent I think is the intra-day trading band which I expect to see a further widening of the trading band before the end of the year. Then it is for market to take the opportunity to trade CNY and CNH stronger or weaker following the PBOC’s rate cut. Put differently, the rate cut – followed by a widening of the USDCNY intra-day trading band – is an open challenge by China to let market takes its currency to where it deems fit. So the ball is in our courts – would you long or short CNY now? In fact, even without a widening of the current 4% band, there is ample room for us to trade this currency as we saw “right” but I will bet that the market has no guts to disregard the PBOC’s daily fixing. We still need one more widening of the band to take that stab and then we may actually push the CNY stronger rather than weaker. We shall see.