×

The real reason behind China's latest 'stimulus'

The People's Bank of China in Beijing's financial district.
Tomohiro Ohsumi | Bloomberg | Getty Images
The People's Bank of China in Beijing's financial district.

A decision by the People's Bank of China (PBoC) to lower short-term borrowing costs for banks is not the standard pick-me-up aimed at a weakening economy.

Instead, the latest step by the PBoC is an experiment towards finding alternatives to benchmark interest rates whose efficacy has been blunted in recent years by the surge in the shadow banking system as well as removal of limits that tied commercial bank rates to official policy rates, economists say.

Late on Thursday, the central bank reduced its Standing Lending Facility (SLF) interest rates, yet another policy tool to inject cash into banks, with the seven-day rate cut to 3.25 percent and the overnight rate to 2.75 percent from 5.5 percent and 4.5 percent, respectively.

Typically, Chinese monetary stimulus relies on interest rate cuts or reductions in bank reserve requirements, with the lesser-known SLF only being used in anticipation of periods of tight liquidity, such as holidays. The facility hasn't been used since March.

Thursday's departure from traditional policy tools suggests that the central bank wasn't necessarily trying to boost economic growth, unlike previous easing episodes.

Thursday's cuts were to "discover the function of the Standard Lending Facility as the ceiling of the interest rate corridor," according to the PBoC's statement.

Global central banks use the interest corridor system to guide market interest rates towards main policy rates. When monetary conditions are tight, short-term money market rates move towards the upper end of the corridor as commercial lenders borrow from the central bank. Conversely, when financial markets are awash with cash, the lower end of the corridor ends up guiding policy.

For Beijing, a rate corridor is especially crucial as the world's second-largest economy seeks to transition from a planned financial ecosystem to one that is more market-based.

"The main significance of the announcement by the People's Bank (PBOC) that it is cutting standing lending facility (SLF) interest rates is that it is experimenting with a new monetary policy framework," said Mark Williams, chief Asia economist at Capital Economics, in a report, adding that he doesn't consider Thursday's news a form of monetary loosening.

"Though the statement doesn't say so, the implication of the move to using the SLF rate as a ceiling is that funds will in future be available at the rate set by the PBoC on demand," he added.

The benchmark lending and deposit rates that were previously used for easing are no longer as effective after Beijing scrapped its ceiling on bank deposit rates last month, he explained, hence the need to experiment.

"The PBoC is looking to shift to a new benchmark policy rate, as they search for new measures of monetary aggregates and credit measures to improve policy effectiveness," echoed Bernard Aw, IG market strategist, in a morning note. The central bank has been reportedly investigating various short-term rates as a viable replacement since 2013, he added.

To be sure, that's not the only reason motivating the central bank.

"The latest PBoC moves are also seen as pre-emptive measures to prevent a liquidity squeeze as the process of initial public offerings (IPOs) resumes," Aw said.

News recently emerged that 28 IPOs will be allowed to proceed by year-end following a suspension that was part of Beijing's stock market stabilization program earlier this year.

"Previously, the IPO batches have led to higher money-market rates as investors' funds were tied up in subscriptions. This time round, the PBoC is keen to avoid the same liquidity drain, ahead of new rules next year which will not require investors to deposit funds equivalent to the amount of stocks they want to subscribe," Aw said.

Nonetheless, it's not the first time the central bank has engaged in policy experimentation.

Williams notes that over the past few years, the PBoC has tested out different approaches, including regular and ad hoc open market operations as well shifts in reserve requirements—both across-the-board and targeted at particular lenders. Thursday marked the most substantive move yet towards a new framework, he said.

The bottom line

Some analysts believe SLF reductions may not be as effective as the benchmark tools.

"Historically, the 1-year deposit rate has exerted the greatest pull on the 7-day repo rate so the cut in the SLF rates will provide little incremental stimulus," said Tim Condon, head of Asia research at ING, in a note.

And while more monetary easing is widely expected, it may no longer be the central bank's top priority.

"Overall, I do not rule out further easing to support growth, but I feel that the PBoC is more likely to balance the need to stimulate the economy with ongoing financial reform efforts, especially on the liberalization of the interest rates,' Aw said.