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A couple of days ago, the PBoC shocked the markets by cutting their lending and deposit rates by 25 basis points – a move they haven’t made since December 2008!

This followed rumors that the central bank might need to ease monetary policy after Premier Wen Jiabao remarked that downward economic pressure was increasing for China and that further stimulus could be necessary to spur lending and growth.

After all, recent manufacturing PMIs hinted at weaker industry expansion while analysts projected that Chinese banks would fall short of their loan targets for the year.

Despite these speculations, the PBoC’s decision to cut interest rates still came as a surprise to the markets since several Chinese officials denied that another stimulus program is in the works.

After all, the prospect of higher inflation and more debt are among the reasons why China shouldn’t launch another round of easing. Besides, a full-scale banking crisis is the least of China’s concerns and other less aggressive options are available.

For the PBoC, however, it’s either they go hard or go home. The central bank decided to push the envelope by adding a slight twist to its recent monetary policy decision and encouraging interest rate flexibility among banks.

Prior to this decision, China’s old rate-setting system didn’t allow deposit rates to rise above the benchmark deposit rate while lending rates weren’t supposed to go below 90% of the benchmark lending rate.

This time around, the PBoC will allow banks’ deposit rates to rise to 110% of the benchmark and lending rates to fall to 80% of the benchmark.

By allowing maximum deposit rates to rise more freely and minimum lending rates to fall sharply, Chinese banks will have more flexibility in setting rates as China takes significant steps towards interest rate liberalization.

This appears to be the PBoC’s way of hitting two birds with one stone as they attempt to introduce reforms to China’s banking system while boosting economic growth at the same time.

You see, higher bank deposit rates mean that individuals would earn more returns on their savings. With that, households could afford to set aside a smaller chunk of their income for savings and be able to free up more cash for spending.

This could boost domestic consumption, which could boost overall economic growth.

But, as economists often say “There is no such thing as a free lunch,” as the PBoC’s move to support growth comes at a cost. In this case, banks might end up paying the price as the smaller interest rate spread between deposit and lending rates could hurt their profitability.

After all, nearly 80% of banks’ profits are made by giving loans at higher rates than the returns they give their depositors.

Effect of PBoC Rate Cut

On top of that, letting lending rates fall would lower the cost of capital for borrowers, and this could expose China to another asset price bubble.

Recall that China ran the risk of overheating and having a real estate bubble burst back in 2008 after the PBoC launched its massive 4 trillion CNY stimulus package.

With the PBoC’s latest aggressive easing move, several analysts are worried that lower borrowing rates could worsen China’s dependence on investment as a source of growth.

For now, it seems that the PBoC made things a little more complicated for the Chinese economy, but only time will tell whether their latest policy decision would work out or not. Do you think the central bank did more damage than good?