China rate cut to revive capital markets
Editor: Bruce Meng
9 Oct 2008 01:33:02 GMT

SHANGHAI, Oct 8 - China's most aggressive monetary easing this decade will help to revive capital markets that had shown signs of succumbing to global financial contagion, and is likely to be followed by more easing in coming months.

Traders and analysts said a package of measures announced by the central bank on Wednesday appeared to stem from a realisation that China's markets were no longer immune to global contagion, despite capital controls and still-high economic growth.

"The steps just announced will give a short-term boost to the Chinese capital markets. Bond yields will fall and the stock market should rebound," said Wang Haoyu, economist at First Capital Securities in Shenzhen.

After the markets closed on Wednesday, China said it was cutting benchmark one-year bank lending and deposit rates by 27 basis points, while reducing the ratio of deposits that all banks must hold in reserve by half a percentage point.

The package was more aggressive than a monetary easing conducted last month, when only lending rates and smaller banks' reserve ratios were reduced.

Wednesday's easing was the first time that the Chinese central bank acted in concert with central banks in the United States, Europe and Britain, making China a partner in the global effort to support the world economy.

Deputy central bank governor Su Ning said last month that although a moderate slowdown underway in China's economy was welcome, he feared weakness in Chinese markets, partly due to the global crisis, "might gradually spread from the financial sector to the real economy".

TRENDS

After being protected by capital controls for most of this year, China's yuan interbank money market began late last month to freeze up in much the same way as foreign markets, with the big banks that dominate fund supply becoming reluctant to lend. (for story, click on [ID:nSHA302632])

And after soaring 21 percent in late September in response to a government rescue package for the stock market, the Shanghai Composite Index has tumbled 9 percent this week because of the global slide in equities.

Analysts said Wednesday's easing could at least temporarily halt these trends. Shi Lei, analyst at Bank of China, predicted the seven-day bond repurchase rate, a key short-term funding rate for banks, would fall to about 3.20 percent on Thursday from Wednesday's close of 3.36 percent.

"Concern about whether liquidity will stay tight will ease now," said Lin Chaohui, analyst at Guotai Junan Securities, predicting long-term bond yields would drop 10-20 bps on Thursday after a similar fall on Wednesday in anticipation of the easing.

Analysts said the Shanghai stock index could rebound 2 or 3 percent on Thursday, barring another meltdown in global equities.

RISKS

However, many analysts said Wednesday's easing was unlikely by itself to save the Chinese markets.

"Long-term prospects remain unclear, with the overseas financial crisis far from over. The latest set of steps will certainly not be able to solve the problems fundamentally," said Wang at First Capital Securities.

In the money market, smaller Chinese banks may gain better access to funds but the foreign banks operating in China may remain frozen out because of concern about the health of their overseas parents.

"It doesn't matter whether they cut to zero percent -- the fact is that it's not about price. Local banks will still be reluctant to lend to us because of credit worries," said a trader at a European bank in Shanghai.

So reserve ratios may be reduced by a further one or two percentage points in coming months, with another interest cut occurring as soon as late this year, traders and analysts said.

"Today's action paves the way for additional cuts in interest rates and reserve ratios," said Shi at Bank of China.

However, such easing involves risks in the foreign exchange market; it could fuel expectations for depreciation of the yuan against the dollar, encouraging large-scale capital outflows which the central bank has said it wants to avoid.

While the central bank should have little problem keeping the yuan stable in the onshore spot market through its reference rate system and indirect intervention when needed, the offshore non-deliverable forwards market is another matter.

In the wake of last month's monetary easing, one-year NDFs <CNY1YNDFOR=> began to imply yuan depreciation against the dollar over the next 12 months for the first time in five years.

"The NDF market is likely to respond to the Chinese rate cuts by forecasting extended depreciation of the yuan," said Liu Dongliang, foreign exchange analyst at China Merchants Bank.