China rate cut helps calm global markets, but for how long?

After triggering the recent carnage in global financial markets, China finally responded by announcing interest rate cuts. Markets had expected the Chinese government to announce measures by this weekend but the mid-week announcement has come as a surprise, pushing European stocks higher.

The People’s Bank of China (PBOC) has cut its one-year benchmark bank lending rate  by 0.25 percentage points after four days of stock market turmoil which saw over 22 per cent of its value shaven off. This is the fifth interest rate cut announced by China’s central bank in the last nine months.

China has also cut banks' reserve requirement ratio by 0.5 percentage points. The People's Bank said that the interest rate cut was to reduce "the social cost of financing to promote and support the sustainable and healthy developments of the real economy". Lending rates in China are at 4.6 per cent and deposit rates are at 1.75 per cent.

There is no doubt that the sharp fall in stock prices is the reason for reducing interest rates, but the other announcements made by the PBOC suggests that the problem has spread from the markets to the economy.

Falling markets sucked up liquidity from the market prompting the Chinese central bank to free up banks capital by reducing reserve requirement. Tao Dong, chief regional economist for Asia excluding Japan at Credit Suisse Group AG in Hong Kong has been quoted in The Guardian as saying “China needs extra liquidity to prevent systemic risks. But ultimately, fixing the economy is more important than fixing the stock market and advancing reforms is critical."

PBOC too agrees that the economy faces downward pressure and the task of stabilizing growth, adjusting its structure, pushing reforms and improving living standards is very challenging. Given volatility in global financial markets, “we need to use monetary policy tools more flexibly,” it said.

In order to prime up the economy, PBOC also reduced reserve requirement by 300 bps for financial and auto leasing companies. This is expected to push up money lending activity in the country, especially the markets as well as revive the auto sector.

  

China is fighting the financial battle on multiple fronts. The country is facing deflation risks, over-capacity, debt overhang which have also resulted in the country growing at the slowest pace since 1990.

Though a small interest rate reduction will not help China win the battle, but it has clearly helped in delaying further damage.

Global financial markets however, are celebrating the rate reduction announced by PBOC, with all markets trading over 4 per cent higher. Commodity markets too have revived with oil prices moving higher by three per cent.

The events of Black Monday and its subsequent recovery has once again shown how global financial markets are now used to artificial liquidity by various central banks. China too has pumped in liquidity by loosening its purse.

China joins the list of countries who are inflating their asset bubble. Infusing liquidity has not worked in the developed world. We will have to wait to see how it impacts China.