China’s surprise interest rate cut is another step toward softening the country’s exchange rate, setting the yuan on course to end the year lower for the first time since its landmark revaluation in 2005.
The People’s Bank of China (PBOC) cut one-year benchmark lending rates on Friday, a move celebrated by Chinese corporations struggling against a toxic combination of high debt load and weak end demand.
Analysts say it could also signal the end of a rally in the yuan since May, especially if the central bank follows up with a cut to reserve requirement ratios, which would flood money markets with cheap yuan.
Investors have long been attracted to yuan-denominated assets, seen as relatively safe given implicit government guarantees, and at the same time higher yielding than similarly rated US dollar-denominated instruments.
However, the rate cut reduces the relative attractiveness of the yuan and makes it more risky to hold going forward.
“The rate cut overnight, along with prolonged weakness in the Japanese yen, will increase political pressure on the PBOC to allow a modest devaluation in the currency, both to reflect a normal market response to rate cuts and also to shore up export competitiveness in the face of downward pressure on Asian currencies across the board,” Eurasia Group analysts wrote in a research note distributed to clients on Saturday.
The yuan dropped sharply at the start of this year, losing more than 3 percent in two months, a phenomenon widely seen as an attack on currency speculators by Beijing.
The currency remains down 1.17 percent for the year, despite rising steadily since May.
However, markets were already growing wary of that trajectory, given a 10 percent rally in the US Dollar Index in the second half of the year, followed by broad drops in Asian currencies led by the Japanese yen.
However, economists warn that the PBOC is unlikely to be seeking to provoke a dramatic drop and markets did not aggressively revalue the offshore yuan in response to the announcement.
“China has a broader agenda, involving economic reform and rebalancing, which sets it apart from the other countries involved in global currency tensions,” HSBC economists wrote in a research note, arguing the ultimate outcome would be more forex market volatility, as opposed to steady rises or declines. “Structural reforms could be accompanied by lower growth, inflation, gradually lower interest rates, and a smaller savings-investments gap [implying a smaller current account surplus]. All of these actually indicate less room for further currency gains.”
Meanwhile, five of 16 listed Chinese banks raised their one-year deposit rates to the ceiling of the regulatory benchmark, in a mixed response by lenders to China’s latest interest rate cut.
The central bank’s latest asymmetric cuts of 40 basis points in its one-year lending rate and 25 basis points in the deposit rate are set to narrow profit margins at banks.
Banks have the option of offering depositors as much as 120 percent of the benchmark rate, up from a previous ceiling of 110 percent.
Offering the maximum could narrow a bank’s interest rate margin, a key source of profit, by 40 basis points, according to JPMorgan Chase & Co.
The asymmetric nature of the central bank’s move is “unusual,” and the smaller deposit rate cut “will be offset by the upward adjustment to the deposit rate ceiling to a certain extent,” HSBC’s chief China economist Qu Hongbin (屈宏斌) wrote in a note. “This will likely further squeeze banks’ margins.”
Additional reporting by Bloomberg
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