China cut interest rates as part of market-oriented reform amid slowing economy

China lowered its lending reference rate through a new market-oriented pricing mechanism on Tuesday, providing a modest easing of monetary conditions to help support the world’s second largest economy amid the trade war with the United States.

The new system will enable the People’s Bank of China to lower lending rates in a flexible and frequent manner via open-market operations, offering a new tool for Beijing to manage the impact of trade tensions with the US and rate moves by the US Federal Reserve.

The new one-year loan prime rate (LPR), which is the average of the rates that 18 designated banks charge their biggest clients, was set at 4.25 per cent, according to the National Interbank Funding Centre, a unit of the People’s Bank of China (PBOC).

The new rate was lower than the previous LPR of 4.31 per cent and also lower than the old benchmark lending rate of 4.35 per cent. The LPR is the rate at which banks lend money to its best customers, based upon the rate of medium-term lending facility (MLF), which is the cost for banks to borrow from the PBOC. The five-year LPR was set at 4.85 per cent.

“The decline is not big,” said Hong Hao, managing director of Bocom International. “It’s more of a medium and long-term reform. Its short-term impact will be limited, especially when participating banks have no strong incentives to lower their rates against narrowed net interest margin.”

The lending rate mechanism change also came at a time when the US Federal Reserve is expected to cut interest rates further to prevent the US economy from falling into recession. US President Donald Trump tweeted this week that interest rates in the US should be reduced by at least a full percentage point, though the US Federal Reserve is more likely to cut by a quarter percentage point at its next meeting in September.

China did not follow the 25 basis points rate cut by the US Federal Reserve at the end of last month – the first US rate cut in more than a decade – partly because a rate cut in the official benchmark rate would have been too dramatic, but with the new mechanism, Beijing will find it easier to respond next move in September, according to Wen Bin, chief economist of China Minsheng Banking Corporation.

China could lower the MLF rate, which forms the basis for the LPR, by 15 basis points, he predicted.

There will be three batches of such MLF loans maturing in the coming weeks – on August 24, September 7 and September 17 – giving the central bank three opportunities to reduce market interest rates, he added.

Like the US, China is also needs to reduce financing costs, particularly for small firms, to help the ailing economy. The country’s industrial output grew in July at the lowest level since February 2002 amid a broad economic slowdown.

Under direction from the State Council, the People's Bank of China announced on Saturday that it now requires banks to benchmark their loan rates against the MLF instead of the official benchmark lending rate – the change of which requires approval from China’s cabinet.

The central bank, in theory, can change interest rates for mortgages and other borrowing contracts by tweaking the MLF rates in the interbank market as these are under full control of the PBOC.

The change by the PBOC, a reform of its interest rate setting mechanism rather than an outright cut in its reference rates, followed steps taken by foreign central banks to cut their official interest rates to bolster economic growth. This includes the US Federal Reserves decision on July 31 to cut its main interest rate for the first time since 2008 due to uncertainty about the global economic outlook.

By basing the main lending reference rate against market rates, the PBOC hopes that commercial banks will provide more credit to small businesses while also lowering their fundraising costs.

“To ensure a lower lending rate, the PBOC can either cut MLF rates or use the window guidance to narrow the spread between banks’ LPR quotations and MLF rate. The scope of rate reductions will be data-dependent,” said Morgan Stanley analysts.

However, other analysts believe that Tuesday’s interest rate cut is just the beginning of monetary easing by the PBOC given the Chinese economy grew at a 27-year low pace of 6.2 per cent in the second quarter of 2019, and because the State Council targeted a cut of 100 basis points for small businesses this year.

July’s economic data and the ongoing trade tensions with the United States indicate further downward pressure, and so the need for greater policy easing, analysts said.

Ding Shuang, chief Greater China economist of Standard Chartered Bank, predicted that there could be two MLF interest rate cuts of 10 basis points each by the end of the year.

The current MLF rate of 3.3 per cent has remained unchanged since April 2018.

About 149 billion yuan (US$21 billion) of one-year MLF will mature on August 24, giving the central bank an opportunity to roll over this funding at a lower rate.