HSBC: China eases monetary policy and starts liberalizing interest rates

This is the first cut since December 2008. Lending and deposit rates of other maturities and individual housing provident fund deposit and lending rates have also been lowered accordingly.

– Surprisingly, the PBoC also lowered the floor of the lending rate to 0.8x the benchmark rate (vs. 0.9x previously) and raised the ceiling on the deposit rate to 1.1x the benchmark rate (vs. 1.0x previously), which signals a small step towards interest rate liberalization.

Our interpretation of the marketimpact
China is trying to reduce the cost of capital by providing more liquidity to banks (the ultimate goal of lower required reserves) and now by cutting interest rates and lowering the lending rate floor to 0.8x from 0.9x of benchmark lending rates. This comes in addition to other announcements over the last couple of weeks, especially the frontloading of China investment projects and the postponement of Basel 3 (stricter accounting rules) implementation until the beginning of 2013.

The timing of the rate cut –two days prior to the May macro data release – probably suggests May data could be worse than the market expected. Market reaction today has been muted, even negative. The market appears to have focused on how bad the May data has to be for the PBoC to front-run the data.

The market reaction also reflects investor disappointment about Fed Chairman Bernanke’ s comments before Congress in which he stuck a balanced tone and avoided making direct overtures to further accommodation. The market has been craving for a policy response from all major central banks particularly from the Fed and ECB. The PBoC rate cut will likely strengthen market expectations for more aggressive policy easing to come.

Possible investment implications
This announcement is positive for markets going forward. From a fundamental, macroeconomic perspective, China has in fact started to liberalize interest rates by introducing a mechanism that will eventually increase competition between banks to attract deposits. This can be seen as an important milestone in improving the allocation of capital and reducing the internal imbalances of the economy.

– Equities
The rate cut reinforces our constructive views on equities as more proactive policy response should help improve China’ s growth prospects

– Fixed Income
Limited impact on government bonds. Positive for highly leveraged companies thanks to lower funding costs. Negative for banks in the short term as net interest margins will be under pressure

– Currencies
Long term positive for CNY against USD due to better management of financial imbalances. Short term more neutral due to weak economic momentum

– Emerging markets
Positive for emerging markets as lower funding costs support demand from China and help stabilise investors expectations

– Developed markets
Limited impact on developed markets but sentiment could be improved in the medium term in the event of a bottoming out of China in the coming months

– Commodities
Medium term positive for cyclical products (energy and industrial metals) but fairly negative in the short term on weak economic momentum

– Alternatives
The Chinese real estate sector is a collateral beneficiary of the rate cut which is aimed at stimulating the broader economy. We remain skeptical though that this will serve as a prelude for relaxation of home purchase restrictions. The government has vowed to keep the curb on the property sector to rein in excessive demand and home price growth

Tactical changes being considered
It is the long term implications of today’ s announcement that represent the real news. In the short term the news reinforces our positive view on risk assets; equities and emerging market equities in particular. To recap, we believe long term returns on equities are likely to exceed those on cash and high grade bonds. We also see emerging markets as better placed to deliver growth than developed markets, where both monetary and fiscal policy are highly constrained.

To this long term view of expected returns, we overlay a secular economic view that global growth will be sub-par in the coming years, that emerging economies will grow more strongly than developed ones, and that the trade-off between growth and inflation will be less favourable than has been the case in recent years.

Recent market declines have meant that markets have discounted the unfavourable secular background, and have priced in at least some probability of a much worse outcome for the global economy than we believe is likely. Although the European story has been very much at the centre stage, worries over the Chinese economy have also played their part. The latest news is a clear indication that Chinese policy has changed.

From a (highly successful) focus on cooling the housing market and bringing down inflation, the emphasis of policy is now to support economic growth. In addition, the structural changes confirm the gradual liberalization of China’ s monetary policy which is of long term benefit to the global economy.

Market reaction today has been muted, even negative. The market seems to be interpreting the interest rate cut to mean that this weekend’ s economic news, on retail sales and industrial production, must be weak. But it is important to remember that economic data releases are information about the past, and we already know economic growth has been subdued of late. What today’ s move affects is the future, and it only makes it rosier.
We believe that China’ s economic miracle continues.