China’s central bank surprised markets on Monday by keeping its key interest rates steady, defying widespread expectations for a cut to support the country’s struggling economy. The move reinforces views that policymakers have limited room to stimulate growth.
Background
China’s economy grew just 3% in 2022, one of its worst years in decades, as repeated lockdowns under its strict zero-COVID policy hammered business activity. Growth is expected to improve only marginally in 2023, with the government setting a target of around 5%.
To prop up the economy, the People’s Bank of China (PBOC) had been expected to reduce key policy rates including the one-year loan prime rate (LPR) – its version of the Fed funds rate – by 10 to 15 basis points. It last cut both LPRs in August 2022.
China GDP Growth (%)
Year Growth
2022 3.0
2021 8.1
2020 2.2
2019 6.0
2018 6.7
But with inflation falling to 1.8% in December, its lowest since February 2021, down from 2% in November, policymakers are torn between supporting the weak recovery and avoiding fuelling financial risks after years of credit stimulus.
“The December activity data suggest further weakness ahead but lower inflation reduces the burden of PBOC to provide liquidity support via rate cuts,” said Yeap Jun Rong, market analyst at IG.
PBOC Holds Rates Steady
On Monday, the PBOC held its one-year Loan Prime Rate (LPR) steady at 3.65% from the previous monthly fixing. It also kept the five-year LPR unchanged at 4.3%. In a Reuters poll of 22 market watchers this week, 16 respondents forecast a 10-basis-point cut in both tenors.
The key one-year LPR was last reduced in August by 5 basis points. Most new and outstanding loans in China are based on the one-year LPR.
Global financial markets were largely unfazed by the surprise decision. China’s yuan currency eased slightly against the dollar while the Shanghai and Hong Kong stock indexes also fell after the move. Government bond futures rose a touch on the news while shorter-end treasury bond futures also gained.
Policy Dilemma Amid Deflation Risks
With widespread expectations of more easing to come, the decision to stand pat appears to reinforce the view that Chinese policymakers have limited room to stimulate the economy, saddled with worries over debt and property market risks.
November’s readings on industrial output, retail sales and fixed-asset investment all missed forecasts – the latest in a string of downbeat data pointing to continued weakness in China’s manufacturing and property sectors.
Economists say China’s determined anti-COVID stance – now being loosened – has hurt employment and consumption, heaping more pressure on an economy already losing steam.
Qinwei Wang, China economist at Capital Economics, said in a client note after the LPR announcement: “Today’s decision suggests that the PBOC does not see loosening monetary conditions as a priority, for fear of fuelling debt risks and property market imbalances.”
The decision also comes after China’s producer prices fell at their fastest pace in nearly two years and consumer inflation moderated, underlining challenges faced by policymakers in shoring up demand while keeping leverage at bay.
Analysts believe the PBOC also avoided lowering rates due to concerns over rising deflation risks. The problem of producer goods inflation turning negative mid-cycle – China’s PPI has been declining year-on-year since September 2022 – can become entrenched, hurting corporate profits and investments, ultimately cascading into job losses if unaddressed.
Tao Wang, chief China economist at UBS, said: “The key message is: it’s quite clear to us at this point that the government’s priority has shifted to dealing with deflation risk.”
Wang expects another 20 basis points cut in China’s LPR before mid-2023 to shore up the weak economy.
Path Ahead: Easing Bias with Targeted Measures
Despite holding rates steady for now, analysts expect Chinese policymakers to continue easing monetary policy via more targeted measures, amid continuing downside risks loom for the economy in 2023 from the property market downturn, still-weak consumer demand and softer export outlook.
Iris Pang, ING chief economist for Greater China, said she expects the PBOC to keep rates on hold through the first half of 2023, noting: “We believe that both rates and (reserve requirement ratio) cuts are ineffective under the current environment… Targeted measures would be more effective to support growth.”
Jiahe Chen, chief China economist at Natixis, expects two RRR cuts this year of 25bp each, adding the central bank will rely more on dollar liquidity injection via foreign exchange swaps while avoiding LPR cuts:
“The policy dilemma stems from weak growth momentum and lingering deflation pressure. The priority of policy making seems to have shifted from growth stabilization to preventing deflation.”
So while standing pat on rates for now, analysts expect the PBOC to step up targeted support measures in coming months – cutting banks’ reserve requirements, injecting short-term cash via repos or scrapping forex reserve requirements to boost overseas fundraising. More infrastructure spending and cuts in taxes, fees and loan rates for small firms are also likely.
The government’s formal 2023 economic growth target – and details on stimulus plans – are expected to be announced at China’s annual parliamentary session in March. But authorities have already flagged infrastructure spending as a key priority in shoring up demand and stabilizing the economy this year, analysts say.
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