China's central bank cutting interest rates by stealth

Rate change starts Tuesday

By Laura He, CNN Business
China Photos / Getty Stringer

Chinese currency

(CNN) - Central banks around in the world are cutting interest rates to head off recession. China is now joining them, but in a roundabout way.

On Saturday, the People's Bank of China launched a long-awaited reform to the way it manages money in the world's second-biggest economy to support growth and employment. Its aim is to make it cheaper and easier for companies to borrow.

The central bank is gradually replacing its existing fixed benchmark lending rate, with a new Loan Prime Rate, starting Tuesday. The idea is that the new fluctuating LPR will better reflect changes in market rates.

"China's new Loan Prime Rate amounts to a rate cut," Pantheon Macroeconomics said in a research note Monday.

The Chinese economy has slumped to its slowest pace of growth in nearly three decades because of a range of factors: unsustainable debt levels, a transition from heavy industry and infrastructure to consumption, and the escalating trade war with the United States.

China's interest rate system has long been criticized for failing to pass on lower rates to borrowers in the corporate sector. Chinese banks prefer to lend to state-backed companies because of the lower risk. That means the private sector, which has been hit hardest by the economic slowdown and the trade war, is usually underserved with credit.

The PBOC's benchmark one-year lending rate stands at 4.35%, and it hasn't changed since October 2015. The new LPR will be set Tuesday, and subsequently on the 20th of each month. It will become the benchmark for banks to price new loans.

"The reform indicates the central bank is trying to tackle a more fundamental issue — making it easier for lower rates to pass through to corporate borrowers," said Hao Zhou, senior China economist for Commerzbank in Singapore.

Joining the 'easing camp'

Ken Cheung Kin Tai, chief Asian foreign exchange strategist for Mizuho Bank in Hong Kong, described the reform as "a bold step." He said it showed that the Chinese central bank wants to join the global easing camp, especially after recent disappointing economic data.

News of the change boosted Chinese markets. Hong Kong's Hang Seng index staged its biggest rally in two months, gaining 2.2%. The Shanghai Composite index also ended up 2.1%, its strongest gain in seven weeks.

Markets will be watching closely on Tuesday to determine the magnitude of the economic boost, Cheung added.

Analysts said it was too early to say how effective the monetary policy overhaul would prove, but added that the PBOC had good reasons not to opt for cutting its benchmark lending rate. It wouldn't lower borrowing costs effectively and could stoke fear about the downturn.

"The authorities probably don't want to garner too much attention, especially at a time when the slowdown is already worse than expected," said Vincent Chan, managing director and head of China equity strategy at Credit Suisse in Hong Kong.

In the current political climate, Beijing would be particularly cautious, he added.

"This is because maintaining stability is a key task ahead of the 70th anniversary of the founding of the People's Republic of China on October 1."

Policymakers have already responded to the economic slowdown with a range of measures this year. The latest came on Friday, when China's top economic planning body announced initiatives to boost spending, including increasing people's disposable income, stabilizing employment, and speeding up reforms in the rural areas.

The Chinese central bank also has a rich policy toolkit to manage the supply of money. In recent years, for example, it has cut the reserve requirement ratio, encouraging banks to lend more.

The PBOC hasn't said when the existing benchmark lending rate will be finally scrapped, but it reiterated on Saturday that it wants to merge its system of fixed and floating rates.

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