Whoever takes over as the new governor of the People's Bank of China faces a massive challenge. Photo: AFP
The People’s Bank of China conducted reverse repo operations of RMB500 billion by interest rate bidding on February 4, 2020.

China seems ready to lower its interest rates and the move, which looks likely to follow closely a similar cut by the US Federal Reserve expected on September 19, should create an attractive environment for investors. The signs from Beijing are certainly there, and none are clearer or more significant than the introduction last week by China’s de facto central bank, the People’s Bank of China (PBOC), of a revamped preferential bank lending rate.

The establishment of this new Loan Prime Rate (LPR), the cornerstone of an improved system for setting interest rates for commercial bank loans, came after a sequence of falls in the yuan in the last few weeks.

The PBOC on August 5 allowed the yuan to break to 7.0 per US dollar and it has since slipped again and sits at 7.18. It seems likely the PBOC will allow it to weaken by another 3-4%, to the 7.35-7.45 level, during September.

It’s no coincidence that the new LPR system – which supersedes a previous benchmark-based system that was easily manipulated by commercial banks to protect their own lending margins – will be set on the 20th of each month.

The next policy meeting of the US Fed is on September 17-18, and this is widely expected to bring a US interest-rate cut of 25 basis points. It now seems highly likely that the PBOC will quickly follow the Fed in this regard, very much like Beijing’s tit-for-tat responses in the escalating US-China trade war.

The markets, as they stand, are not positioned for such a cut and it will create an environment where a meaningful market rally is likely, especially in the Chinese bond sector as the pursuit of yield becomes paramount.

Furthermore, a drop in Chinese interest rates will bring a significant fall in the cost of borrowing for yuan-denominated corporate loans. Also, the weaker yuan combined with the lower interest rates will encourage outflows in all channels that facilitate RMB and this will include outbound mergers and acquisitions and also, possibly, even gold imports (which are paid for in US dollars).

Rapidly falling interest rates means income and returns from term deposits will also fall, and this could happen very quickly.

It should also mean Chinese property prices will rise.

People’s Republic of China regulators are likely to attempt to cap price rises in the residential sector but will likely allow commercial property prices to climb. This is because the new LPR is deliberately targeted toward borrowing costs for corporations rather than consumers because the main drag on China’s slowing economy is a corporate credit excess rather than a consumer lending excess (which, actually, is an issue in the making).

Indeed, Beijing does not want to cut interest rates across the board just yet as lower consumer mortgage rates would encourage speculation and cause residential property prices to rise more rapidly, and this could bring about the risk of social unrest.

This is why the LPR is tied to the interest rates of the open market operations undertaken by the central bank, namely its one-year medium-term lending facility (MLF), which is a policy lending tool that the PBOC uses to manage liquidity across China’s banking system.

As the PBOC sets the rate on the MLF, the LPR is a direct way to manage borrowing costs for the economy. Corporate loans are tied to the one-year MLF, while consumer mortgages are tied to the five-year one. Because of the concerns about property speculation, it is unlikely that there will be a cut to the five-year MLF any time soon.

The LPR is set in essence as a spread over the MLF. The first LPR, which was set last week, was 4.25%, or a 95bp spread over the current one-year MLF of 3.30%. By comparison, the current PBOC benchmark rate is 4.35%, meaning there was a 10bp cut in loan rates, which may seem small but it is a sure signal of things to come.

This calculation change is important because the previous system was based on the PBOC’s benchmark rates that could be manipulated by commercial banks in essence to create a floor on lending rates that protected their own lending margins. The central bank has now banned this practice.

In fact, last week the PBOC laid out requirements for the banks to apply the LPR to new loans in the very near future, as follows:

  • 30% of new loans must be based on LPR by end-September 2019 and a cut to the MLF is likely to immediately follow the Fed cut;
  • 50% by end-December 2019;
  • 80% by end-March 2020.

Moreover, the PBOC also said banks that collude with one another with the purpose of attempting to set an implicit loan rate floor will be punished through the quarterly macro-prudential assessment, which will basically serve as an audit of the banks.

Markets sold off hard after the last yuan reset and the signs clearly indicate that the next meaningful stimulus out of China will be interest-rate cuts. These cuts will create a significant bond-market rally, followed by one in equities.

This is a compelling time to invest.

Andy Brown

Andy Brown is a partner at ShoreVest Capital, a distressed debt and structured credit specialist in China, where he provides strategy on macroeconomics, bank balance sheets, regulatory developments, and structuring in the distressed credit space. 

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