China eases monetary policy. Economy needs financial support

BEIJING – China's slowing economy needs more than interest rate cuts to boost growth, analysts say.

The People's Bank of China surprised markets on Tuesday by announcing plans to cut a number of interest rates, including those on existing mortgages. Mainland Chinese stocks rose on the news.

The move could mark “the beginning of the end of China's longest contractionary streak since 1999,” Macquarie's chief China economist Larry Hu said in a note. The country has been struggling with weak domestic demand.

“The most likely path to re-inflation, in our view, is through fiscal spending on housing, financed by the People's Bank of China's balance sheet,” he said, stressing that more fiscal support is needed, as well as more efforts to support the housing market.

Bond markets have been more cautious than stocks. The yield on 10-year Chinese government bonds fell to an all-time low of 2% after news of the rate cut, before recovering to around 2.07%. That’s still well below the average yield on Chinese government bonds. 10-Year US Treasury Bond Yield 3.74%. Bond yields move inversely to price.

“We would need significant fiscal policy support to see higher yields on Chinese government bonds,” said Edmund Goh, head of China fixed income at Bank of Aberdeen. He expects Beijing to ramp up fiscal stimulus because of weak growth, though he has been hesitant so far.

“The gap between short-term interest rates in the US and China is wide enough to ensure that there is almost no chance of US interest rates falling below Chinese interest rates in the next 12 months. China is also cutting interest rates,” he said.

The spread between U.S. and Chinese government bond yields reflects divergent market expectations for growth in the world’s two largest economies. For years, Chinese yields have traded much higher than U.S. yields, giving investors an incentive to park capital in the fast-growing emerging economy at the expense of slower growth in the United States.

But that changed in April 2022. The Fed’s aggressive interest rate hikes sent U.S. bond yields above their Chinese counterparts for the first time in more than a decade.

This trend has continued, with the gap between US and Chinese bond yields widening even after the Federal Reserve shifted to an easing cycle last week.

“The market is forming medium- to long-term expectations about U.S. growth and inflation,” said Yifei Ding, fixed income portfolio manager at Invesco. “A 50 basis point cut doesn’t change these expectations much.”

On Chinese government bonds, Ding said the company has a “neutral” view and expects Chinese yields to remain relatively low.

China’s economy grew 5% in the first half of the year, but there are concerns that full-year growth could miss the country’s target of around 5% without additional stimulus. Industrial activity has also slowed, while retail sales have grown about 2% year-on-year in recent months.

China’s finance ministry has remained conservative. Despite a rare increase in the fiscal deficit to 3.8% in October 2023 with the issuance of special bonds, the authorities returned to their usual deficit target of 3% in March this year.

There’s still a trillion-yuan spending gap if Beijing is to meet its fiscal target for this year, according to an analysis released Tuesday by CF40, a major Chinese think tank focused on finance and macroeconomic policy. That’s based on government revenue trends and the assumption that planned spending will continue.

“If fiscal revenue growth does not pick up significantly in the second half of the year, it may be necessary to widen the deficit and issue additional treasury bills in due course to close the revenue gap,” said a research report by the International Finance Corporation (CF40).

Asked Tuesday about the downward trend in Chinese government bond yields, People’s Bank of China Governor Pan Gongsheng attributed it in part to a slowdown in the issuance of government bonds. He said the central bank is working with the Ministry of Finance to set the pace of bond issuance.

Earlier this year, the People's Bank of China repeatedly warned the market of the risks of engaging in a one-sided bet that bond prices would only rise while yields fell.

Analysts generally do not expect the yield on China's 10-year government bonds to fall significantly in the near future.

“After the People’s Bank of China announced the interest rate cut, market sentiment has changed significantly, and confidence in the acceleration of economic growth has improved,” Haizhong Zhang, managing director of Fitch Ratings (China) Bohua, said in an email. “Based on the above changes, we expect the yield on China’s 10-year T-bonds to exceed 2% in the near term, and will not decline easily.”

He noted that monetary easing still requires fiscal stimulus “to achieve the effect of expanding credit and moving money into the real economy.”

Zhang believes this is because high leverage among Chinese companies and households makes them reluctant to borrow more. “This has also weakened the marginal effects of loose monetary policy,” he added.

In theory, the Federal Reserve’s interest rate cut last week should ease pressure on Chinese policymakers. Easing U.S. policy should also weaken the dollar against the Chinese yuan, boosting exports, a rare bright spot for Chinese growth.

The Chinese offshore yuan hit its strongest level against the U.S. dollar in more than a year on Wednesday morning.

“Lower US interest rates provide relief to China’s foreign exchange market and capital flows, thereby easing the external constraints that high US interest rates have imposed on the People’s Bank of China’s monetary policy in recent years,” Louis Kuijs, chief economist for Asia-Pacific at S&P Global Ratings, said in an email on Monday.

On China's economic growth, Xi is still looking for more fiscal stimulus: “Fiscal spending is lagging behind the 2024 budget allocation, bond issuance has been slow, and there are no signs of major fiscal stimulus plans.”