Asian markets reacted positively to China’s unexpected rate cut over the weekend and the HSI gained approximately 2% to finish at 23,893 on Monday, paring its month-to-date loss to just 0.4%. Macquarie Equities Research (MER) issued a research report regarding the rate cut on 24 November, some excerpts from the report are shown below.
 
The PBoC conducted the first interest rate cut since July 2012: Markets should be positively surprised by it, as the current government had not cut the rate before. Today’s cut is asymmetric, small for deposit rate (1yr: from 3.00% to 2.75%), and big for lending rate (1yr: 6.00% to 5.60%). Meanwhile, as a major step in interest rate liberalization, the ceiling for deposit rates was raised to 1.2x the benchmark rate (from 1.1x previously). Today’s cut suggests that China has entered a new rate cutting cycle and MER expects more to come in the next six months. Today’s cut is positive to the market, especially for property and brokers. That said, today’s cut is far from enough in lowering financing costs and the economy still faces significant headwinds.
 
Behind the cut: weak growth and inflation: Almost every macro data coming in the past two weeks has disappointed. Meanwhile, inflation pressure is non-existent at this stage, given CPI disinflation and PPI deflation. Even worse, business confidence is pretty low, evidenced by a prolonged inventory destocking cycle. That is why China’s top policy makers finally made the difficult decision to make the first rate cut after the first two years in office, in hope of showcasing their determination in supporting growth. It is a meaningful deviation from the prevalent mini-cycle/mini-stimulus mode since 2012.
 
Positive to property by lowering mortgage rate: The cut today will lead to a lower mortgage rate, which is priced based on a benchmark lending rate. After the rate cut, MER expects mortgage rates in the coming months could be 100bp lower compared with 3Q14. A fall of similar size in mortgage rates was the key in turning the property sector around in 2012.
 
But not enough for lowering funding costs: The impact of rate cut on overall credit growth is far from certain. In the past few months, the key issue in China’s liquidity system is disappointing loan growth. It’s due to rigid loan quota, loan-to-deposit ratio and lower risk appetite. Rate cut could do little to change any of them. If new loans fail to pick up, liquidity supply will remain tight and financing costs will still be elevated.
 
Reserve Required Ratio cut/Loan-Deposit Ratio ease might come soon: The asymmetric rate cut today will likely hurt banks’ net interest margin (NIM), as lending rates get cut more than deposit rates. Indeed, banks’ funding costs might change little after the cut, as a majority of banks nowadays pay rate ceiling for their deposits (3.0*1.1=3.3). The new 1.2x ceiling means banks have to pay the same deposit rate as before (2.75*1.2=3.3%). As such, policy makers could compensate banks by cutting RRR or easing LDR soon.
 
A key step in interest rate liberalization: A highlight of today’s policy changes is the lift in deposit rate ceiling from 1.1x to 1.2x. MER has held the view that interest rate liberalization is the most significant reform area in 2015, as other reforms (State Owned Enterprises, land…) are still too controversial in ideology. It’s likely that at some point next year, China will fully liberalize benchmark deposit rates, thereby effectively ending the current dual-track interest rate system. In MER’s view, the most likely outcome of it will be the convergence of regulated deposit rate and unregulated market rate. If it happens, it will lead to a lower risk-free rate economy-wise, thereby lowering the cost of equity for China’s equity market. Along with RMB internationalization, reforms in financial areas will likely be the biggest catalyst for China market in 2015.

Source: Macquarie Research - 25 Nov 2014