China cuts interest rates, allows freer fluctuation

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The People's Bank of China (PBOC), the central bank, said Thursday it would cut the benchmark interest rate for deposits and loans by 25 basis points beginning Friday.

After the cut, the one-year deposit interest rate will fall to 3.25 percent while the loan interest rate will be lowered to 6.31 percent.

It marks the first time for China to cut the benchmark rates since December 2008, after which it has raised the rates five times to drain liquidity¹.

"Given China's current economic situation and its policy shift towards maintaining growth, the cut is well within expectations," said Zhang Liqun, researcher from the Development Research Center of the State Council, or China's cabinet.

The latest move came as China's GDP growth slowed to a nearly three-year low of 8.1 percent in the first quarter and key economic indicators³ for April continued to suggest downward risks, prompting the government to shift focus from inflation control to securing growth.

China's inflation rate slowed to 3.4 percent in April from 3.6 percent in March and was widely expected to ease further in May due to falling food prices and the base effect.

In a State Council meeting last month, Premier⁴ Wen Jiabao said the government should "place maintaining growth in a more important position and carry out preemptive policy adjustments and fine-tuning more forcefully according to the changing situation."

It also came as new yuan-denominated loans in April ran at the lowest level this year and manufacturing activities continued to stagnate⁵ in May.

Guo Tianyong, a professor from the Central University of Finance and Economics, said the rate reduction will play a significant role in stabilizing⁶ growth as it will lower operation costs for businesses and stimulate⁷ credit demands.

Dragged down by sluggish⁸ demand, China's new yuan-denominated loans in April totaled 681.8 billion yuan (107.9 billion U.S. dollars), far below market estimates of around 800 billion yuan and was also the lowest this year.

Tang Yunfei, chief macroeconomic analyst⁹ at Founder¹⁰ Securities, saw the cut as a signal of a new round of monetary¹¹ loosening and he expected an acceleration¹² in credit supply for the latter half of the year.

"Credit supply for the whole year will exceed 8.5 trillion yuan," he predicted.

With major global economies mired¹³ in recessions, Gao Shuguang, an economist¹⁴ with the Development Research Center under the State Council, said China's gradually loosening policy, including three cuts in bank reserve requirement ratio (RRR) so far, is in line with international practices.

"Stabilizing growth has become the focus for many countries, and our latest move was in line with the international trend," he said.

Lifted by the move, U.S. stocks surged at opening time Thursday, with the Dow Jones industrial average up 1.3 percent to 12,543.

Accompanying the reduction in borrowing costs that will have an immediate¹⁵ impact in stimulating¹⁶ the economy, the real surprise on Thursday was the central bank's decision to allow banks more freedom in setting the deposits and interest rates, a significant step towards the liberalization of the interest rates, analysts¹⁷ said.

The PBOC said the upper limit of the floating band of deposit rates will be adjusted to 1.1 times the benchmark while banks are allowed to offer a 20 percent discount to borrowers.

China's commercial banks until now were generally not allowed to offer deposits rates higher than the set benchmark and the downward float for loan profits were controlled within 90 percent of the benchmark.

"The move is of great significance as it means a big step forward in the reforms of the interest rate mechanism," said Xia Bin², counselor¹⁸ of the State Council and former member of the monetary policy committee of the People's Bank of China.

The somewhat sudden adjustment echoed promises made by PBOC earlier this year to push forward market-oriented interest rates.

Ba said the new policy will test banks' price-setting and innovation abilities, which allowed competitive banks to create diversified¹⁹ products to attract loans.

Meanwhile, the adjusted floating band will benefit businesses with lower financing costs, stimulate credit demand, and foster an amiable²⁰ environment for the country to spur growth through fiscal²¹ means.

Although the cuts to the reserve requirement ratio and interest rates, which analysts believe will happen again times this year, are aimed at stimulating credit supply and demand, respectively, the realization²² of a balance between the two will need additional efforts from the government, including the assistance of fiscal policies, analysts said.

"Especially in terms of economic restructuring and easing business burdens, fiscal policies have a larger role to play," said Cai Yanfei, an analyst with Industrial Securities.

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