China is easing monetary policy. The economy needs budget 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 shares were positive on the news.

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

“The most likely path to reflation, in our view, is through budgetary spending on housing, financed by the PBOC’s balance sheet,” he said, emphasizing the need for more fiscal support, in addition to more efforts to strengthen the housing market.

The bond market showed more caution than the stock markets. China’s 10-year yield fell to a low of 2% after news of the rate cut, before rising to around 2.07%. That is still well below The yield on 10-year US government bonds of 3.74%. Bond yields move inversely to prices.

“We will need significant fiscal support for CNY government bond yields to rise,” said Edmund Goh, head of China fixed income at abrdn. He expects Beijing is likely to step up fiscal stimulus due to weak growth, despite its restraint so far.

“The gap between US and Chinese short-term bond yields is wide enough to ensure that there is virtually no chance of US yields falling below Chinese yields over the next 12 months,” he said. “China is also cutting tariffs.”

The difference between US and Chinese government bond yields reflects how market expectations for growth in the world’s two largest economies are diverging. For years, Chinese interest rates traded well above US rates, giving investors an incentive to park capital in the fast-growing developing economy versus slower US growth.

That changed in April 2022. The Fed’s aggressive rate hikes caused US interest rates to rise above those of China for the first time in more than a decade.

The trend has continued, with the gap between US and Chinese yields widening even after the Fed shifted to an easing cycle last week.

‘The market forms a medium to long-term expectation about the US growth rate, the inflation rate. [The Fed] A 50 basis point cut does not change this outlook much,” said Yifei Ding, senior fixed income portfolio manager at Invesco.

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

The Chinese economy grew by 5% in the first half of the yearbut there are concerns that full-year growth could miss the country’s target of around 5% without additional stimulus. Industrial activity has slowed, while retail sales have grown at just over 2% year-on-year in recent months.

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

There is still a 1 trillion yuan deficit in spending if Beijing is to meet its budget target for this year, according to an analysis released Tuesday by CF40, a major Chinese think tank focused on finance and macroeconomic policy. This is based on government revenue trends and assuming that planned expenditures continue.

“If overall fiscal revenue growth does not recover significantly in the second half of the year, it may be necessary to widen the deficit and issue additional government bonds in a timely manner to close the revenue gap,” the CF40 research report said.

When asked on Tuesday about the downward trend in Chinese government bond yields, PBOC Governor Pan Gongsheng attributed it partly to a slower increase in government bond issuance. He said the central bank is working with the Finance Ministry on the pace of bond issuance.

The PBOC repeatedly warned the market earlier this year about the risks of a one-sided gamble that bond prices would only rise while interest rates would fall.

Analysts generally do not expect Chinese 10-year government bond yields to fall significantly in the near future.

Following the rate cuts announced by the PBOC, “market sentiment has changed significantly and confidence in the acceleration of economic growth has improved,” Haizhong Chang, executive director of Fitch (China) Bohua Credit Ratings, said in an email. “Based on the above changes, we expect the 10-year Chinese government bond to rise above 2% in the near term and not break through it easily.”

He pointed out that monetary easing still requires fiscal stimulus “to achieve the effect of expanding credit and transferring money to the real economy.”

That’s because high levels of debt among Chinese companies and households make them unwilling to borrow more, Chang says. “This has also led to a weakening of the marginal effects of loose monetary policy.”

The US Federal Reserve’s interest rate cut last week theoretically eases the pressure on Chinese policymakers. A more dovish U.S. policy weakens the dollar against the Chinese yuan, boosting exports, a rare bright spot in China’s growth.

China’s offshore yuan briefly hit its strongest level against the US dollar in more than a year on Wednesday morning.

“Lower US interest rates provide relief for China’s foreign exchange market and capital flows, easing the external pressure that high US interest rates have imposed on the PBOC’s monetary policy in recent years,” said Louis Kuijs, chief economist of APAC at S&P Global Ratings. Monday by email.

For China’s economic growth, he is still looking for more fiscal stimulus: “Fiscal expenditure is lagging behind the 2024 budget allocation, bond issuance is slow and there are no signs of substantial fiscal stimulus plans.”