China easing to drag down yields, boost stocks

By Karen Yeung and Lu Jianxin - Analysis

SHANGHAI (Reuters) - China's biggest interest rate cut in a decade is expected to shift its yield curve down as much as 50 basis points and boost the stock market by at least 5 percent, while it could add to long-term downward pressure on the yuan.

The cut was twice as large as many traders had expected and came earlier than anticipated; bill yields had actually risen in the past week on speculation that interest rates might not be lowered again until mid-December.

Traders and analysts said the central bank may have acted because it felt a policy of gradual easing, which began in September, might fail to avert the deflation which economists believe is threatened early next year.

By flooding the money market with funds, the central bank apparently hopes to drive down banks' cost of funding sharply and quickly enough to trigger a surge of commercial lending, which would coincide with fiscal stimulus steps now being launched.

"The size of easing is very unexpected, and it's probably because advisers to the central bank suggested a quick and sharp easing would be more effective in supporting the economy," said Shi Lei, analyst at Bank of China.

As the interbank bond market was closing on Wednesday, the central bank slashed banks' one-year lending and deposit rates by 1.08 percentage point, bringing the one-year deposit rate to 2.52 percent. It also said it would cut banks' reserve ratios by between 1 and 2 percentage points on December 5.

In response, the five-year, offshore non-deliverable yuan interest rate swap, which had been moving sideways in the past week, plunged 39 bps to 1.45 percent bid.

YIELDS

Shi said China's long-term bond yields could tumble about 20 bps on Thursday, while short-term bond and bill yields could plunge by 50 bps to multi-year lows.

Just as importantly, the reserve ratio cuts are expected to inject between 600 and 700 billion yuan ($88 billion to $103 billion) into the money market, equivalent to three or four months of the money flowing in from China's huge trade surplus.

That could drag the weighted average seven-day bond repurchase rate, a key funding rate for banks, down to 2.0 percent or below in the next few weeks. The rate ended Wednesday at 2.5351 percent.

Analysts said further monetary easing might come as soon as late December, depending on economic data. Shi expects the one-year deposit rate to bottom out next year at 1.98 percent, its level when China was last battling deflation in 2002.

HSBC predicted in a report that the central bank would cut interest rates by a further 200 to 250 bps and reserve ratios by 400 bps by June 2009.

"The cuts in all rates suggest that the central bank wants to send a clear signal to the market that it will continue to ease monetary policy to bolster corporate lending," said Lin Chaohui, bond analyst at Guotai Junan Securities.

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