August 28, 2019 / 5:44 AM / 20 days ago

China seen cutting key rates from September but moves likely gradual

BEIJING/SHANGHAI (Reuters) - Deteriorating Sino-U.S. trade ties and interest rate reforms are fueling speculation China will start cutting key rates from next month, but bankers expect borrowing costs to come down only gradually, offering limited support for the slowing economy.

A man walks in the rain along the financial district of Pudong in downtown Shanghai August 18, 2014. REUTERS/Carlos Barria

Chinese policymakers need to kickstart flagging investment to save jobs, but big rate cuts could fuel a further build-up in debt and squeeze banks’ profit margins, heightening financial sector risks.

Still, as the economy cools, analysts say landmark reforms launched last week have paved the way for the first cuts in major China policy rates in four years, with a move seen by mid-September, coinciding with expected easing by the U.S. Federal Reserve.

Initial rate cuts are expected to be modest, however, as banks and regulators get used to the new, more market-oriented loan pricing system. The People’s Bank of China (PBOC) will not push lenders too hard to lower rates at first, analysts said.

“The first step is to ensure a smooth transition. It’s fine if interest rate margins widen, but it could be troublesome if interest rate margins narrow,” said Lu Zhengwei, chief economist at Industrial Bank.

To reduce the pressure on banks, the central bank is expected to first reduce their funding costs by lowering the rate on its medium-term lending facility (MLF). That will open the door for a cut in the PBOC’s new benchmark lending rate, the loan prime rate (LPR), the next time it is set on Sept. 20.

The MLF forms the basis for the new LPR rate, but banks can add a premium to reflect funding costs and credit risks.

“Whatever the final rate is, net interest margins of smaller banks will be narrowed for sure,” said the department chief at a city commercial bank, who asked not to be identified.

In what was seen as a symbolic move, the revamped one-year LPR CNYLPR1Y=CFXS was set at 4.25% last week, down 6 basis points (bps) from 4.31% previously and 10 bps lower than the existing benchmark one-year lending rate, which will still apply to older loans. The current MLF rate is 3.3%.

China will set lower limits on mortgage rates, however, highlighting concerns about potential property bubbles and rising household debt.

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The PBOC’s Shanghai branch urged banks at a meeting on Monday to increase lending to smaller firms, saying it was a “political point”, according to a statement by the branch.

To smooth the transition, banks were told the proportion of new loans that are priced by referring to the LPR must be at least 30% by end-September, a target many see as a challenge, two banking sources at the meeting told Reuters. The target would rise to 80% by March, 2020.

“The majority of the system should see some negative pressure...with greater pressure on the profitability of the system outside the state banks,” said Jonathan Cornish, head of Asia-Pacific bank ratings with Fitch Ratings.

Smaller companies - which generate a large share of China’s economic output and jobs — may not benefit much from the reforms in the early stages, analysts said.

Banks may reduce average loan rates in line with the central bank’s broader goals, but still charge higher rates to small businesses considered bigger credit risks.

“There will be winners and losers. Banks’ high-quality clients such as big state-owned enterprises (SOEs) will benefit from lower LPRs, but we don’t see much benefit for small- and medium-sized clients,” said Ting Lu, China economist at Nomura.

Lu expects the PBOC to trim its one-year MLF rate by around 10 basis points next month.

The PBOC has quietly guided short-term money market rates sharply lower since early 2018 though massive cash injections in various forms, but that has not driven down corporate lending rates as banks still priced loans in line with the fixed benchmark lending rate - the catalyst for the reform.

Facing more unpredictable financing costs, some companies have rushed to sign interest rate swaps to hedge risks.

Seventeen interest rate swap deals were signed on Aug. 21 with a nominal value of 1.86 billion yuan ($262.24 million), media reported, a day after the central bank set the new rate.

Bank of Communications(3328.HK), China’s fifth-largest state-owned lender, has signed a five-year rate swap with another lender and swaps with clients to convert one-year fixed-rate loans into floating-rate loans, according to an official who declined to be identified.

Reporting by Cheng Leng, Kevin Yao in BEIJING and Samuel Shen in SHANGHAI; Additional reporting by Engen Tham; Editing by Kim Coghill

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