China loosens monetary policy. The economy needs fiscal support

BEIJING – China’s slowing economy will need more than an interest rate cut to boost growth, analysts say.

The People’s Bank of China on Tuesday surprised markets by announcing plans to cut several rates, including on existing mortgages. Mainland Chinese stocks jumped on the news.

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

“The most likely path to reflation, in our view, is through fiscal spending at home, financed by the PBOC’s balance sheet,” he said, stressing that more fiscal support is needed, in addition to more efforts to improve the housing market.

The bond market reflects more caution than stocks. China’s 10-year government yield fell to a record low of 2% after the rate cut news, before rising to 2.07%. That is still well below 10-year US Treasury yields from 3.74%. Bond yields move inversely to prices.

“We need major fiscal policy support to see higher CNY government bond yields,” said Edmund Goh, head of China fixed income at abrdn. They expect Beijing to increase fiscal stimulus because of weak growth, although they are reluctant to do so.

“The gap between US and Chinese short end rates is wide enough to guarantee that there is almost no chance that US rates will drop below those of China in the next 12 months,” he said. “China is also reducing tariffs.”

The difference between US and Chinese government bond yields illustrates how market expectations for growth in the world’s two largest economies have diverged. For years, China’s yields have traded higher than those of the US, giving investors an incentive to park capital in the fast-growing economy rather than the US’s slower growth.

That changed in April 2022. Aggressive Fed rate hikes pushed US yields above their Chinese counterparts 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 moved into an easing cycle last week.

“The market is forming medium-term to long-term expectations about the US growth rate, the inflation rate. (The Fed’s) cut of 50 basis points does not change this outlook much,” said Yifei Ding, senior fixed income portfolio manager at Invesco.

As for Chinese government bonds, Ding said the firm has a “neutral” view and expects China’s yields to remain low.

China’s economy grew by 5% in the first half of the year, but there are concerns that a year’s growth could miss the country’s target of around 5% without additional stimulus. Industrial activity has slowed, while retail sales have barely risen by more than 2% year-on-year in recent months.

China’s Ministry of Finance remains conservative. Although the fiscal deficit rose to 3.8% in October 2023 by issuing special bonds, the authorities in March of this year returned to the 3% deficit target.

There is still a 1 trillion yuan shortfall in spending if Beijing is to meet its fiscal targets for the year, according to an analysis released Tuesday by CF40, a major Chinese think tank focused on macroeconomic finance and policy. That is based on government revenue trends and assumes planned spending going forward.

“If the general budget revenue growth does not recover significantly in the second half of the year, it is necessary to increase the deficit and issue additional treasury bonds in a timely manner to fill the revenue gap,” CF40 research report said.

Asked Tuesday about the declining trend in Chinese government bond yields, PBOC Governor Pan Gongsheng partly attributed the slower increase in government bond issuance. He said the central bank is cooperating with the Ministry of Finance on the pace of bond issuance.

The PBOC earlier this year repeatedly warned the market about the risk of piling into one-sided bets that bond prices will only rise, while yields fall.

Analysts generally do not expect the yield on China’s 10-year government bonds to fall significantly in the near future.

After the PBOC rate cut announced, “market sentiment has changed significantly, and confidence in the acceleration of economic growth has improved,” said Haizhong Chang, executive director of Fitch (China) Bohua Credit Ratings, in an email. “Based on the above changes, we expect that in the short term, China’s 10-year treasury bond will exceed 2%, and will not default easily.”

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

This is because the high leverage of Chinese companies and households makes them reluctant to borrow more, Chang said. “This also leads to a reduction in the marginal effects of loose monetary policy.”

The US Federal Reserve’s rate cut last week theoretically eased pressure on Chinese policymakers. Easier US policy weakened the dollar against the Chinese yuan, bolstering exports, a rare growth point in China.

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 to China’s FX market and capital flows, thus reducing the external constraints imposed by high US rates on the PBOC’s monetary policy in recent years,” said Louis Kuijs, Chief APAC Economist at S&P Global Ratings. stated. in the email there.

For China’s economic growth, it is still looking for more fiscal stimulus: “Fiscal spending lags the 2024 budget allocation, bond issuance has been slow, and there are no signs of substantial fiscal stimulus plans.”