China rate cut a gamble that banks will boost economy

China's second surprise rate cut and lending reform in the space of a month shows that Beijing wants borrowing to play a greater role in reviving an economy struggling with its weakest pace of growth since the global financial crisis.

But the approach that policymakers have adopted also highlights the constraints they face in trying to steer credit to the parts of the economy that need it. 

The easiest way to create credit is simply to free the country's four biggest banks to lend up to the 75 percent loan-to-deposit ratio (LDR) regulatory ceiling. They all have lower ratios. 

Since the top four hold more than half of total deposits, a small adjustment could potentially have a big impact. The risk though is that easing the LDR might simply fuel overcapacity in inefficient industries without improving growth prospects.

"Bringing up the loan-to-deposit ratio is probably a better move to spur lending, but it's a long-term systemic risk," said Sheng Nan, an analyst at CCB International, the HK investment banking arm of China Construction Bank.

"They ultimately want banks to be domestic deposit funded, and an easing of LDR may shift funding towards wholesale lending."

Therefore, policymakers have adopted a more complex path of bringing down borrowing costs while trying to persuade banks to more actively manage their loan books.

They are trying to overcome the tendency of state-backed banks to extend extra credit to big, cash-hoarding state-owned enterprises and over-extended property developers.

Instead, they want the funds directed to small, dynamic, job-creating private-sector firms that the government is trying to encourage as it seeks to bolster the domestic private sector.

CUTS

The central bank announced on Thursday it was giving banks more leeway to set lending rates in a move analysts suggested was aimed at stimulating borrowing by creating a more competitive landscape. 

The People's Bank of China (PBoC) cut the benchmark one-year lending rate by 31 basis points to 6 percent and the one-year deposit rate by 25 basis points to 3 percent. 

It lowered the floor banks can apply to lending rates to 70 percent of benchmark rates from 80 percent previously. That means that on the one-year basis, bank lending rates can be as low as 4.2 percent. It had also lowered the floor in June. 

Share prices in China's big four banks all fell on Friday as investors worried the new measures would erode their net interest margins.

China Construction Bank was the weakest of the group, falling 2.7 percent. Agricultural Bank of China fell 2.5 percent, ICBC, the world's largest bank by market value, slipped 0.7 percent and Bank of China fell 1 percent.

The cut in benchmark rates came ahead of a slew of data next week including second-quarter GDP, sparking fears that the world's second-largest economy may be slowing down more sharply than expected.

"The rate cut is necessary but not enough," said Gao Shanwen, chief economist at China Essence Securities in Beijing.

"Looking at some leading indicators, it's hard to say the second-quarter will be the bottom for growth," he said, forecasting that annual GDP growth will remain weak in the second- and third-quarter and improve modestly in the fourth.

A Reuters poll published on Thursday showed economists expect the data next week to show China's economy expanded in the second quarter by 7.6 percent from a year earlier, its weakest performance since the 2008-09 financial crisis and the sixth straight quarter of lower growth.

Gao expects full-year growth to be near 7.5 percent, in line with the government target set by Premier Wen Jiabao in March. At the time, the official target was seen as conservative, to give Beijing more economic room to push structural changes to help sustain long-term growth.

Fast-tracking some projects that help rebalance the economy towards domestic demand is designed to help deliver those changes.

The central bank has cut required bank reserves three times since November, freeing up some 1.2 trillion yuan in cash. Analysts expect it to continue cutting the reserve levels to try to pump money into the banking system, alongside more interest rate cuts.

DIFFICULT JUNCTURE

Complicating policymakers' job in spurring growth is that they are also maintaining curbs on property, a sector that generates about 13 percent of economic activity and directly affects more than 40 industries.

"This is a difficult juncture for policymakers: they want to maintain growth, control the property sector while pushing some structural changes at the same time," said Zhao Xijun, an economist at Renmin University in Beijing.

"The impact (of the rate cuts) on the economy could be diluted by the property curbs. If they ease property curbs, all the previous efforts will be wasted and there could be risks for the economy," he said. 

What worries Chinese policymakers is that growth may not pick up in the third and fourth quarters, threatening the 2012 official growth target, analysts said.

The say jobs could be threatened if growth slips below 7 percent. Vice Premier Wang Qishan underlined official concerns about the global economy, saying China will have difficulty meeting its 10 percent trade growth target this year.

There are already some signs of layoffs in coastal cities, where exporters are struggling to cope with the impact of falling oversees orders and rising wages, according to several local officials and company executives.

China's job market has remained relatively tight partly reflecting the country's demographic shifts, a contrast to 2008/09, when some 20 million migrant workers lost jobs, one of the triggers for Beijng's massive 4 trillion yuan ($629 billion) stimulus package.

"Reports of job losses are appearing and will get worse in the third quarter," Stephen Green, China economist at Standard Chartered Bank in Hong Kong, said in a research note.

Beijing has made clear it will not repeat its massive fiscal stimulus package, which bolstered growth but left an unwelcome legacy of strong inflationary pressures and a potential property bubble.