China just made a historic rate cut - but markets aren't buying

For more than a year now, financial markets have been crying out to the Chinese government to initiate a humongous stimulus package after its COVID-reopening strategy to boost consumption fell through. But the People's Bank of China (PBOC) and the Xi administration have repeatedly emphasised the need to run a targeted, smaller stimulus program rather than the broad-brushed approach that was used in the West.

Well, it seems like that tune has changed - even if only marginally. 

The PBOC initiated a 25 basis point cut to the country's five-year loan prime rate yesterday. Economists had expected anywhere between a 5 and 15 basis point cut. 

This might seem like a small shift to Western investors but it's the first cut since August 2023. It is also also the largest cut since the rate was made the benchmark in 2019.

So if the cut is broad-based, larger than it's ever been, and a response that has been a long time coming, why isn't the market reaction bigger? This wire will attempt to answer that question.

When in doubt, look at iron ore

As of writing, the largest reaction in the asset markets has been in iron ore prices. Dalian iron ore futures declined by almost 4% on the news (although the decline in prices may have as much to do with post-Chinese New Year inventories as it is to do with the macro). 

Equity investors did not initially react to the news with a lot of buying while the offshore Yuan rose only slightly against the Australian Dollar. 

What is the Loan Prime Rate?

Good question! Put simply, the Loan Prime Rate (LPR) is the PBOC's equivalent of the RBA cash rate, or the Federal Reserve's Fed Funds Rate. That is, it's the benchmark for China's lending rates.

The 25 basis point cut is good news for a property market that has been left in tatters as sales, prices, and the number of solvent construction firms plummeted. 

"Cutting the 5-year LPR ahead of the peak season is a symbolic move to support the property sector but [it is] likely still not enough to stem property price declines," Lisheng Wang, China economist at Goldman Sachs wrote.

It's important to note that the cut was made to the five-year rate and not the one-year rate. Yes, that's right, China has two benchmark lending rates and both are key to the sentiment and performance of Chinese assets.

So, why was the rate cut?

As Citi's Xiangrong Yu explains, it could be for any number of reasons:

"Strong market expectations, a persistent property downturn, elevated real rates amid deflation, as well as concerns on NIMs could have driven the asymmetric cut today," Yu wrote. 

The largest of these reasons, at least to most market participants, is the property crisis. A few weeks ago, the IMF's economists predicted that new housing demand may fall by as much as 50% over the next decade. This was "largely due to decline in new urban households and a large inventory of unfinished and vacant properties" (as Goldman Sachs described it).

"The size of today’s move also reveals — in our view — a genuine concern among Beijing policymakers that the ‘incremental’ slow-drip of policy easing implemented thus far has had little impact," Louise Loo, lead China economist at Oxford Economics wrote. 

Two reasons why markets barely reacted

A read of the available research suggests there are two key reasons why markets have not reacted in an overwhelmingly positive way:

1. Mortgages are only repriced in China once a year anyway: "Outstanding mortgage rates are repriced once a year, and whether the large cut today could help restore new-homebuyers’ confidence remains to be seen," wrote Yu.
2. The major Chinese banks also have discretion in whether to pass on the rate to existing customers: "Today’s 5 year LPR cut will affect new rates immediately when issuing loans; on existing mortgages will depend on resetting cycle (majority likely only in Jan). Banks also have some discretion to reprice outstanding mortgages, but likely only coming from PBOC’s instruction to do so," Wang wrote.

The last reason is by far the most important. It is fiscal policy that has the best chance of increasing buyer confidence - and therefore, demand – despite the best efforts of monetary policy. 

The next hint of when any policy pivots are coming is 27-28  February, when the next meeting of the National People's Congress takes place in Beijing.