China is easing monetary policy. The economy needs fiscal support

BEIJING — China’s slowing economy needs more than interest rate cuts to boost growth, analysts said.

The People’s Bank of China surprised markets on Tuesday by announcing plans to cut a number of rates, including existing mortgages. Shares in mainland China jumped on the news.

The move could mark “the beginning of the end of China’s longest deflationary period since 1999,” Larry Hu, chief China economist at Macquarie, said in a note. The country is facing weak domestic demand.

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

The bond market reflected more caution than stocks. China’s 10-year government yield fell to a record low of 2 percent after news of the rate cut, before climbing to around 2.07 percent. That’s still way below The 10-year US Treasury yield of 3.74%. Bond yields move inversely to price.

“We will need major fiscal policy support to see higher CNY government bond yields,” said Edmund Goh, head of China fixed income at abrdn. He expects Beijing is likely to step up fiscal stimulus because of weak growth, despite reluctance so far.

“The difference between US and Chinese short-term bond rates is wide enough to guarantee that there is almost no chance that US rates will fall below those of the Chinese in the next 12 months,” he said. “China also cuts rates.”

The gap between US and Chinese government bond yields reflects how market expectations for growth in the world’s two largest economies have diverged. For years, Chinese yields have traded well above U.S. yields, giving investors an incentive to park capital in the fast-growing developing economy compared to slower U.S. 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 persisted, with the gap between US and Chinese yields widening even after the Fed switched to an easing cycle last week.

“The market is forming a medium to long-term expectation on the US growth rate, the inflation rate. The (Fed) cut by 50 basis points doesn’t change that outlook much,” said Yifei Ding, senior fixed income portfolio manager at Invesco. .

On Chinese government bonds, Ding said the firm has a “neutral” view and expects Chinese yields to remain relatively low.

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

China’s Ministry of Finance remained conservative. Despite a rare increase in the fiscal deficit to 3.8% in October 2023, with the issuance of special bonds, the authorities returned in March this year to the usual deficit target of 3%.

There is still a 1 trillion yuan shortfall in spending if Beijing is to meet its fiscal target for the year, according to an analysis released Tuesday by CF40, a major Chinese think tank that focuses on finance and macroeconomic policy. This is based on government revenue trends and assuming planned spending goes ahead.

“If general budget revenue growth does not rebound significantly in the second half of the year, deficit increases and additional Treasury bond issuance may be needed in due course to fill the revenue gap,” the CF40 research report said.

Asked on Tuesday about the downward trend in Chinese government bond yields, PBOC Governor Pan Gongsheng attributed it in part to slower growth in government bond issuance. He said the central bank is working with the Finance Ministry on the pace of bond issuance.

Earlier this year, the PBOC repeatedly warned the market about the risks of piling into a one-sided bet that bond prices would only rise while yields fell.

In general, analysts do not expect the yield on 10-year Chinese government bonds to fall significantly in the near future.

After the cuts announced by the PBOC, “market sentiment has changed significantly and confidence in accelerating economic growth has improved,” Haizhong Chang, chief executive of Fitch (China) Bohua Credit Ratings, said in an email. “Based on the changes above, we expect the Chinese 10-year Treasury bond to exceed 2% in the near term and not slightly above.”

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

That’s because the high leverage of Chinese corporations and households makes them unwilling to borrow more, Chang said. “This has also led to a weakening of the marginal effects of loose monetary policy.”

The US Federal Reserve’s interest rate cut last week theoretically eases pressure on China’s policymakers. Easier US policy weakens the dollar against the Chinese yuan, supporting exports, a rare bright spot for growth 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 foreign exchange market and capital flows, thus easing the external constraint that high US rates have imposed on the PBOC’s monetary policy in recent years,” pointed out Louis Kuijs, chief economist APAC at S&P Global Ratings. in an email on Monday.

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