China’s interest rate caution shines light on $56tn banking system

The vow by China’s leaders last month to address the “new difficulties and challenges” besetting the world’s second-largest economy appeared to open the way for bolder government measures to stimulate activity.

But a subsequent call by the People’s Bank of China for lenders to be allowed to make a “reasonable profit” helps explain why smaller than expected reductions to core interest rates were unveiled on Monday.

Experts said the limited cuts highlighted a dilemma for Beijing: how to balance any desire to stimulate the stuttering economy — by reducing borrowing costs — with the need to preserve the stability of China’s $56tn banking system and support its weakening currency.

As China’s central bank said in a monetary policy report: “It will take some time for banks’ lending risk to be exposed and they should have a certain amount of financial reserves and risk buffers.”

Monday’s modest action on lending rates — which are partly determined by a group of the country’s top commercial banks — came despite a recent wave of gloomy economic data.

The five-year “loan prime rate”, which underpins mortgage rates, was kept unchanged despite unanimous economist forecasts of a cut, while the one-year LPR was cut by 10 basis points rather than an anticipated 15bp.

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Worries about the profitability of China’s mostly state-owned banks have been seen as a central factor in a decision that raised questions about authorities’ willingness to take bold stimulus action. Lower interest rates generally reduce banks’ profits by narrowing the gap between the amount they pay on deposits and what they charge on loans.

“Pressures on banks’ net interest margins” were “one key reason behind the smaller than expected LPR cut”, Goldman Sachs analysts said on Monday, while counterparts at Morgan Stanley pointed to policymakers’ focus on “sharp declines” in those margins.

Yet the overall health of the economy is also a big concern for banks.

“The worst case that could happen to China banks is not [a narrowing in] the interest margin,” said Larry Hu, chief China economist at Macquarie. “The worst-case scenario is China’s economy falling into recession.”

Market participants have become alarmed in recent weeks over signs that a two-year liquidity crisis among China’s property developers is feeding through into the country’s $2.9tn so-called trust industry, which like the banking sector pools savings to provide loans.

Country Garden, China’s largest privately owned homebuilder, missed payments on its international debts this month, while entities linked to sprawling conglomerate Zhongzhi failed to repay savings products.

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The concerns come as China contends with the direct impact of the property slowdown, as well as weakening exports, soaring youth unemployment and a slide into deflation in July. Big investment banks have in recent weeks cut their forecasts for full-year growth below a 5 per cent government target that was already China’s lowest in decades.

Those economic issues are expected to be reflected in the quarterly results of Chinese banks when they report this week and next.

Their net interest margin — a critical indicator of profitability — has already narrowed in the first half of 2023, according to the PBoC, which did not disclose a sector-wide figure. The sector’s profits still grew 2.6 per cent in the first six months of this year, data from the National Administration of Financial Regulation showed, but the pace of growth was the slowest since the start of the coronavirus pandemic and compares with 7.1 per cent in the first half of 2022. Banks reported a total profit of Rmb1.3tn ($179.6bn) in the first half.

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Chinese loan prime rates determine the cost of much bank lending to households and businesses. They are partly decided by 18 of the country’s leading banks, which submit the rates they charge their best customers to the PBoC.

The lower than expected cuts this week do not rule out more stimulus in the coming months. Carlos Casanova, senior Asia economist at Union Bancaire Privée, said the decision to “save some firepower” suggested another LPR cut in the fourth quarter.

Casanova added that Beijing was likely to try other approaches to boost growth. “We expect to see targeted fiscal stimulus and broad-based macroprudential easing,” he said.

“We should expect rates to continue to come down,” said Hong Hao, the chief economist at Grow Investment Group. “Lower outstanding mortgage rates will reduce [households’] burden and increase consumption. But it will also mean commercial banks’ interest margins will compress.”

For policymakers, the challenge could be identifying the point at which lower bank margins become a bigger problem than the economic weaknesses they are intended to address. “[A] further drop in net interest margin and [a] reduced capability to digest risk could be the true challenge in the next few years,” Morgan Stanley analysts said.

For Hu at Macquarie, the PBoC’s ability to inject liquidity into the banking system will mitigate against any broader banking crisis.

“I’m more concerned about the property sector,” he said. “If it remains weak or gets weaker, that’s going to impact the growth outlook this year.”