China is easing monetary policy. The economy needs fiscal support

BEIJING – China's slowing economy needs more than just interest rate cuts to boost growth, analysts say.

The People's Bank of China surprised markets on Tuesday by announcing a number of interest rate cuts, including on existing mortgages. Mainland China's stock market surged after the news broke.

Larry Hu, chief China economist at Macquarie, said in a note that the move could mark “the beginning of the end of China's longest deflationary trend since 1999.” The country has been struggling with weak domestic demand.

“We believe the most likely path to reflation is fiscal spending on housing financed through the balance sheet of the People's Bank of China,” he said, stressing that in addition to stepping up efforts to boost the housing market, more is needed financial support.

The bond market is more cautious than the stock market. After the news of the interest rate cut came out, China's 10-year government bond yield fell to a record low of 2%, and then climbed to around 2.07%. This is still well below U.S. 10-year Treasury bond yield 3.74%. Bond yields are inversely related to prices.

“We will need significant fiscal policy support to see yuan government bond yields rise,” said Edmund Goh, abrdn's head of China fixed income. He expects Beijing may step up fiscal stimulus due to weak economic growth, although it has so far been reluctant .

“The gap between U.S. and Chinese short-term bond rates is large enough to make it almost impossible for U.S. interest rates to fall below Chinese rates over the next 12 months,” he said. “China is also cutting interest rates.”

The difference between U.S. and Chinese government bond yields reflects the divergence in market expectations for growth in the world's two largest economies. For years, China's yield rates have been much higher than those in the United States, giving investors an incentive to put money into fast-growing developing economies rather than the slower-growing U.S.

This changed in April 2022.

The trend continues, with the gap between U.S. and Chinese yields widening even after the Federal Reserve shifted to an easing cycle last week.

Ding Yifei, senior fixed income portfolio manager at Invesco, said, “The market is forming medium- and long-term expectations for the U.S. growth rate and inflation rate. (The Federal Reserve) cutting interest rates by 50 basis points will not change this outlook much.”

As for Chinese government bonds, Ding said the company holds a “neutral” view and expects Chinese bond yields to remain relatively low.

Chinese economy Growth of 5% in the first half of the yearHowever, some people worry that if additional stimulus measures are not taken, the full-year economic growth may not reach the country's target of about 5%. Industrial activity has slowed in recent months, while retail sales have increased by just over 2% annually.

China's Ministry of Finance remains conservative. Although the fiscal deficit rarely rose to 3.8% in October 2023 with the issuance of special bonds, the authorities restored the usual 3% deficit target in March this year.

According to an analysis report released by CF40, China's main financial and macroeconomic policy think tank, on Tuesday, if Beijing is to meet this year's fiscal target, the spending gap will still reach 1 trillion yuan. This is based on government revenue trends and assumes planned spending continues.

The CF40 research report stated, “If the general budget revenue growth rate does not rebound significantly in the second half of the year, it may be necessary to expand the deficit in a timely manner and issue additional government bonds to fill the revenue gap.”

Asked on Tuesday about the downward trend in Chinese government bond yields, People's Bank of China Governor Pan Gongsheng attributed it in part to slower growth in government bond issuance. He said the central bank was working with the Treasury Department to determine the pace of bond issuance.

Earlier this year, China's central bank repeatedly warned markets of the risks of unilaterally betting that bond prices would only rise while yields fell.

Analysts generally do not expect China's 10-year government bond yields to fall significantly in the near future.

Chang Haizhong, executive director of Fitch (China) Bohua Credit Ratings, said in an email that after the central bank announced the interest rate cut, “market sentiment has changed significantly, and confidence in accelerating economic growth has improved.” “Based on the above changes, we predict that the 10-year Treasury bond will run above 2% in the short term and will not easily fall below.”

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

Zhang said this is because the high leverage of Chinese companies and households makes them reluctant to borrow more money. “This also leads to a weakening of the marginal effect of loose monetary policy.”

The Federal Reserve's interest rate cut last week theoretically eased pressure on Chinese policymakers. U.S. easing policies have weakened the dollar against the yuan and boosted exports, a rare growth bright spot for China.

China's offshore yuan briefly hit its highest level against the dollar in more than a year on Wednesday morning.

Louis Gao, chief economist of S&P Global Ratings' Asia-Pacific region, noted: “Lower U.S. interest rates have eased the pressure on China's foreign exchange market and capital flows, thus easing the external constraints imposed by high U.S. interest rates on China's central bank's monetary policy in recent years.” Monday in an email.

Regarding China's economic growth, he is still seeking more fiscal stimulus: “Fiscal expenditure lags behind the 2024 budget allocation, bond issuance is slow, and there is no sign of a substantive fiscal stimulus plan.”