The Bank of China Blinks

It’s official – the economic downturn is a global phenomenon – even China has been forced to make interest rate cuts and to provide concessions to banks to help with liquidity issues. Faced with economic growth of only 10.1 percent over the summer months (oh, if only the U.S. had the same problem) and inflation dropping to 4.9 percent, the People’s Bank of China felt compelled to act. While these growth numbers look rather impressive when compared to what is happening in the U.S. and the eurozone, the truth is that things are also slowing in China and with continuing woes in China’s major export markets, there is reason to believe that growth may continue to fall.

Let’s recap what took place yesterday. The Bank of China started the day by quietly announcing on its website its first rate cut in the lending rate in over six years. The rate was dropped from 7.47 percent to 7.2 percent which is still considerably higher than most Western countries with Japan at just half a percent, Canada at 3.0 percent, the Eurozone and England at 4.25 and 5.0 percent respectively, while the U.S. – at least until later this afternoon, at 2.0 percent. Only Australia and New Zealand at 7.5 and 7.0 percent are close to China’s rate. In addition, the Bank also lowered the reserve ratio that smaller banks must maintain – for larger banks, the reserve ratio will remain at the same level of 17.5 percent.

What These Changes Mean

Despite the rather odd amount of 27 basis points, the rate cut only marginally closes the gap between the yuan and the dollar. In addition, only the lending rates were cut while deposit rates were left unchanged. With respect to the reserve ratios, the reduction only applies to a handful of China’s smallest banks so the rising juggernaut that is the Bank of China – together with China’s other major banks – receives no benefit from the reserve changes.

Looking at the announcement in this light, it seems that the policy changes are far from a drastic course alteration, leading one to suggest that it has more to do with China sending a signal to its trading partners. Indeed, for the past two or three years, the Bank of China has been under pressure – from the U.S. particularly – to devalue the yuan to lower the cost of imported goods. This request was met with little enthusiasm of course as a cut in interest rates during a time of double-digit inflation doesn’t exactly fit with what is taught in Economics 101.

However, as the next few months unfold, we’ll see if the Bank of China is now ready to make policy changes in response to a weaker economic outlook or if the Great Bear was simply spooked by the recent chaos on Wall Street. One thing is certain, if the global economy continues to struggle, China has far more arrows in its quiver than the west to help it ride out the storm. At 7.2 percent, China has considerably more room to make interest rate cuts should it become necessary to further devalue the yuan, and with inflation still at nearly 5 percent, growth is still strong even if this is down from previous months.

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