China's interest rate cut hints at sharper downturn

China's surprise cut suggests its economy or its inflation is slowing faster than expected. Rate cut includes a doubling of discount rate, encouraging banks to lend.

By , CNBC.com

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    China's nation flag flies in front of the headquarters of the People's Bank of China, the nation's central bank, in Beijing in this November file photo. China's central bank cut benchmark interest rates by 25 basis points on June 7, 2012, in a surprise move to shore up slackening economic growth.
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China’s surprise 25 basis point cut in benchmark lending rates on Thursday caught economists and the markets by surprise, and could signal the economy is slowing faster than previously thought.

Most analysts had expected China to keep interest rates unchanged and to cut the reserve requirement ratio (RRR) for banks instead, thus allowing them to lend more of their deposits. But the interest rate cut suggests industrial production data for the month of May, due on Saturday local time, will show a further deterioration in growth and an easing of inflation.

“The timing of tonight's rate cut suggests two things. Either inflation has eased to less than 3 percent already, or, growth is slowing sharply faster than policymakers' previous expectations,” Donna Kwok, economist for Greater China told CNBC.

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The country’s official purchasing managers' index last week signaled that growth was already slowing last month, while the HSBC PMI, which tracks small and medium sized firms fell to 48.4 from 49.3 in April. That was the seventh straight month the number had been below the 50-mark that demarcates expansion from contraction.

Kwok says there’s more to the “rate cut than meets the eye.” The discount that banks will be allowed to offer on lending rates, relative to the benchmark, has been more than doubled, she said. China strictly controls the interest rate at which banks can lend money and pay depositors.

“The discount that banks were previously allowed to offer on lending rates relative to the benchmark rate has been doubled, from 10 percent to 20 percent, which means that the lowest official lending rate has effectively been cut by 63 basis points, not just 25 basis points,” Kwok said in an email.

With China’s first-quarter gross domestic product growth falling to a three-year low of 8.1 percent, Brown Brothers Harriman said policymakers could follow up with more action to help the economy out of its rough patch.

“We expect a more aggressive easing cycle ahead as we think the downturn is becoming more severe,” the firm wrote in a note to clients Thursday.

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