China delivered a surprise interest rate cut on Thursday to combat faltering growth, underlining concern among policymakers worldwide that the euro area’s deepening crisis is threatening the health of the global economy. The country’s first rate cut since the depths of the global financial crisis in 2008/09 came after the Federal Reserve’s second-highest official made a case for more policy easing in the United States, and followed an emergency conference call on Tuesday by the financial leaders of the Group of Seven industrialized nations to discuss Europe’s debt crisis.
It was followed shortly after by comments from Fed Chairman Ben Bernanke that the U.S. central bank was prepared to take action to protect the financial system and U.S. economy. "The Federal Reserve remains prepared to take action as needed to protect the U.S. economy in the event that financial stresses escalate," Bernanke said in prepared testimony to the U.S. Congress.
Marc Ostwald, a rate strategist at Monument Securities in London, said the China rate cut combined with Federal Reserve hints and hopes in markets that Europe will deal urgently with Spain’s banking crisis would support risk assets. "It will be construed positively particularly in close alignment with what we’ve seen," he said.
The People’s Bank of China, the central bank, cut the official one-year borrowing rate by 25 basis points to 6.31 percent and the one-year deposit rate by a similar amount to 3.25 percent. The cuts confounded the call of many economists who thought the central bank would refrain from cutting policy rates this year even though policymakers had voiced the need to support growth.
"It’s obviously a very strong signal that the government wants to boost the economy, given the current weakness, especially in demand," Qinwei Wang, economist at Capital Economics in London, told Reuters. The European Union is China’s single biggest foreign customer, and faltering demand there has led to worries about the knock-on effect to domestic consumption if industrial activity slows dramatically.
A sudden collapse in global trade in late 2008 saw an estimated 20 million Chinese jobs axed in a matter of months, prompting Beijing to roll-out a 4 trillion yuan ($635 billion) fiscal stimulus plan to bolster domestic economic activity.
While the cut to borrowing costs should help in the near term to shore up an economy on course for its weakest full-year expansion since 1999, the central bank also gave banks more room to set competitive lending and deposit rates to further liberalize China’s financial market. The rate cut, announced after financial markets closed in Asia, helped shares elsewhere rally. World shares, measured by the MSCI world equity index rose to its highest level in more than a week. The euro rose. China last changed the borrowing rate in July 2011 when the 1-year benchmark lending rate was raised by 25 bps to 6.56 percent.
GOOD AND BAD
European leaders have been alarmed about the latest turbulence in the euro area debt saga as Spain is fast losing the confidence of financial markets, and a Greek election this month could push Athens closer to leaving the bloc. After the G7 call this week, Japan’s Finance Minister Jun Azumi said the grouping shared the view that it should work to ease financial market worries ahead of a G20 meeting in Mexico later this month, where Europe is likely to top the agenda.
Janet Yellen, the Fed’s vice chair, warned on Wednesday of "significant" risks facing the economy. "Hence, it may well be appropriate to insure against adverse shocks," she said in remarks before the Boston Economic Club.
Several countries, including China and India, have seen economic growth take a hit this year as the euro zone crisis has hurt global confidence. Several euro area countries are struggling with recession. Still, China’s policy announcement on Thursday raised concerns for some that the rate move is pre-empting grim news in a deluge of China data due over the weekend that will include all of the country’s key barometers, such as investment and industrial production.
"The concern is that with industrial production and CPI data coming out of China at the weekend, that it’s indicative of them knowing something about weak data going forward," said Adrian Schmidt, currency strategist at Lloyd’s Bank in London. The market consensus was for May’s data to show signs of the economy stabilizing from a surprisingly weak April, albeit keeping it on course to deliver its weakest quarter of growth in three years in the second quarter. The April data had prompted an immediate cut in bank reserves, and a call from Premier Wen Jiabao that policymakers give "more priority to maintaining growth."
The PBoC has cut bank reserves for the biggest banks by 150 basis points from a record-high of 21.5 percent in three moves since November, after a two-year tightening campaign to rein in inflation and cool steaming economic growth. That has freed an estimated 1.2 trillion yuan ($190 billion) for new lending, as Beijing sought to stimulate economic activity without resorting to a major fiscal spending package like 2008′s initiative.
Beijing is still tackling the after-effects of that program, which triggered a frenzy of real estate speculation, saw local governments amass 10.7 trillion yuan of debt, and drove inflation to a three-year peak by July 2011.
(Additional reporting by Koh Gui Qing and Aileen Wang)