China:“Double cut”once more:PBOC lowers rate and RRR to stabilise growth momentum and avoid deflation

The PBOC has just announced its decision to cut benchmark interest rates (either deposits or loans) by 25basis points and the RRR (required reserve ratio) by 50basis points, effective on 24October. Meanwhile, the PBOC is removing the cap on deposit interest rates. However, the interest rate for mortgage loans is kept unchanged. After this move the benchmark 1-year deposit rate will be 1.5% and the 1-year loan rate 4.35%, while the RRR will be 17.5%.

    Our key takeaways are as follows:

    The “double cut” move is stronger than we expected. The timing of the RRR cut is in line with our expectations (see China: Weaker momentum, continued rebalancing behind Q3GDP growth, 19October 2015), but we did not expect the interest rate cut. The monetary easing is driven by weakening economic activity data in Q3. In particular, IP growth dip to only 5.7% and FAI growth continued its downtrend in September, pointing to strong headwinds in the economy.

    The GDP deflator turned negative again in Q3, suggesting the economy is on the verge of deflation.

    The central bank may feel an increasing need to lower the real interest rate to avoid a possible prolonged deflation.· The PBOC kept interest rates for mortgage loans unchanged, suggesting policymakers do not want to support the economic growth by boosting a property bubble, as home prices have escalated sharply in some first- and second-tier cities.

    The move is unlikely to boost FAI growth or economic growth, but should help to relieve corporate pain in the ongoing economic growth slowdown, considering the high leverage of the corporate sector. Looking ahead, we continue to expect GDP year-on-year growth to decline to 6.4% in Q4and to 5.8% in 2016.

    After this move, we expect no more rate or RRR cuts for the rest of this year. But we maintain our call that there will be four RRR cuts and two benchmark rate cuts next year.

    For RMB, we view the surprise rate and RRR cut as negative as the new FX fixing regime should allow for more alignment of interest rate and FX policy. Given the risk of further rate and RRR cuts ahead and sustained medium-term growth concerns, we continue to forecast RMB depreciation and look for USD/CNY at 6.50by end-2015. Key in the near term is the 6.40level on onshore spot, which is perceived to be an important level for judging whether the authorities’ FX stance has changed. However, whether our forecast of 6.50will be achieved also depends on other factors, such as the timing of China’s SDR announcement and whether there is a shift in FX policy afterwards, but also local and global macroeconomic and policy developments.

    The near-term risks to our view of RMB depreciation include consistent PBOdevelopments. C FX USD selling intervention and growth developments such as a stabilisation in Q4growth. However, we believe this is now consensus and highlights some asymmetric risks if data turn out to be weaker than expected. The same is true for the IMF SDR announcement, where the market is strongly of the view that China will win entry in November.