Introduction

In a surprise announcement on 22 July, the PBoC cut its 7-day Reverse Repo rate by 10bps to 1.70%.  Subsequently, the central bank also cut the LPR by 10bps to 3.35% for 1-year tenor and 3.85% for 5-year tenor.  While the PBoC confirmed the cuts were implemented to “support the real economy”, the likely trigger was last week’s weaker-than-expected GDP data and disappointing Third Plenum communiqué which fell short of announcing any substantive fiscal stimulus measures to address the China’s current economic challenges.

New benchmark rate    

Historically, the PBoC has prioritized longer tenor rates like the 1-year deposit and 1-year Medium Term Lending Facility (MLF) rates as its primary tools for guiding market expectations and monetary policy.  However, in a series of speeches last month, PBoC Governor Pan Gongsheng indicated a shift towards a new monetary policy framework and confirmed the 7-day OMO as the de-facto policy rate.  

This switch has significant implications for investors and markets.  Firstly, it should allow the central bank to pivot its focus to the price rather than the amount of money in the financial system.  Secondly, it will narrow China’s interest rate corridor, which should help reduce market volatility.  Thirdly, it should improve the transparency of monetary policy and remove the need for asymmetric rate movements.  Last but not least, it should allow the PBoC to respond more quickly and flexibly to variable economic conditions.

Increasing monetary policy support

China’s second quarter GDP was weaker than expected, decelerating materially to 4.7%y/y as manufacturing and domestic consumption moderated.  Key economic data for June was sluggish with retail sales growth slowing and fixed asset investments eased on persistent negative property sentiment.  Although industrial production was stronger than expected, this was mainly due to robust exports, which face increasing tariff risks.  

Concurrently, while the Government’s Third Plenum communiqué highlighted growth priorities and key reforms, investors were disappointed at the lack of immediate or substantive fiscal policy actions.  The fragile, uneven and unstable economic growth, combined with a lack of clear fiscal policy support, naturally shifted focus to a more agile monetary policy. 

Conclusion

The PBoC’s latest action sends a clear signal of government support to bolster the economy. While the central bank’s incremental monetary policy stimulus is unlikely to reignite the economy, it should help the government achieve its GDP targets by lowering the cost of funding and encouraging lending.

This move also suggests that the PBoC is less concerned about the impact of lower interest rates on the Renminbi and long-term, market-driven interest rates. Although markets now expect additional OMO, MLF, and Reserve Requirement rate cuts in the coming months, we believe the PBoC will be reluctant to cut rates aggressively ahead of the anticipated US Federal Reserve rate cuts.

For RMB cash investors, there are two significant implications. Firstly, the PBoC’s switch to a shorter tenor interest rate aligns Chinese monetary policy more closely with global central banks' standard practices, simplifying understanding of the PBoC’s policy stance. Secondly, the shift from a dovish policy stance to actual rate cuts implies that market-driven interest rates are likely to trend lower. However, given recent movements, it could be challenging for interest rates to rally significantly further. We believe maintaining diversification across instruments while slightly extending duration should help lock in current interest rates while achieving the best balance of risk and return.