China’s Latest Rate Cut Is Not About the Economy or the Stock Market

August 25, 2015 Updated: August 27, 2015

For its own stock market, the latest intervention by the People’s Bank of China (PBOC) was too little and most importantly too late. Because the bank chose to cut rates after trading stopped in Shanghai on Aug. 25, the Chinese market crashed another 7.6 percent, a tad higher than the regime’s official growth target.

Western markets were happy that somebody did something, and stocks rose across Europe and the United States. However, the PBOC’s latest reduction in interest rates has nothing to do with the economy and also not with the stock market.

If China had wanted to save the stock market, it would have cut rates over the weekend, when everybody was expecting it. As to the real economy, there have been four rate cuts predating this one and none has done much good to generate some real economic activity.  

So why lower the benchmark lending rate and the percentage of assets that banks need to keep at the central bank as reserves (required reserve ratio)?

Again everything has to do with the yuan–dollar interplay since the yuan devaluation of mid-August.

China let the currency slip because some companies needed funding from international dollar markets to pay back trade credit, which the PBOC could not supply at that time. Also, international speculators and domestic savers have been funneling money out of the country like there is no tomorrow.  

All this puts pressure on the currency, which the PBOC has been supporting since last year by selling $317 billion of its $4 trillion foreign exchange stash since last August. However, because of central bank balance sheet dynamics, this decreases the size of the balance sheet and shrinks liquidity for the domestic yuan system.

This is why the bank pushed another $20 billion directly into the system on Monday to make up for the dollars it sold during the past week. Nobody knows how many dollars were sold during August so far as the data is delayed by a month, but the direct liquidity injections put the estimate in the $100 billion ballpark.

The rate cuts are supposed to alleviate tight interbank lending conditions (one week deposit rate for offshore yuan skyrocketed to 22.9 percent Tuesday) but will do nothing to help the real economy or expand assets in the banking system because banks have to lend to pass on the lower rates. With every asset class in a terminal decline, this is unlikely to happen.