What the PBOC Rate Cut Means for Markets

In the wee hours of the New York morning, the Peoples Bank of China slashed its benchmark lending rate by 40 bps to 5.6%. This is a move of desperation that few market watchers predicted. Usually the PBOC only cuts rates as a last resort to boost growth. This move startled the markets, sending both stock and bond futures higher on the day, a classic sign that central banks are intervening. 

Chinese (PBOC) Foreign Exchange Reserves Historical ChartSince 1980, Chinese forex reserves have increased at a breakneck speed. The 2008 subprime crisis created the first wobble in the PBOC’s accumulation of cash, but reserves resumed their climb. Net changes in reserves started to become more volatile, and for the first time we witnessed periods where reserves plateaued.

Big downward changes in Chinese reserves have been associated with periods of stock market instability: note the drawdowns in late 2008, May 2010, August 2011, the summer of 2012, and finally now in October of this year.

Change in Chinese Forex Reserves vs Change in S&P 500

For decades, the Chinese have used their forex reserves to manage their domestic money supply and control the price of the Yuan. Persistent trade surpluses with the United States meant that surplus dollars accumulated at the PBOC. The central bank would take in dollars from exporters and issue local currency. The surplus cash was then invested in dollar-denominated financial instruments; the domestic Chinese money supply increased heavily as a result.

Changes in PBOC forex reserves are a decent predictor of future market changes.

Changes in PBOC forex reserves vs Changes in the S&P 500; the R^2 of 25% is remarkably large

In July 2014, however, the PBOC signaled an end to heavy-handed intervention in the currency markets. Since then, worries of a Chinese manufacturing slowdown have been confirmed by this weeks poor PMI results. The risk is increasing for a hard-landing for China’s economy and the PBOC is acknowledging that by lowering rates.  The amount of non-performing loans has continued to increase, hitting a total of 1.16% of loans outstanding. This rate cut was an attempt to relieve pressure on the nations distressed borrowers. This being China, one can only assume the real rate of NPL’s to be much higher; many Chinese borrowers seem to be in a general state of distress.

Watch for more volatility as the market waits how long the PBOC’s gambit, which comes hot on the heals of more stimulus from the BOJ and ECB, can put off the inevitable. China has enjoyed a period of unparalleled economic growth for nearly three decades. But during this time dangerous instabilities grew; for years they were hidden by a rising economic tide. Now that the waters are receding from the shores of the global economy, how many companies swimming in Chinese waters will be caught naked?

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