Why not cut interest rates?

Key Points

There was an expectation of an interest rate cut on June 17th, but the central bank did not choose to cut interest rates. We have three understandings for the central bank's decision not to cut interest rates.

First, existing policies are still being implemented, and the overall economic growth rate has not significantly deviated from the target. In the first quarter of 2024, the GDP growth rate was 5.3%, higher than the annual GDP growth target of 5.0%. Our calculated monthly GDP indices for April and May were 4.7% and 5.0% respectively. Although there are signs of a weakening growth rate compared to the first quarter, it has not significantly deviated from the initial target. Manufacturing investment and infrastructure investment are supported by policies and are maintaining relatively high growth rates. The high growth rate in manufacturing investment is related to the previous large-scale equipment renewal policies, and this year, the growth rate of investment in equipment and tools purchases has been accelerating. Additionally, investment in water conservancy management within the infrastructure sector has been increasing since the beginning of the year. We believe that the issuance of one trillion yuan in national bonds last year has to some extent boosted investment in water-related projects. With the subsequent acceleration of special bond issuances and the implementation of ultra-long-term special national bonds, there is potential for a continuous flow of funds into infrastructure investments.

Second, the real estate sector remains sluggish, but it has become less sensitive to the Loan Prime Rate (LPR). After the release of the "5.17 Real Estate New Policy," the property market has not shown a clear sign of recovery. We believe that the current policy rate cuts may have limited stimulating effects on the real estate sector. Firstly, mortgage rates are no longer determined by the LPR. On May 17, 2024, the People's Bank of China announced the cancellation of the lower limit of the commercial individual housing loan interest rate policy for first and second homes nationwide. Therefore, the chain of "MLF-5-year LPR-mortgage rate" to reduce housing costs is no longer applicable. Secondly, in an environment of low income expectations, the relationship between loan rates and real estate sales has changed, and a mere 5 or 10 basis point reduction in mortgage rates may not be effective in stimulating demand. We believe that the opportunity for significant improvement in the real estate sector may still lie in local government land reserves.

Third, a decrease in interest rates may to some extent be unfavorable for the elimination of enterprises. From 2016 to 2019, influenced by supply-side reforms, the growth rate of the number of industrial enterprises in China significantly declined. However, after 2020, the number of enterprises saw a substantial increase, with the growth rate exceeding 10% in 2022. In theory, during the downturn of an economic cycle, the number of enterprises in an economy should decrease as excess capacity is eliminated, leading to the start of a new cycle. For example, the historical changes in the number of manufacturing enterprises in Germany align with this economic logic. However, looking back at China, due to various reasons, the natural elimination of enterprises in China may be more challenging, requiring administrative measures such as supply-side reforms to achieve the goal of reducing overcapacity. In the long term, this may be related to the mechanism of enterprise exit in China, while in the short term, the decrease in financing costs allows some enterprises to survive.

Looking ahead, we expect a probability of further interest rate cuts in the third quarter. Firstly, the GDP growth rate accelerated in the third quarter of last year, and this year's third quarter will face a higher base. If the economic momentum continues to weaken, there is a risk of the growth rate falling below 5% in the third quarter. Secondly, the United States, Europe, and other economies have successively announced plans to impose tariffs on Chinese goods such as electric vehicles. We predict that if there is an increase in geopolitical disturbances in the future, a reduction in policy rates by the central bank may become more likely Risk Factors: Tightening policies; Overseas economic downturn has a greater-than-expected impact on exports.

Main Text

I. Why no interest rate cut?

There was an expectation in the market for an interest rate cut on June 17th, but the central bank did not choose to cut interest rates. In the financial data released on June 14th, financial institutions added RMB 950 billion in loans, a decrease of RMB 410 billion year-on-year, lower than the consensus expectation of RMB 10.178 trillion; M1 decreased by -4.2% year-on-year, further declining from the previous -1.4%. Economic data released on June 17th showed that industrial value added increased by 5.6% year-on-year, lower than the previous 6.7% and the expected 6.0%; real estate development investment decreased by -10.1%, lower than the previous -9.8%. Despite both financial and economic data showing weakness, the central bank chose to maintain the 7-day OMO rate and 1-year MLF rate at 1.8% and 2.5% respectively, indicating a cautious stance on interest rate cuts.

We have three understandings for the central bank's decision not to cut interest rates.

Firstly, stock policies are still being strengthened, and the overall economic growth rate has not significantly deviated from the target. The GDP growth rate in the first quarter of 2024 was 5.3%, higher than the annual GDP growth target of 5.0%. Our calculated monthly GDP indices for April and May were 4.7% and 5.0% respectively. Although the growth rate weakened compared to the first quarter on a month-on-month basis, it has not significantly deviated from the target set at the beginning of the year.

Looking at specific sectors, manufacturing and infrastructure investments are supported by policies and maintaining a high growth rate. The investment growth rate in the manufacturing sector from January to May was 9.6%, a decrease of 0.1 percentage points from January to April. The high growth rate in manufacturing investment is related to the previous large-scale equipment renewal policies. This year, the growth rate of investment in equipment and tools purchase has been accelerating, with a year-on-year growth of 17.5% from January to May, contributing 52.8% to the overall investment growth. In addition, infrastructure investment has also maintained a relatively fast growth rate. From January to May, infrastructure investment grew by 5.7%, a decrease of 1.1 percentage points from January to April, showing resilience. Within infrastructure investments, the investment growth rate in water conservancy management has been increasing since the beginning of the year, reaching 18.5% from January to May. We believe that the issuance of one trillion yuan of national bonds last year to some extent drove investment in water conservancy-related projects. It is worth noting that the focus of infrastructure investment in recent years has changed, making it difficult to effectively track the progress of physical work volume in infrastructure using high-frequency indicators such as asphalt start rates. With the acceleration of special bond issuances and the landing of ultra-long-term special national bonds, there is hope for a continuous flow of funds into infrastructure investments.

. After the release of the "May 17 Real Estate New Policy," the property market has not shown a clear recovery yet. From January to May, the sales area of commercial housing decreased by 20.3%, expanding by 0.1 percentage points compared to the previous value, significantly higher than the full-year decline of 8.5% last year. In terms of housing prices, in May, among the 70 large and medium-sized cities, prices in various tier cities continued to decline month-on-month. We believe that the current policy rate cuts may have limited stimulating effects on the real estate sector.

Firstly, mortgage rates are no longer determined by the LPR. On May 17, 2024, the People's Bank of China announced the cancellation of the lower limit of the national first and second home commercial individual housing loan interest rate policy. According to 21 Caijing, except for the three cities of Beijing, Shanghai, and Shenzhen, all other cities nationwide have canceled the mortgage lower limit. Therefore, the chain of "MLF - 5-year LPR - mortgage rate" that used to reduce housing costs is no longer applicable. Commercial banks in various cities can adjust mortgage rates according to market conditions.

In an environment of low income expectations, the relationship between loan rates and real estate sales has changed. Before 2022, there was a clear negative correlation between real estate sales and mortgage rates. When the government lowered mortgage rates, property sales usually showed signs of recovery. However, the relationship between the two has changed recently. With low income expectations among residents and weakening expectations of rising house prices, a mere 5 or 10 BP reduction in mortgage rates may not effectively stimulate the market.

We believe that the significant improvement in the real estate sector may still lie in the local government's land acquisition and storage. After the People's Bank of China established a 300 billion yuan guarantee housing refinancing on May 17, on June 12, the People's Bank of China held a meeting to promote the progress of guarantee housing refinancing, proposing to accelerate the destocking of existing commercial housing. On June 7, the State Council meeting stated, "For the digestion and revitalization of existing real estate and land, we must not only liberate our thinking and broaden our horizons but also steadily advance and solidly promote the work." We believe that the subsequent acceleration of local government land acquisition and storage is expected to help improve market expectations The third is that the decline in interest rates may to some extent be unfavorable for the elimination of enterprises. The industrial enterprise financial data released by the National Bureau of Statistics includes a set of data called the number of industrial enterprises above a certain scale. It can be seen that from 2016 to 2019, influenced by the supply-side reform, the growth rate of the number of industrial enterprises in China showed a significant decline. However, after 2020, the number of enterprises surged, with the growth rate exceeding 10% in 2022. In theory, during the downward phase of an economic cycle, the number of enterprises in an economy will decrease, excess capacity will be eliminated, and a new cycle will begin, as seen in the historical changes in the number of manufacturing enterprises in Germany. However, looking back at China, based on our observations, due to various reasons, the Chinese enterprise sector may face difficulties in natural elimination, requiring administrative measures such as supply-side reform to achieve the goal of reducing overcapacity. We believe that in the long run, this may be related to the mechanism of enterprise exit in China, while in the short term, the decrease in financing costs also enables some enterprises to survive.

"Zombie enterprises" clearing slowly or low enterprise profit margins may be one reason. The profit margin from January to April 2024 was 5.0%, which was 0.05 percentage points higher than the same period last year, but still at a relatively low level in nearly 10 years. Considering that the number of industrial enterprises in the first quarter of 2024 continued to grow at a rate of around 6%, we believe that some "zombie enterprises" with outdated technology and low competitiveness are unwilling to exit voluntarily.

Second, there is still a probability of interest rate cuts in the second and third quarters

In the short term, the failure of interest rate cuts may affect market sentiment. In May, economic data such as industrial added value and fixed asset investment were lower than expected. Benefiting from the holiday mismatch, social retail sales exceeded expectations. We believe that the overall economic momentum weakened in May, but the failure of interest rate cuts may have a certain impact on market sentiment in the short term.

Looking ahead, we expect that there is still a probability of interest rate cuts in the second and third quarters. First, supported by the base effect, the GDP growth rate in the second quarter of this year may be higher than the annual target of 5%, but the GDP growth rate accelerated in the third quarter of last year, and this year's third quarter will face a higher base effect. If economic momentum continues to weaken, there is a risk of the growth rate falling below 5% in the third quarter. Second, the United States, Europe, and other economies have successively announced plans to impose tariffs on Chinese electric vehicles and other goods. We expect that if there is an increase in geopolitical disturbances in the future, a central bank rate cut may become more likely

Author of this article: Xie Yunliang S1500521040002, Xiao Zhangyu S1500523030001S15005; Source: XinDa Securities Research and Development Center; Original title "Why not cut interest rates?"