China requires more than just interest rate reductions to stimulate economic expansion.

• Analysts stated that China's sluggish economy requires more than just interest rate reductions to stimulate growth.
• According to Edmund Goh, head of China fixed income at abrdn, a significant fiscal policy support is necessary for higher CNY government bond yields.
• If Beijing wants to achieve its fiscal target for the year, it will have a 1 trillion yuan shortfall in spending, according to an analysis by CF40, a prominent Chinese think tank that specializes in finance and macroeconomic policy.

Beijing - Analysts stated that China's sluggish economy requires more than just interest rate reductions to stimulate growth.

On Tuesday, the People's Bank of China surprised markets by announcing plans to reduce various rates, including those for existing mortgages. As a result, mainland Chinese stocks experienced a rise in value.

Since 1999, China has been experiencing its longest deflationary streak, and Larry Hu, the chief China economist at Macquarie, believes that the move may signal the beginning of the end of this streak. The country has been grappling with weak domestic demand.

In our view, the most probable route to reflation is through government spending on housing, which will be financed by the PBOC's balance sheet. He emphasized the need for additional fiscal support, along with increased efforts to strengthen the housing market.

The Chinese 10-year government yield fell to a record low of 2% after the rate cut news, before climbing to around 2.07%. That's still well below the 3.74% yield of stocks. Bond yields move inversely to price.

Beijing is likely to increase fiscal stimulus due to weak growth, according to Edmund Goh, head of China fixed income at abrdn. He believes major fiscal policy support is necessary to achieve higher CNY government bond yields.

"The difference in short end bond rates between the U.S. and China is significant enough to ensure that the U.S. rates will not fall below those of China in the next 12 months, as stated by him. Additionally, China is also lowering its rates."

The gap between the yields of U.S. and Chinese government bonds indicates how market expectations for economic growth in the two largest economies have diverged. For a long time, the Chinese yield has been higher than that of the U.S., motivating investors to invest in the rapidly expanding developing economy rather than the slower-growing U.S.

In April 2022, the Fed's aggressive rate hikes caused U.S. yields to rise above Chinese yields for the first time in over a decade.

Despite the Fed's shift to an easing cycle last week, the gap between U.S. and Chinese yields has continued to widen.

According to Yifei Ding, senior fixed income portfolio manager at Invesco, the market has a medium to long-term expectation on the U.S. growth rate and inflation rate, and the Fed cutting 50 basis points doesn't significantly alter this outlook.

Ding stated that the firm holds a "neutral" stance on Chinese government bonds and anticipates that yields will remain relatively low.

Despite China's economy growing by 5% in the first half of the year, concerns persist that full-year growth may fall short of the country's 5% target without additional stimulus. Industrial activity has slowed, while retail sales have only grown by 2% year-on-year in recent months.

Fiscal stimulus hopes

Despite a brief increase in the fiscal deficit to 3.8% in Oct. 2023 due to the issuance of special bonds, China's Ministry of Finance has continued to maintain its conservative approach, setting a 3% deficit target for the year.

The Chinese government faces a 1 trillion yuan shortfall in spending to meet its fiscal target for the year, according to a report by CF40, a prominent Chinese think tank that focuses on finance and macroeconomic policy. This is based on revenue trends and assuming that planned spending proceeds as planned.

The CF40 research report stated that if the general budget revenue growth does not increase significantly in the second half of the year, it may be necessary to increase the deficit and issue additional treasury bonds promptly to close the revenue shortfall.

PBOC Gov. Pan Gongsheng attributed the downward trend in Chinese government bond yields partially to a slower increase in bond issuance. He stated that the central bank was collaborating with the Ministry of Finance on the issuance pace.

Earlier this year, the PBOC cautioned the market against making a one-sided bet on rising bond prices and falling yields.

The Chinese 10-year government bond yield is not expected to drop significantly in the near future, according to analysts.

Following the PBOC's rate cuts, market sentiment has shifted, and confidence in the economic growth acceleration has increased, according to Haizhong Chang, executive director of Fitch (China) Bohua Credit Ratings. As a result, we anticipate that in the near future, the 10-year Chinese treasury bond will surpass 2%, and it will be challenging to fall below this level.

To achieve the effect of expanding credit and transmitting money to the real economy, he emphasized that monetary easing must be accompanied by fiscal stimulus.

The reluctance of Chinese corporates and households to borrow more due to high leverage has weakened the marginal effects of loose monetary policy, according to Chang.

Breathing room on rates

The rate cut by the U.S. Federal Reserve last week theoretically relieves pressure on Chinese policymakers. As a result, the dollar weakens against the Chinese yuan, which in turn boosts exports, a positive aspect of China's growth.

On Wednesday morning, the offshore yuan reached its strongest level against the U.S. dollar in over a year.

According to Louis Kuijs, APAC Chief Economist at S&P Global Ratings, lower U.S. interest rates provide relief on China's FX market and capital flows, thus easing the external constraint that the high U.S. rates have imposed on the PBOC's monetary policy in recent years.

Despite the slow pace of fiscal expenditure and bond issuance, there are no indications of significant fiscal stimulus plans for China's economic growth.