China Rate Cut Hacks a Perilous Path -- Heard on The Street

By Alex Frangos 

        It didn't take much for the People's Bank of China to blink.
        After Chinese stocks cratered Friday--the culmination of a 10-trading-day run that erased nearly a fifth of the stock market's value--China's central bank sprang a surprise quarter-point interest rate cut along with a loosening of bank reserve requirements Saturday.
        Responding so obviously to the stock market sets a dangerous precedent.
        While most assumed the government found great virtue in the bull market to help companies raise capital and deleverage balance sheets, Saturday's move removes whatever pretense some may have had that market forces were the main driver of Chinese stocks.
        The PBOC cited persistently high borrowing costs in the real economy for the cut. That is true. Banks have been reluctant to cut rates and the effect of very low inflation means real, price-adjusted rates have fallen only slightly.
        But if this was the rationale, then the central bank should have moved earlier in the month when May's sluggish inflation data was released, notes Standard Chartered. But back then, the stock market was near its recent high point.
        It is also the case that the economy has finally been showing signs of reacting--albeit tepidly--to previous rates cuts and myriad other measures to boost liquidity in the banking system. A move in recent days to scrap loan-to-deposit ratios as a key regulatory tool was itself an easing signal. Given these encouraging signs, Beijing seemed set to take a wait-and-see attitude before easing further.
        But fear of a pause in stimulus became a factor behind the stock market selloff. Chinese investors know the good times will last only so long as the easing does.
        So will the rate cut restore the faith? Easing moves have worked before--at least over the short term. Those who thought April's reserve ratio cut was too desperate a move to buoy the market missed out on a nearly 1000-point rally in the Shanghai Composite--though most of that rally is now erased.
        The real question becomes, how long is the PBOC willing to keep this up? Given how poorly supported stocks are by the fundamentals, and given how much margin leverage is embedded in investors' positions, withdrawal of state support will give a shock that could prove calamitous.
        It remains prudent for central banks to keep the stock market in mind when making policy moves. But making stocks the implicit target of central bank policy, as China now has, sets the economy on a perilous path.
        Write to Alex Frangos at alex.frangos@wsj.com
        (END) Dow Jones Newswires

        June 28, 2015 21:20 ET (01:20 GMT)

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