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China cuts rates by 0.25% and lowers reserve requirement ratio by 0.50%

China’s central bank, the People’s Bank of China (PBOC), surprised the markets on Tuesday by announcing a reduction in interest rates, cutting its one-year loan rate to 4.60% from 4.85%. The one-year deposit rate has been cut by 0.25% to 1.75%. The PBOC also cut its reserve requirement ratio (RRR) for most large banks by 50 basis points to 18.0%, effective as of September 6.

This is the fourth rate cut so far this year and the third reduction in the RRR to large banks. The move comes after speculation that the PBOC would have acted over the weekend to stem further losses on the stock market after shares plummeted over 12% during the week. But the absence of any measures led to further falls of around 15% on Monday and Tuesday.

The PBOC said that the economy faces downward pressure and the low level of inflation generates the conditions for reducing borrowing costs. It pledged to monitor fluctuations in market liquidity more closely and said that the cut in RRR should provide a boost to long-term liquidity. They also announced the removal of the ceiling on interest rates for deposits with more than one year tenor.

China’s economic growth has fallen to the lowest level since the height of the financial crisis in 2009 and the government’s efforts so far have failed to lift growth. State authorities have spent $200 billion on buying Chinese stocks after a year-long rally that took prices up by 150% ended with the stock market plummeting by 30% in June/July. Government intervention provided a temporary boost but shares have now resumed their downtrend, wiping out all the gains since the start of the year.

Exports have also been hit by muted global demand and a depreciation in other emerging market currencies, making the yuan less competitive. The PBOC rattled financial markets when it unexpectedly devalued the yuan on August 11. The size of the devaluation was small – 1.9%, but it signalled increased concern by Chinese officials that the slowdown could be much more severe than anticipated. This sent global markets into panic with Asian shares and currencies falling sharply.

The latest policy moves should help markets stabilize but a longer-term correction in China’s overvalued stock market may be inevitable. Further monetary easing in the months ahead is possible if economic growth fails to pick up. But authorities are more likely to stick to more conventional tools following the failed attempts to support share prices.

The dollar, which has fallen significantly against a basket of currencies since the yuan’s devaluation on reduced expectations of a US rate increase in September, rose after the announcement. Against the yen, it briefly jumped above the 120 level before slipping back to 119.89. It was firmer against the euro as the single currency fell from 1.1573 to 1.1455. The Australian dollar was less moved by the central bank’s actions and eased back to around 0.72 after briefly climbing to 0.7249.

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