Even as the market continues to speculate over when the U.S. Federal Reserve will increase its benchmark interest rates, China is continuing on its path of monetary easing. After three rate cuts between November and June, the People's Bank of China (PBoC) announced yet another rate cut over the weekend. Interestingly, the rate cut came after the Shanghai Composite Index plunged more than 7%. Many might see the PBoC's move as a way to provide support to China's equity market, which has been on a roll since late last year. However, more than supporting the equity market, the PBoC has to bring down real rates to support the economy.
Over the past year, the Shanghai Composite has gained more than 105%, leading many to question whether the rally is sustainable especially as China's economic data continues to point to weakness. Indeed, the PBoC, itself has been a little concerned about a potential bubble in equities. As I had noted last month, the PBoC drained some money from the financial system. The dilemma for the central bank though is that it needs to support the economy and therefore more easing measures are needed. At the same time, it does not want the easing measures to create a bubble. Friday's pullback though gave the central bank an opportunity to cut rates without further fueling the rally. Importantly, the rate cut will also help in bringing down real rates, which is crucial to support economic growth.
As I have noted before (here and here), although the PBoC has gone down on the easing path, its measures are not having the expected impact as real interest rates have remained high. Before the weekend's 25 basis point rate cut, China's nominal interest rates were at 5.10%, while inflation rate for the month of May was 1.4%. Real interest rate of around 3.7% was still higher than in May 2014. In May 2014, nominal rates were at 6%, but inflation was hovering around 2.5%. This means that real rates were actually 20 basis points lower in May 2014 than in May 2015. With the rate cut over the weekend, real rates are now 5 basis points below the level in May 2014. In November 2014, when China first announced a rate cut after a period of more than two years, real rates were at 4%.
While nominal rates have declined, the impact on real rates has not been much. In fact, for a brief period, real rates actually rose despite a steep rate cut in November. With the latest rate cut, real rates have edged below the levels seen in last May; however, given the economic weakness in China, further rate cuts will be needed. Indeed, the PBoC had hinted in its Annual Financial Stability Report that it is ready for further easing measures.
The easing measures will continue to fuel the rally in Chinese equities even as the real economy remains weak. These measures though will provide support to China's property sector in the medium term once real rates are down significantly. In fact, in May, house prices in 70 large-and-medium-sized cities rose 0.2% on a month-on-month basis. On an annual basis, prices still fell sharply (5.7% drop); however, the pace of decline has slowed. In April, prices had fallen 6.1% on a year-over-year basis.
Leju Holdings Ltd. (NYSE:LEJU) is an interesting play on a potential recovery in China's property market. Shares of the online-to-offline real estate services provider have fallen more than 27%, year-to-date. In the first quarter of 2015, Leju reported a 19% year-over-year growth in its revenue, which is impressive considering the state of China's housing market. The year-over-year increase in revenue was driven by ecommerce, which accounted for nearly 72% of the total revenue and saw a 35% growth on a year-over-year basis.
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