What UBS And Bank Of America Are Saying About China's Ongoing Devaluation

The People's Bank of China on Tuesday announced it has cut the benchmark one-year lending and deposit rate by 25 basis points to 4.60 percent and 1.75 percent, respectively. This marks the fifth rate cut initiated by the PBoC since November 2014.

The Chinese central bank also removed the interest rate ceiling for deposits with maturity above one-year, while the ceiling for deposits of one-year or below remains unchanged at 1.5x benchmark. In addition, it cut the reserve requirement ratio (RRR) by 50 basis points for all banks, and an extra 50 basis points for rural financial institutions and an extra 300 basis points for financial leasing and auto financing companies.

Bank Of America: Four Reasons To Explain The Cut

Xiaojia Zhi, Bank of America's China Economist commented in a note that the PBoC's cut is intended to "stabilize" both growth and the financial markets.

The analyst offered four "major triggers" for the cuts:

1) The foundations for the recovery do not "appear to be firm" and downward growth pressures "are on the rise" based on recent weak data.

2) Inflation is still "very low" and PPI could drop further from minus 5.4 percent year-over-year in July after commodity prices "plummeted."

3) Lending rates are still "undesirably high" in real terms (deflated by CPI) at 4.3 percent which is 0.6 percentage point lower than the average rate in 2014 and similar to levels seen in 2012 and 2013.

4) Policy easing is needed to boost market confidence and ensure financial stability.

Related Link: Citi: More Bad Than Good For China Right Now

Zhi said the Chinese government is expected to introduce further policy easing measures and there is "still room" for one or two interest rate cuts of 25 basis points each through the end of the year along with at least 50-100 basis points of further RRR cuts in 2015 to "offset liquidity drain."

UBS: Move Should Improve Sentiment

Tao Wang, UBS' China Economist commented in a note that the market has been expecting a RRR cut since August 11 as the stock market turmoil, the CNY move and central bank intervention in the foreign exchange market "aggravated" foreign exchange outflow and tightened domestic liquidity.

Wang said PBoC's foreign exchange denominated assets shrank by a record $50 billion in July and may continue seeing heightened outflow. As such, the RRR cut is "necessary" to keep its base money supply stable and ensure a steady growth of money and credit in the near term.

"To the extent that rate cut and RRR cut contribute to the macro stability of China economy, market expectation on CNY will likely improve," Wang wrote. "More importantly, we believe PBC will continue to maintain USDCNY relatively stable in the near term, in order to anchor market expectation (and thus capital flows)."

Wang further noted that an accommodative monetary condition is "warranted to contain financial vulnerabilities" and added that further RRR cuts are likely. However, monetary easing policies have to be combined with fiscal policy to enhance its effectiveness.

Bottom line, Wang stated that the government will "do whatever it takes" to stabilize growth at 6.5-7.0 percent.