In recent discussions regarding the economic landscape of China, a pressing concern has emerged: the unexpected cut in interest rates by the central bank serves as a reflection of weakening in the real economyObservers posit that an increased emphasis on maintaining growth could lead to a series of risk-prevention policies in the near future, indicating a potential shift in investment focus towards the banking sector amidst this backdrop of economic uncertainty.

Specifically, on August 15, the People's Bank of China (PBOC) initiated operations in the open market that included a significant injection of capital—4010 billion yuan via a one-year medium-term lending facility (MLF) and an additional 2040 billion yuan through a seven-day reverse repurchase agreementThe bid rates for these actions were set at 2.5% and 1.8%, marking notable decreases of 15 basis points and 10 basis points, respectively, compared to previous rates.

This surge in liquidity provision and the drop in interest rates surpassed market expectations, evidencing a proactive stance by the central bank aimed at enhancing counter-cyclical adjustments

Such fortifications are intended to lower the financing costs for the real economy, thereby improving financing demand and ultimately fostering economic growthA reduction of 15 basis points in the one-year MLF is anticipated to influence a concurrent reduction in the Loan Prime Rate (LPR). The relatively lesser drop in the seven-day reverse repo rate may suggest concerns regarding excessive leverage and potential capital inefficiencies, thereby aiming to bolster the transmission efficacy of monetary policies.

The rationale behind these interest rate cuts is predominantly geared towards enhancing market sentiment and expectationsAccording to projections by Zhejiang Merchants Securities, considering the anticipated adjustments in LPR and potential mortgage reductions, banks listed on the stock market might witness a decrease in quarterly net interest margins in the latter part of 2023, as well as in 2024.

Notably, the current return on equity (ROE) for the banking sector has already dipped beneath the requisite levels for internal growth

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Assuming that the long-term growth of bank assets aligns with a nominal GDP growth of about 7% from 2021 to 2035, banks require an ROE of approximately 9.8%. The actual ROE observed in 2022 was already 0.5 percentage points lower than this thresholdShould there be a unilateral decrease in lending rates, banks could face heightened pressure on both profits and capital, adversely impacting their lending capabilitiesHence, a reduction in deposit rates would be urgently needed to offset these margin pressures.

Deposits are typically priced in relation to bond market rates, particularly using the yields on ten-year government bonds and the one-year LPR as benchmarks for banking interest ratesFollowing the anticipated decline in LPR, further adjustments to bank deposit rates are expectedEstimations suggest a potential drop of 10 basis points for two-year time deposits and a reduction of 15 basis points for three-year and five-year time deposits.

These predictions hinge on two primary factors: Firstly, a comparative analysis of time deposit rates against corresponding government bond yields indicates that rates for three-month and six-month deposits are less than those of government bonds

In contrast, one-year through five-year deposits yield premiums over government bond rates, ranging from 8 to 61 basis pointsSecondly, regarding government policy bank bonds, three-month and six-month deposits underperform these rates as well, while two-year, three-year, and five-year deposits exhibit yields higher by 4, 49, and 40 basis points respectively.

With the unexpected interest rate cuts, ongoing measures in real estate stabilization and debt resolution highlight the likelihood of continued policies designed to underpin economic growth and mitigate risksThe LPR might persist in its downward trend, adversely affecting net interest margins; yet simultaneous reductions in the LPR and mortgage adjustments are likely to lead to decreases in deposit costs, potentially alleviating some negative impacts.

Moreover, it is essential to recognize that the core issues facing bank stocks are not intricately tied to interest margins alone; they are profoundly influenced by economic and policy expectations

The current suppression of bank stock prices is largely driven by pessimistic outlooks regarding China's economy and its policy framework, which in turn affect profit margins, asset quality, and growth metrics—essential determinants of the banks' long-term viability.

Looking forward, ongoing policies concerning real estate, debt management, and the capital markets are expected to progressively mitigate adverse assessment on economic expectationsHowever, it is important to note that this recovery trajectory may also uncover risks, leading to a potential cycle of recurrent pessimismNevertheless, there is optimism regarding the performance of bank stocks; the perceived cyclical nature of both policy and economic recovery could motivate a strong rebound as financial frameworks adapt to an evolving economic landscape.

In summary, the recent adjustments in interest rates signify a crucial juncture in the Chinese banking sector and the broader economy