How to make sense of surprise rate cut by PBOC

If I have to pick the most interesting macroeconomic topic this year, my first choice would be the divergence between the monetary policies of the world's two biggest economies.

The US Federal Reserve has raised interest rates by as much as 225 basis points since March to rein in runaway inflation that's hovering around a 40-year high.

In contrast, the People's Bank of China, the country's central bank, has maintained an accommodative stance, with the country's broad money supply, or M2, up 12 percent year-on-year as at the end of July.

The divergence came into sharper relief last week when the PBOC cut a key policy rate to support economic recovery.

The PBOC conducted 400 billion yuan ($58.89 billion) in medium-term lending facility operations on Aug 15 at an interest rate of 2.75 percent, down from 2.85 percent a month earlier.

Not only has the rate cut surprised most market participants, but marked the PBOC's first-ever policy rate cut amid the Fed's rate hike cycles, according to a report from Sealand Securities.

Theory and practice have shown the Fed's rate hikes can tighten global liquidity and pile the pressures of capital outflow and currency depreciation on emerging markets, keeping them from monetary easing, which could intensify such pressures.

So, how come the PBOC has chosen the seemingly risky rate cut at a time when the Fed is in its most aggressive rate hike cycle in decades?

First of all, stable economic growth acts as the fundamental support for the stability of cross-border capital flows, given that mid- to long-term asset returns still depend on economic development prospects.

This rationale finds evidence in China's A-share market. Data compiled by China International Capital Corp, or CICC, showed northbound trading of the connect programs between the mainland and Hong Kong exchanges saw nearly 80 billion yuan in net capital inflows in June, the highest figure so far this year.

Analysts at CICC attributed the rise in inflows to market confidence in China's economic recovery strengthened by the reduction in the over-five-year loan prime rate in May, a market-driven benchmark on which lenders base their mortgage rates.

Second, as China's steady supply capacity stands out in a shattered global industrial chain and meets the global demand for goods, its strong trade surplus has underpinned the exchange rate of the yuan and helped offset the pressure of capital outflows.

China's trade surplus in goods surged by 36 percent year-on-year to $320.7 billion in the first half, the highest reading on record for the same period, the State Administration of Foreign Exchange said.

Indeed, the onshore exchange rate of the yuan against the dollar weakened to around 6.79 on Tuesday following the rate cut, but it has gained a firmer footing on Wednesday at around 6.77, still performing within a reasonable range.

The above possible justifications for the PBOC's rate cut not only feed one's curiosity, but can provide clues to the central bank's policy-setting in the rest of the year.

The pressure imposed by Fed's tightening may not stop the PBOC's easing moves as long as domestic economic data point to the need for more support while the country's international payments stay generally stable.

This could be particularly true as the Fed may slow down rate hikes with the US inflationary pressure having shown signs of mitigation in July.

As the PBOC said in its second-quarter monetary policy report, it will still take domestic factors as the dominant determinants in policy-setting, while keeping a close eye on the spillover effects of the economic situation and monetary policy adjustments in developed economies.