China rate cut sparks fears of grim May

China's surprise rate cut unveiled on Thursday boosted hopes that cheaper credit would help combat its faltering economic growth, and it encouraged global share markets in their belief that the major economies were stepping up stimulus.

But the central bank's cut, the first since the global financial crisis in late 2008, also raised concerns the economy may be weaker than previously thought.

Asian shares lost ground on Friday, worried that a deluge of May Chinese data due this weekend could produce ugly numbers.

Reuters polls published earlier in the week suggested the world's second-largest economy probably showed signs of stabilizing last month from a surprisingly weak April.

Now, those expectations are in doubt.

"The rate cut should have been a positive but it comes at suspicious timing," said Norihiro Fujito, senior investment strategist at Mitsubishi UFJ Morgan Stanley in Tokyo. "It makes people think that really bad news is going to be unleashed this weekend."

The People's Bank of China (PBoC) cut the official one-year borrowing rate by 25 basis points to 6.31 percent, and the one-year deposit rate by a similar amount to 3.25 percent.

The cut marked Beijing's biggest move to date to support growth. Premier Wen Jiabao had announced on May 23 a decision to accelerate key investment projects, adding to other efforts to support growth, including three cuts in bank reserves since last November and signs that the government was speeding up fiscal spending.

Even before the rate cut the outlook was looking grim by Chinese standards.

Analysts forecast in a Reuters benchmark poll in May that China would deliver its weakest quarter of growth in three years in the second quarter at 7.9 percent. It would also mark the sixth straight quarter of slowing growth.

They expected 2012 full-year expansion of 8.2 percent, a pace that industrial nations would envy but would be the weakest outcome for China since 1999.

While the cut to borrowing costs should help in the near-term to shore up the economy, the central bank also gave banks more flexibility to set competitive lending and deposit rates in a step along the path of financial liberalization.

Credit Suisse analysts said the move though would reduce bank margins by up to 8 basis points. An index of Chinese financial shares in Hong Kong .HSHFI fell 1.0 percent, with China Construction Bank (0939.HK) dropping 2.6 percent and Industrial and Commercial Bank of China (1398.HK) sliding 2.9 percent.

EXPECTATIONS

Based on Reuters polls earlier this week, fixed asset investment and industrial production numbers for May - two of China's most crucial indicators of activity and job creation - are forecast to show signs of stabilizing.

Industrial production was thought to have risen by 9.9 percent in May from a year ago, picking up from a 34-month low in April of 9.3 percent.

Annual growth in fixed-asset investment in the first five months of the year is expected to stay at a decade-low pace of 20 percent, little changed from annual growth of 20.2 percent between January and April.

Trade data on Sunday is expected to paint a gloomy picture too. Growth in exports and imports may have picked up compared with April but it is likely to undershoot the 10 percent pace that Beijing is targeting for 2012.

Reflecting concerns the data this weekend could be weaker than expected, Ting Lu, an economist at Bank of America-Merrill Lynch in Hong Kong, said forecasts that China's economy may grow 7.9 percent in the second quarter may be too optimistic.

"It's likely that economists could further revise down their second-quarter gross domestic product forecasts in coming days, and growth worries could weigh on market sentiment," Ting said.

BENIGN INFLATION

The rate cut wrong-footed many economists who thought the PBoC would stand pat this year lest inflation rebounds.

The cut therefore suggests Beijing is more confident it has inflation under control than many had assumed, said Wang Jun, an economist at the government think-tank CCIEE in Beijing.

The Reuters poll earlier this week forecast the consumer price index rose in May by 3.2 percent from a year earlier, down from April's 3.4 percent rise and safely below the official 4 percent target for 2012. Wang expects even lower numbers.

"Consumer inflation is likely to be 3.1 percent this month and could fall below 3 percent in June. The central bank may have anticipated the fall and took the pre-emptive rate cut," he said.

Beijing is highly sensitive to price risks. High inflation has preceded political tension in China in the past - something the government is desperate to avoid as Beijing approaches its once-a-decade leadership change this year that is already marred by a political scandal.

Falling producer prices may also have argued for rate cuts sooner rather than later, said Peng Wensheng and Zhao Yang from CICC. The May producer price index is seen down 1.1 percent from a year earlier, the third straight month of decline.

"The drop in inflation expectations for businesses is sharper than the retreat in consumer inflation," they said. "Firms were facing higher real interest rates, and that had pressured investment and firms' demand for loans."

Jin Zhongia, head of a PBoC research institute, said China was concerned about Europe, China's single biggest foreign customer, especially if it slides into a recession.

"That will affect China's net exports, and China is already experiencing a deceleration in exports," he told a conference in California.

Until Thursday, Beijing had been wary of making any big policy moves to aid growth, given it is still tackling the after-effects of a 4 trillion yuan ($635 billion) stimulus programme unveiled during the 2008 global financial crisis.

The programme triggered a frenzy of real estate speculation, saw local governments amass 10.7 trillion yuan of debt and drove inflation to a three-year peak by July 2011.

"China is recognizing that they have to keep their economy stimulated and growing," said Gordon Charlop, a managing director at Rosenblatt Securities in New York.

"They will be proactive to make sure they don't run into any of the problems we've faced and are facing and Europe is facing."

(Additional reporting by Kevin Yao and Koh Gui Qing in BEIJING; Editing by Neil Fullick and Mark Bendeich)