THE constant cycle of interest rate cuts is posing a huge challenge for banks in their aim to sustain high profit growth.
On October 8, the People's Bank of China cut both lending and deposit rates. The one-year benchmark lending rate dropped to 6.93 percent and the one-year deposit rate is now 3.87 percent.
This is the second time in a month that China's central bank announced interest rate cuts. On September 16, lending rates were cut for the first time in six years.
"The second rate cut in one month resulted in a combined drop of 36 to 64 basis points on interest rate," said Qiu Zhicheng, a Haitong Securities Co analyst. "The big lending cut aimed to reduce corporate cost of enterprises and encourage investments."
This was good news for companies struggling on the brink of collapse due to lack of liquidity and poor demand from the West, which is bracing for a chilly economic winter.
However, the cycle of rate cuts does not bode well for lenders, who are alarmed by the narrowing of their interest spread.
"The latest rate cut makes the slowdown of the banking industry seem more and more probable," said Qiu.
The central bank has left current account deposit rates unchanged this time while all lending rates were marked down. This decision severely squeezed the interest spread of banks.
Traditional income from interest rate spread still forms a major portion of the profit pie of Chinese banks.
For instance, Industrial and Commercial Bank of China, the country's biggest lender, reported an interest income of 131.79 billion yuan (US$20 billion) in the first half, up 29 percent from a year ago. This was the largest income among the country's 14 listed banks on the Chinese mainland.
In its latest policy package, the central bank also said it will ratchet down the reserve requirement - the amount banks must keep on hand - to 16 percent this week for joint stock banks and small players. The requirement will also be scaled down to 17 percent for the country's big five state owned banks - ICBC, Bank of China, Agricultural Bank of China, China Construction Bank and Bank of Communications.
Together with the rate cut, the State Council also scrapped the 5 percent interest gains tax "temporarily."
Analysts said the package is meant to trim borrowing costs for companies against the threat of slowdown. This would also stabilize banks' profits by increasing their liquidity, while not diminishing their interest rate spread. It would also placate millions of savings account holders affected by the reduction in savings interest rate.
"The timing of the policy package is somewhat surprising as the market had expected the central bank to announce some major trading policies after the third plenary session of the Central Committee of the Communist Party of China," said Feng Wei, a Sealand Securities Co analyst. But Feng says, policy makers were driven by the global financial turmoil.
China's rate cut is in sync with moves by other major economies like the United States, United Kingdom and European Union nations.
"We think there is a potential for more economic slowdown and more rate cuts," Feng said. He felt there could be four to five more rate cuts through 2009.
The market too shares this view. Wang Qi, a Morgan Stanley economist, has called for four to five rate cuts through 2009 in China's base interest rates, equal to a cumulative reduction of 1.08-to-1.35 percentage points.
To bankers' relief, the central bank cut both lending and deposit rates this time, leaving them a cushion against the shrinking of interest spread.
However, analysts said, in future, lending rates are more likely to be cut, than savings.
"The tax incentive can't be given yet again and it is unlikely for the central bank to choke the savings rate if inflation continues above 3.8 percent," said Haitong's Qiu.
Banks are also facing greater lending costs.
"The best time to invest in listed banks hasn't come yet," said Feng. He rated the banking industry neutral.