By MoneyMorning.com.au

The People’s Bank of China (PBOC) finally cut its benchmark interest rate last Friday.

The move may have been a little surprising, but deep down you knew this was bound to happen sometime.

The problem here is structural risk management versus short term risk management.

Just like surfing, when you are paddling out to get over that big wave towering in the distance, there are often smaller waves that you need get through first. The interest rate cut is intended to address the immediate risks that China faces today. In other words, to get it through those smaller waves.

In the meantime the big wave on the horizon, China’s big structural problems, are not going away anytime soon.

Immediate problems

China’s risk profile today is very different from a few years ago.

Over time, China has built up structural-level risks. Credit and fixed investment went wild in the past and led to bubbles and overcapacity. The natural result of that unhealthy build-up was bubble-like inflation in ‘hot’ assets followed by deflation in those that ‘popped’.

These structural risks have not left by any means. In fact, some are now more visible than ever.

Pollution is one of the most visible structural problems. Not only can you can see it, but you can taste it and smell it in every Chinese city. The people recognise this problem and the administration is rushing to find a solution, mainly through renewable energy.

This massive investment in renewables by the world’s second largest economy is opening up some unique investment opportunities. I revealed my favourite way to potentially gain from this trend to readers of New Frontier Investor earlier this month.

Runaway property prices are another key structural risk. Property prices have dropped since last year. However, they are still nowhere near low enough for the average citizen to afford to own their own place.

These are aspects of the big wave forming in the distance that China needs to paddle over, before it breaks on its head.

Today’s immediate problems — those smaller, tricky waves working to slow China’s progress — are deflation, as well as slowdowns in industrial activities, investment and consumption. And I am also talking about employment.

And that’s what the latest rate cut is designed to tackle.

A change in thinking

Does Friday’s rate cut signal a change in thinking at China’s central bank and the central government?

Yes, I believe it does.

There has been a belief, a ‘determined’ belief rather, that China’s structural imbalances require very tough actions.

That is partially right. China’s reform does require strong leadership and a change in the ‘old way’ of doing things.

For example, a focus on the ‘quantity of growth’ resulted in the uncontrolled addition of new capacities. This is the primary reason for China’s current overcapacity. Stimulus programs also became a custom in China’s industries. When things got tough, the government always provided subsidies and access to credits to industries.

However, the unintended consequences are a something the economy needs to wrestle with. I am referring to slowing down too much and the prospect of deflation.

At the end of the day, the question becomes, ‘How much pain can China take before it starts to provide easing?’

The answer is ‘a lot’.

Considering what the US, Japan and Europe have done with their credit policies, China has done extremely well managing a slowdown with very little stimulus. It shows a fundamental difference in economic thinking between China and the West when it comes to macroeconomic policies.

China does not want to just throw money at the problem. In fact, when it did that in the Global Financial Crisis, it only worsened the imbalances.

Now, China is easing because the current ‘pain’ is hurting growth and employment too much.

Will there be additional easing?

Yes, I believe so. China will ease to the point where some floor is present for the real economy. However, it will not loosen to the point where assets inflate to become new bubbles again.

For those who think the government is doing this to help the capital market, they are mistaken. The government is easing to support the real economy.

However, the end result is the same, capital market stands to gain.

Immediate results

As an investor, I can see a few asset classes and sectors that will benefit from this new trend.

With more money in the system, debt-related businesses will benefit, such as banking and financing.

For banks, it may not necessarily be the traditional saving-lending business that will boom. It may be other segments such as fund management and insurance. This is because savers tend to channel capital to higher yielding assets when rates drop. Again, it may very well be properties, which could serve to add fuel to real estate bubbles.

With the possibility of further cuts to rates, bonds will also benefit in value.

In terms of specific types of credit China’s banks have been focusing on SME loans for a while now.

Small to medium sized enterprises (SMEs) will get additional boosts from rate cuts.

Agricultural loans have also been a focus for the banking sector. They will get a boost too.

Property assets will no doubt benefit from a lowering in rates. Prices will stabilise if not rise. This means construction, real estate and property developers will benefit from rate cuts.

Then, there are the secondary industries that are in overcapacity. Lower capital costs will fatten liquidity and improve solvency to a certain extent. However, do not expect the effect to be huge.

Lower capital costs will also boost falling fixed investments and financial investments.

The flow-on effect from the investment side to employment can also improve consumption in time. Confidence levels will turn around before real indicators do.

Lastly, the stock market will benefit if the ‘brutal’ tightening cycle is over. We will likely see the start of a new bull market in China.

All in balance

So, how many basis points are the PBOC willing to cut going forward?

I believe there will be more coming if economic performance continues to deteriorate.

There has been a change in thinking, so I am expecting to see the government actively tackle the immediate slowdown and deflation risks in 2015.

Many Chinese stocks stand to benefit from this new trend. These are exactly the types of opportunities I spend my days researching for New Frontier Investor.

Stay tuned. This could be the start of a new bull market in China.

Ken Wangdong +
Emerging Markets Analyst, New Frontier Investor

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By MoneyMorning.com.au