By Karen Yeung and Lu Jianxin
SHANGHAI, Nov 26 (Reuters) - China's biggest interest rate cut in a decade is expected to shift its yield curve down as much as 50 basis points and boost the stock market by at least 5 percent, while it could add to long-term downward pressure on the yuan.
The cut was twice as large as many traders had expected and came earlier than anticipated; bill yields had actually risen in the past week on speculation that interest rates might not be lowered again until mid-December.
Traders and analysts said the central bank may have acted because it felt a policy of gradual easing, which began in September, might fail to avert the deflation which economists believe is threatened early next year.
By flooding the money market with funds, the central bank apparently hopes to drive down banks' cost of funding sharply and quickly enough to trigger a surge of commercial lending, which would coincide with fiscal stimulus steps now being launched.
"The size of easing is very unexpected, and it's probably because advisers to the central bank suggested a quick and sharp easing would be more effective in supporting the economy," said Shi Lei, analyst at Bank of China.
As the interbank bond market was closing on Wednesday, the central bank slashed banks' one-year lending and deposit rates by 1.08 percentage point, bringing the one-year deposit rate to 2.52 percent. It also said it would cut banks' reserve ratios by between 1 and 2 percentage points on Dec. 5.
In response, the five-year, offshore non-deliverable yuan interest rate swap, which had been moving sideways in the past week, plunged 39 bps to 1.45 percent bid.
YIELDS
Shi said China's long-term bond yields could tumble about 20 bps on Thursday, while short-term bond and bill yields could plunge by 50 bps to multi-year lows.
Just as importantly, the reserve ratio cuts are expected to inject between 600 and 700 billion yuan ($88 billion to $103 billion) into the money market, equivalent to three or four months of the money flowing in from China's huge trade surplus.
That could drag the weighted average seven-day bond repurchase rate, a key funding rate for banks, down to 2.0 percent or below in the next few weeks. The rate ended Wednesday at 2.5351 percent.
Analysts said further monetary easing might come as soon as late December, depending on economic data. Shi expects the one-year deposit rate to bottom out next year at 1.98 percent, its level when China was last battling deflation in 2002.
HSBC predicted in a report that the central bank would cut interest rates by a further 200 to 250 bps and reserve ratios by 400 bps by June 2009.
"The cuts in all rates suggest that the central bank wants to send a clear signal to the market that it will continue to ease monetary policy to bolster corporate lending," said Lin Chaohui, bond analyst at Guotai Junan Securities.
STOCKS
Analysts said Wednesday's easing would lift the Shanghai Composite Index, which ended the day at 1,897.884 points before the announcement, by at least several percentage points on Thursday.
Interest rate-sensitive property shares in particular will benefit, while bank shares may receive a smaller boost because authorities' determination to stimulate bank lending during the economy's slowdown could expose banks to more bad loans.
The index is likely to test chart resistance on its 60-day moving average, now at 2,010 points, which capped a rally earlier this month. Any break of that could point up as far as 2,300 points, where the market peaked in late September, said Tang Yonggang, analyst at Hongyuan Securities.
"But poor corporate earnings in the fourth quarter, and doubts about the market's ability to absorb fresh supplies of shares, may eventually suffocate this rebound," he said.
In the foreign exchange market, which traded for 45 minutes after the announcement, the yuan barely moved against the dollar on Wednesday.
Traders believe the central bank will intervene indirectly if necessary to keep the currency in the tiny range of roughly 6.82-6.85 that it has maintained for the past several months.
The central bank has said it wants to avoid the large capital outflows suffered by some other Asian countries in recent months, and this is seen as a key motive for keeping the yuan steady.
Nevertheless, analysts said that by reducing the yuan's interest rate premium over foreign currencies, and by suggesting that the Chinese economy needed an aggressive rescue, the easing could add to long-term pressure for yuan depreciation.
Now that China is using both radical interest rate cuts and massive fiscal stimulus to aid its economy, currency depreciation cannot entirely be ruled out, the analysts said.
"No doubt it will be negative for the yuan's exchange rate in the medium and long run," said Liu Dongliang at China Merchants Bank. (With additional reporting by Claire Zhang; editing by David Stamp)