Editor's Note: Jimmy Zhu is chief strategist at Fullerton Research. The article reflects the author's opinion, and not necessarily the views of CGTN.

The People's Bank of China (PBOC) cut the LPR (Loan Prime Rate) at a moderate pace in the month of February, quashing any earlier speculation that its monetary policy has started to become more aggressive. Before production moves towards the normal capacity, the central bank's policy will stay prudent and mainly focus on targeted measures.

The central bank lowered the one-year LPR by 10 bps (basis points) to 4.05 percent. The five-year rate, one of the key reference rates for mortgage lending, was cut by 5 bps to 4.75 percent. The scale of the 10 bps cut in the one-year tenor wasn't as large as some market participants had anticipated earlier. Shanghai stocks quickly pared the gains during morning trade. The 5 bps cut in five-year tenor signals that the central bank's policy on the housing market remains the same, after some earlier growing speculation officials may ease the property market to support growth activities.

The main purpose of the cut is to restore market confidence when COVID-19's impact on the economy remains unknown at this stage. Lowering the borrowing cost will definitely ease the financial burden for private companies, but the rate cuts themselves aren't going to solve the main issue for now: Liquidity. Many private companies from factories to retailers do not have enough cash flow due to being short of income, so demands on short-term loans have largely increased. In order to prevent the interbank funding cost surging due to increasing borrowing activities, the current priority on monetary measures is to inject liquidity more than reducing policy rates.

At this stage, the PBOC is not likely to introduce large-scale policy change when production and consumption levels remain well below the full capacity, so the rate cuts have a limited effect on boosting activity. According to the data from the Ministry of Transport, the average travelling volumes are only around 15 percent of this period last year, and for migrant workers – around 65 percent of them haven't returned to the cities they are working in. For consumption, many people are still not able to purchase all kinds of products even if they want to. As of February 19, data shows that 37.2 percent of the street shops have opened. However, both online and offline retailers are encountering logistical issues when they receive products from wholesalers; delivery to customers is impacted due to many cities's closed transportation in order to contain virus' spread.

In our base-case scenario, production will gradually return to normal levels by end of the first quarter as long as there are no further outbreaks of COVID-19. Having said that, the main monetary policy objective is to ensure ample liquidity in the financial system. As of today, liquidity remains ample in the banking system. China's 7-day repo rate, one of the key interbank funding rates, is trading at 2.3 percent, well below the 2.6 percent at the beginning of February. Thus, we only expected some targeted measures in coming weeks, such as injecting some short-term tenor lending facilities.

Looking forward

It's still to early to gauge the COVID-19 impact on both of the domestic and global economy. The Baltic Dry Index (BDI), one of the best indicators to gauge the global shipping activities seems to be bottoming out for now, and similar pattern is seen in the Bloomberg commodity index. As China is the world's largest commodities buyer, stabilizing signs in these two indices suggest that the country's production levels are starting to pick up.

The following two economic data points, which could be seen to reflect COVID-19's impact on the economy, will be closely watched. South Korea's trade data for the first 20 days of this month, to be released on February 21, which will show how the virus has disrupted regional trade and supply chains. Besides this, China's official PMIs for the month of February will be released on February 29. Readings of the Chinese PMIs may have a direct impact on the upcoming the PBOC's monetary policy. Based on our estimates, the current moderate and prudent monetary policies will be maintained as long as the manufacturing PMI this month does not drop below 46.

On the other hand, aggressive monetary policy will have a side-effect on currency. According to a recent statement from the U.S. Federal Reserve, the Fed will only act when the virus has a material impact on the U.S. and global economy. At this moment, the Fed will continue to leave its policy rate unchanged. If the PBOC is to reduce its policy rates on a large scale, this may increase the downward pressure on Chinese yuan. The policy divergence may reduce the gap of the China–U.S. government bonds yield, currently standing around 130 bps. The onshore yuan was trading above the 7.01 level versus the U.S. dollar.

Looking ahead, the virus' impact on the economy looks to stay in the short-term only and be contained in the first quarter of this year. To accelerate the recovery in production and consumption without affecting its financial stability, the PBOC is likely to stick to targeted measures such as liquidity injections in near term.