This is the next high-wire act China is going to have to pull off

China is about to try and perform a high-stakes balancing act.

The country cut interest rates on Tuesday in a bid to keep money flowing through its economy.

Now that it has done that it has a new gargantuan challenge on it hands — making sure the yuan stays stable.

Here is why.

Cutting interest rates reduces the cost of finance for China’s companies, making debt cheaper at a time when the economy is slowing and debt-laden Chinese companies are seeing manufacturing slump.

Reducing rates also puts pressure on the currency and increases the risk of capital flight, however, as investors take their money out of the country for fear of it being worth less tomorrow than it is today. That forces China to use its foreign-exchange reserves to keep the yuan where it wants it.

“China’s policy environment is increasingly complex, with no clear way to balance competing objectives,” wrote Bloomberg economist Tom Orlik after the rate cut was announced.

“A cut in interest rates will reduce corporates’ debt-servicing costs. But it also puts downward pressure on the yuan and risks capital flight, which would add to stress in the financial system.”

These two moves contradict each other

That means China has a decision to make. It can either let the currency fall further, or it can cut the interest rate again and use up its foreign exchange reserves trying to maintain the yuan at the current exchange rate.

“Our current forecast is that the USD/CNY will get to 6.8 by year-end, assuming that the PBoC would truly let the market decide (more) and thereby the drawdown in official FX reserves can be limited,” wrote Societe Generale analyst Wei Yao.

“In this case, we expect one more 50bp RRR cut. However, if the PBoC chooses to keep the currency around the current level, then it just has to keep RRR cuts coming.”

If it decides it needs to keep the yuan stable — as it has been doing at what Bloomberg estimates could be a cost of about $US40 billion a month — it is going to have to keep RRR cuts coming in order to keep the economy liquid.

That will put pressure on China’s foreign-exchange reserve war chest. China publishes a headline number on its foreign exchange reserves, but doesn’t provide a detailed breakdown. Analysts have estimated that China has about $US900 billion in liquid reserves to do all of this work.

And it’s a lot of work

“The PBoC’s war chest is sizeable no doubt, but not unlimited,” Yao pointed out. “It is not a good idea to keep at this battle of currency stabilisation for too long.”

The question is, then, when will China be ready to let the market decide the fair value of th yuan so it can stop bleeding reserves?

Will it be when export data is more positive? When it has restructured the debt of some of its state owned enterprises? When the stock market stabilizes?

It is unclear. The only objective we can see here is to hold on.

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