China's purchases of beaten-down bank shares may be one of several baby steps along an easing path that eventually leads to interest rate cuts.
It will probably be a slow process. Before Beijing reaches for a blunt instrument like interest rates, it may first unwind some of the tightening measures put in place over the past few months to try to prevent lending from getting out of hand.
Options might include suspending initial public offerings, as it did in 2008; easing up on so-called punitive bills that banks are sometimes required to buy as a means of restricting the flow of credit; or injecting a bit more money into the economy through regular open market operations.
This is not 2008. China's economic growth looks far more sturdy than it did after the financial crisis struck. But there are a few air pockets, particularly within lending, so a targeted policy response that begins with supporting banks makes sense.
This is the start of something more concerted from Beijing, said Hong Hao, a global equity strategist at China International Capital Corp in Beijing. Somebody had to pull the trigger at some point. But it's very difficult to say when the central bank will loosen monetary policy.
The initial share purchases by a unit of China's sovereign wealth fund on Monday were relatively small, according to two of the banks that received investment.
The message to the market was clear: Beijing is prepared to stand behind the banks in times of trouble. That in turn sends an important signal for the broader economy that China will ensure lending does not dry up.
It also shows that China's government is behind the banks and believes in the banks, said Mike Werner, an analyst with Sanford Bernstein. They wouldn't be doing this if, for instance, they were concerned about these banks having to raise capital in the near future on an industry-wide basis.
The four big banks whose shares were purchased gained $46 billion in market value on Tuesday morning. Bank stocks had taken a pounding this year as investors worried that China's cooling property market would expose over-extended developers as well as local governments who pledged land as collateral for loans, driving up defaults.
China has been down this road before. Just days after the Lehman Brothers bankruptcy in September 2008, the same arm of the wealth fund bought shares in the big four banks, according to media reports at the time.
That proved to be the opening salvo in an aggressive easing campaign that included more than two full percentage points in interest rate cuts and almost $600 billion in stimulus spending.
It looks highly unlikely that China will follow the 2008 script to the letter. The economic conditions are markedly different. But the general pattern of market intervention followed by broader policy moves may hold true.
Unless economic conditions deteriorate, China may opt for smaller, intermediate steps before cutting rates, such as aiming to ease strains in small-business lending.
Beijing has reason to be wary of flooding the economy with easy money like it did during the financial crisis. Some of that money found its way into questionable projects that may lead to a worrisome spike in loan defaults.
TIMING THE BIG MOVE
That post-Lehman easing cycle was swift. The last rate cut came in December 2008, just three months after the panic began. By October 2010, the PBOC was tightening again.
After five interest rate hikes and 12 increases in banks' reserve requirements, there are some signs that credit conditions have become too tight, especially for smaller companies that cannot borrow as readily from state-owned banks.
Last week, Premier Wen Jiabao urged banks to tolerate a higher level of bad debt from small- and mid-sized companies.
He also dropped a strong hint that the tightening cycle could be over, saying the government had tentatively contained rapidly rising prices.
The next batch of inflation data is due on Friday, and is expected to show price pressures eased modestly in September from August, according to a Reuters poll of economists. But the consensus CPI forecast for 6.1 percent would still leave year-over-year inflation far above Beijing's 4 percent target.
Even if price pressures continue to recede, there are some hurdles to cross between the end of the tightening cycle and the beginning of easing.
Arguably the biggest obstacle is the Group of 20 meeting in France next month, when European leaders have promised a plan for addressing their sovereign crisis. Making a big policy move before that meeting would be an enormous risk.
If European officials get it right, that all but eliminates the imminent threat of a global recession, and markets rally. If they get it wrong, it could trigger a global panic.
That would seem to rule out any move before the G20 meeting wraps up on November 4. The next window of opportunity may be December, when China holds an economic policy meeting. Even that may be too soon for anything dramatic if growth remains solid.
I expect to see a formal announcement before year-end of a shift from prudent monetary policy to... something that sounds like neutral, said Tim Condon, an economist with ING in Singapore.
The trigger for a rate cut would probably be a significant downturn in China's economic growth data. Next week's report on gross domestic product probably will not fit the bill. Economists in a Reuters poll predicted 9.2 percent growth -- not exactly a hard landing.
Indeed, HSBC strategist Steve Sun said investors were taking a far too gloomy view of China's growth prospects.
The market is now pricing in a 70 percent probability of economic hard landing in China, he wrote in a note to clients, at odds with HSBC's forecast for growth in the 8 to 9 percent range in the coming quarters.
If growth remains in that region but lending becomes more constricted, trimming banks' reserve requirements may be the logical policy step. If the slowing property market appears to be heading for a more precipitous fall, Beijing could also reverse some of the restrictions it placed on home buying.
(Reporting by Emily Kaiser in Singapore; Additional reporting by Clement Tan, Jian Xin, Jason Subler and Terril Jones in Shanghai, and Vikram Subhedar in Hong Kong.)