BEIJING (Reuters) - China’s central bank is not yet ready to cut benchmark interest rates to spur the slowing economy, despite cooling inflation and a stronger yuan, which have fanned market expectations of such a move, policy sources told Reuters.

But the People’s Bank of China (PBOC) is likely to cut market-based rates and further lower banks’ reserve ratios (RRR) to boost credit growth and reduce firms’ borrowing costs, according to the sources involved in internal policy discussions.

“We cannot rule out a (benchmark) rate cut, but we still need to watch economic data for a few months,” one said. “There is no sufficient reason for cutting benchmark rates if we look at the huge amount of new loans in January.”

China’s trading partners and major central banks are increasingly concerned over how quickly the world’s second-largest economy is decelerating and much it will drag on global growth.

Premier Li Keqiang reiterated on Wednesday that China will not resort to “flood-like” stimulus like that unleashed in past downturns. But after a spate of weak data, investors are asking if Beijing needs to speed up or intensify support to reduce the risk of a sharper slowdown.

Analysts polled by Reuters expect China’s official growth rate to cool to 6.3 percent in 2019, a 29-year low, and some believe real activity levels are already much weaker than government data suggest. [ECILT/CN]

But China watchers note the PBOC has many policy tools to choose from before wielding blunter instruments such as a lending rate cut, which would lower financing costs across the board but risk adding to a mountain of debt.

More RRR cuts have been expected in coming quarters after five in the past year, most recently in January. The PBOC has also been guiding money market rates lower in various ways, and offered a slightly better rate on a new medium-term lending program launched in January.

The PBOC did not immediately respond to Reuters request for comment.

WAITING FOR SIGNS OF A TURNAROUND

In one sign that recent policy loosening measures may be starting to be felt, China’s mostly state-backed banks doled out a record 3.23 trillion yuan ($480.43 billion) in loans in January, following months of urging by the PBOC to keep financing open to cash-strapped companies.

But the PBOC was quick to say after the data that it has not opened the credit floodgates.

Analysts note there is a time lag before a jump in lending will translate into growth, suggesting business conditions may get worse before they get better.

But the government is also planning to step up fiscal stimulus ranging from more infrastructure spending to sweeping tax cuts, building on moves last year.

In the last downturn in 2014-2015, China cut the benchmark six times. But it has kept the benchmark at 4.35 percent since October 2015 while the central bank focuses on building a more market-based regime that will get funding to parts of the economy that need it most.

Only a handful of analysts have predicted a benchmark cut this time around, but speculation has been growing that the PBOC may take other action soon as deflationary pressures build and the yuan strengthens, threatening more pressure on exporters.

Data last week showed January producer price inflation cooled for a seventh straight month.

The yuan has gained about 2.6 percent against the dollar this year, buoyed by hopes for progress in Sino-U.S. trade talks, after falling 5.3 percent in 2018.

LOST IN TRANSMISSION?

While the PBOC has been pushing a lot of funds into the financial system, the money has not been flowing smoothly to companies, particularly private firms which account for over half of China’s economy.

Banks are wary of lending to smaller firms with higher credit risks, preferring state-backed customers, while businesses are reluctant to take on debt when sales and profits are weakening. Bond defaults hit a record last year.

That has prompted the central bank to become more innovative in developing new policy tools to encourage growth.

Most recently, it allowed banks to issue perpetual bonds, in a major step toward recapitalization of the country’s banks that could give them more room to lend.

PBOC officials say policy steps are starting to show some results. The average lending rate for small firms fell to 6.16 percent in January from 6.37 percent a year earlier.

But analysts caution it is too early to tell if many firms are refinancing existing debt or planning new investments. DBS economists said recently that real interest rates (the benchmark rate minus producer inflation) have shot up to 4.3 percent.

Societe Generale expects PBOC to cut the 7-day reverse repo rate by at least 20 basis points by end-2019 and could cut other market-based rates, while lowering RRR by 100 bps each quarter.

Sources believe a benchmark cut may only happen if the economy slows abruptly and broad-based deflation emerges, but they expect stimulus measures will start to put a floor under economic growth around mid-year.

A trade deal between China and the United States would also reduce the chance of a benchmark cut, sources said. Negotiators are racing to meet a March 1 deadline, and failure could lead to a sharp hike in U.S. tariffs on Chinese goods.

A benchmark cut could also been seen as a setback in long-promised reforms to allow market forces to determine the cost of capital in China, which is key to producing more sustainable and higher quality growth and reducing inefficient investment.

“There are many tools in the central bank’s toolkit, and financing costs could fall as liquidity is ample and policy transmission mechanism improves,” said one of the sources.