SHANGHAI (Reuters) - China cut its new one-year benchmark lending rate for the second month in a row on Friday, a step by the central bank to try to wrestle down borrowing costs and support the economy as the Sino-U.S. trade war drags on.

FILE PHOTO: Headquarters of the People's Bank of China (PBOC), the central bank, is pictured in Beijing, China September 28, 2018. REUTERS/Jason Lee/File Photo

But the move was far smaller than easings by the U.S. Federal Reserve and the European Central Bank over the past week, suggesting Chinese policymakers remain reluctant to join a global stimulus wave due to worries about mounting debt.

Still, analysts say Beijing’s restraint is being put to the test, as worsening economic data in August has raised fears that third-quarter growth could slip below 6%, breaching the lower end of the government’s 2019 target.

With higher U.S. tariffs looming, many China watchers believe more forceful measures will be needed soon to avoid a sharper slowdown.

As widely expected, China’s new Loan Prime Rate (LPR) was cut 5 basis points (bps) at Friday’s monthly fixing to 4.2% [CNYLPR1Y=CFXS], the second time it has been trimmed since it was revamped in August, and days after the central bank’s latest reduction in banks’ reserve requirements (RRR) took effect.

But the boost to economic activity is expected to be slight. The rate is for banks’ best customers and total reductions so far, of 11 bps, are less than half of the Fed’s quarter-point rate cut on Thursday, reflecting Chinese policymakers’ concerns that much-cheaper credit could lead to unproductive investment and property bubbles.

Indeed, the five-year benchmark rate [CNYLPR5Y=CFXS], which is likely to be used for mortgages, was left unchanged at 4.85%.

“Since the new rate is relatively untested, the PBOC (People’s Bank of China) appears to be taking a measured approach at first,” Julian Evans-Pritchard, senior China Economist at Capital Economics, said in a note.

“However, with economic activity likely to come under further pressure in the coming quarters and monetary easing so far failing to generate much of a pick-up in credit growth, we think the PBOC will need to start engineering larger declines before long.”

While small, the latest cut signals to markets that policymakers remain open to further easing, even as they try to avoid creating additional financial risks, some analysts said.

With an eye on debt, Beijing has been leaning more heavily on fiscal stimulus to weather the current downturn, announcing trillions of yuan in tax cuts and special local government bonds to finance infrastructure projects.

The Politburo, a top decision-making body of the ruling Communist Party, took the unusual step in July of explicitly ruling out using stimulus for the property market - a key growth driver - to pull the economy out of its funk. Home prices in China have risen for 52 straight months despite a series of curbs on speculation.

(GRAPHIC - China benchmark rate cut, key policy rates - tmsnrt.rs/31Eqwno)

REFORMS TO BRING RATES DOWN OVER TIME

China’s central bank has been struggling to bring down financing costs for years, particularly for small, private companies which generate a large share of country’s economic activity and jobs. But such firms are considered bigger credit risks, and banks have long favoured state-backed enterprises.

In long-awaited interest rate reforms, the PBOC designated the LPR as its benchmark for new loans last month to guide borrowing costs lower, though the previous benchmark lending rate will still apply to older loans for a while longer.

The new reference rate is set by 18 banks, and is loosely pegged to the rate on the central bank’s medium-term lending facility (MLF), now at 3.3%.

Still, economists believe the central bank plays a key role behind the scenes in adjusting the LPR.

“The LPR is based on banks’ quotations. If there is no government intervention, it’s hard to believe banks are willing to lower their quotations, because corporate demand for loans is not weak at all,” said Luo Yunfeng, an analyst at Merchants Securities in Beijing, noting that lower rates also mean smaller profit margins.

A PROTECTION STORY?

Iris Pang, Greater China economist for ING in Hong Kong, said Friday’s rate move “is not a growth-stimulation story, I think it is more a protection story, to not fall into a weaker growth range. Growth has been very weak and this is more for lowering interest costs for production and infrastructure.”

A more effective way to reduce borrowing costs would be for the PBOC to directly cut MLF rates, said Tang Jianwei, analyst at Bank of Communications (BoComm), saying “more loosening is highly necessary because the economy is sluggish.”

The PBOC last cut the MLF rate in early 2016, and its policy benchmark lending rate in 2015.

It has cut banks’ reserve requirements seven times since early 2018, to the lowest levels since 2007, to free up more funds for banks to lend.

Wen Bin, an economist at Minsheng Bank in Beijing, also said China needs to cut interest rates further, and by the same margin as the Fed.

“That will help stabilise market expectations, investment, consumption and will not put pressure on the exchange rate.”

Wang Yifeng, analyst at Everbright Securities, forecast another 5-10 bps fall in the LPR in November, as the long-running trade war takes a deeper toll.

($1 = 7.0863 Chinese yuan renminbi)