The cost of financing in China has consistently seen a downward trend, bolstered by the refinement of interest rate regulation mechanismsAt a recent meeting held by the People's Bank of China (PBOC) regarding monetary policy for the second quarter of 2024, the need to enhance the formation and transmission mechanisms of market-based interest rates was again underscoredThe focus is on expanding the toolbox of monetary policy tools, with an aim to harness the guiding role of the central bank's policy ratesThe reforms seek to leverage improvements in the loan market quotation rates and the market-based adjustment mechanisms for deposit rates, ultimately stabilizing and reducing the borrowing costs for businesses and individuals.

Since the reform of the Loan Prime Rate (LPR) in 2019, the LPR has emerged as the benchmark interest rate for loans provided by commercial banks in ChinaCurrently, a vast majority of loan contracts signed between companies, households, and banks stipulate interest rates that are either added to or subtracted from the LPR of corresponding maturities

Advertisements

As of May this year, new corporate loans and personal housing loans were reported at approximately 3.7% and 3.6%, respectively, marking declines of about 1.6 and 1.9 percentage points compared to rates before the LPR reform.

"The LPR reform has produced favorable outcomes, with loan interest rates declining steadily and the synergy with money market rates strengthening progressively," notes Liang Si, a researcher at the Bank of China Research InstituteChina is gradually shaping a comprehensive interest rate framework that spans from policy rates to market benchmark rates and then to actual market ratesIn this system, the Medium-term Lending Facility (MLF) rate serves as the medium-term policy rate, while the LPR is based on the MLF rate, directing credit interest rates anchored to the LPR, which facilitates the transmission of monetary conditions from the money market to the credit market

Advertisements

The LPR reform is a critical aspect of the broader movement towards interest rate liberalization, with expectations to evolve towards a more market-driven nature that transparently reflects the dynamics of supply and demand in the marketplace.

It is essential to note that the central bank's policy rates not only include medium-term rates but also short-term ratesObservations over recent years indicate that short-term market rates tend to fluctuate around a central policy rate, which suggests a robust guiding effect of these policy ratesPreviously, MLF rates served as the medium-term policy interest yet often diverged from the trajectory of market rates of the same maturity period, leading to confusion in the marketIndustry insiders suggest that experiences from major developed economies demonstrate that central banks achieve better outcomes by managing short-term rates while allowing the market to dictate mid and long-term rates.

From this perspective, gradually diminishing the policy implications of the MLF rate and streamlining the mechanisms that govern the transmission of interest rates from short to long across various monetary policy tools stands as a significant direction for enhancing the interest rate liberalization mechanisms

Advertisements

At the 2024 Lujiazui Forum, PBOC Governor Pan Gongsheng acknowledged that the central bank might consider designating a specific short-term operational rate of the PBOC as the primary policy rateCurrently, the seven-day reverse repurchase rate has assumed this functionOngoing reforms aim to enhance the LPR further, particularly addressing the issue where certain quotation rates significantly diverge from the actual favorable rates for customers, improving the quality of LPR quotations to more accurately reflect the prevailing interest levels in the lending market.

The LPR represents the borrowing rate financial institutions offer to their most favorable clientsTheoretically, such institutions may consider various factors such as funding costs and risk levels in establishing this loan rate and derive the LPR quotation based on a specific formulaWang Qing, the chief macro analyst at Dongfang Jincheng, asserts that the LPR quotation does not necessarily need to be tied to or reference MLF rates

• Bridgewater Offloads Large Stake in Gold ETFs
• The Dilemma of Russia's Interest Rate Decision
• AI Investors Need More Patience
• The Rise of Sustainable Investment in Financial Markets
• US Stock Market Plummets

However, due to various influencing factors, banks' self-determined LPR quotations do not always accurately mirror their actual favorable client loan rates — a scenario also reflective in the pre-reform era of the London Interbank Offered Rate (LIBOR) within developed economies.

Experts emphasize that the reform journey moving forward must aim to cultivate a lending framework that both borrowers and lenders perceive as fairSome studies have suggested embracing international best practices, exploring similar market benchmark rates such as the Secured Overnight Financing Rate (SOFR) to serve as the basis for pricing floating loansConcurrently, it is crucial to utilize the interest rate corridor to manage short-term rates effectivelyOver the past few years, China has progressively established and refined its interest rate corridor, so far forming a system where the Standing Lending Facility (SLF) anchors the upper corridor, and the rate for excess reserve deposits marks the lower corridor

However, compared to major developed economies, it is observed that China’s interest rate corridor remains relatively wide, measuring about 245 basis points.

This relatively broad interest rate corridor arrangement is historically justified, as it allows for the market pricing mechanism to operate more effectively and ensures ample flexibilityNonetheless, there are trade-offs involved; the market's understanding of the central bank's target range for interest rate regulation is not particularly clear, and the underlying assurance might not be robustZhang Xu, chief fixed-income analyst at Everbright Securities, stressed that as the focus on the overall volume of finance diminishes, price-oriented adjustments will assume a more significant role in the execution of monetary policyGiven this context, a timely reduction of the width of the interest rate corridor to deliver clearer signals regarding interest rate regulation objectives to the market is deemed highly necessary.