How China is shaking up its interest-rate regime

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Policymakers in China have set themselves a tricky task. While the economy is slowing and debt defaults are mounting, the People’s Bank of China is attempting the biggest reform of interest rates in years.The central bank of the world’s second-biggest economy recently announced a new regime that will change the benchmarks for almost all floating-rate loans. It will be a key step in policymakers’ push to liberalise a loan market that grew to about Rmb150tn ($21.6tn) in 2019, according to an estimate from Société Générale.“The ultimate objective is that the banks can start to properly price loans for themselves instead of relying on the government’s signals,” said Michelle Lam, SocGen’s Greater China economist. “Policymakers want to give up a little bit of control.”Here, we explain what will happen, and what the central bank is hoping to achieve.So what’s the key part of the shake-up?The PBoC wants to promote the Loan Prime Rate, or LPR. Helen Qiao, chief greater China economist for Bank of America, said policymakers are trying to make it “the foremost . . . interest rate that matters to China”.The rate was created in a push for rates reform seven years ago, but officials gave it an overhaul last August, turning it into a hybrid rate that is shaped by commercial banks as well as the central bank.The rate is determined in part by another policy lever — the medium-term lending facility rate, or MLF rate, which serves as a floor for the new benchmark. Introduced in 2014, the MLF is one of the tools used by the PBoC to inject liquidity into the interbank market. The PBoC sets the MLF rate, and can tweak it at any time.To determine the LPR, a spread is added on top of the corresponding MLF rate based on the average lending rate provided by 18 commercial banks to their most creditworthy customers. Hence the word “prime.”Is the LPR really that important?It will be soon. The PBoC has ordered that between March and August this year, banks must rework all floating-rate loan contracts to refer to the one- and five-year LPRs instead of the previous benchmark loan rates.But the central bank is taking a different approach with the country’s Rmb30tn mortgage market, in which rates are based on the old five-year benchmark plus a spread. Rates for these contracts will be changed to refer to the five-year LPR from last December, plus whatever spread is needed for the top-line rate to remain unchanged in 2020. So by the start of 2021, all of China’s floating-rate loans will have been altered to rely on the new benchmarks.So the old benchmark loan rates are no more?Yes, China’s one and five-year benchmark loan rates will soon become obsolete. They have acted as a floor for interest rates since 2004, with the one-year rate used mainly by corporate borrowers while the five-year rate has served as the baseline for most mortgages. The PBoC has almost always moved the rates in lockstep, and slashed both in response to the global financial crisis and an regional economic downturn that started in 2015.For the current slowdown, which began in 2018, Beijing left the rates where they were and instead relied on other macroprudential measures.Officials had grown concerned over the side effects of unleashing cuts to the old benchmarks, which sent property prices through the roof during the last two rounds of easing, said Andrew Tilton, chief Asia Pacific economist at Goldman Sachs.How much influence is the PBoC really giving up?Perhaps less than might seem. Rosealea Yao, an analyst at Gavekal Dragonomics, noted that the central bank can still provide guidance to the lenders, many of them state-owned, that determine the LPR’s spread over the MLF.Ms Yao added that the mechanics of the five-year LPR have not been fully explained, potentially leaving the PBoC with substantial influence over whether a cut to the MLF feeds through to the new benchmark rate for mortgages.“They can interfere as always,” she said, “but are actually starting to have some sort of transparency [in] setting these numbers.”So all of China’s key lending rates will operate differently?Not quite. Some will be untouched by the reforms, chief among them the seven-day reverse repo rate used by the PBoC to manage short-term liquidity. Lowering this rate, which sets the cost of seven-day lending from the central bank, pulls down the cost of short-term loans and boosts interbank liquidity when funding conditions get tight. Then there are the reserve requirement ratios for banks. Reducing these ratios, which are higher for bigger institutions, frees up liquidity locked away in China’s banking system, which can help bring down interest rates.Ms Lam at SocGen added that the PBoC has also shown no inclination to liberalise China’s one and five-year benchmark deposit rates. “There is a worry that intense competition for deposits between banks may drive up deposit rates,” Ms Lam of SocGen said. With the economy weakening and liquidity already squeezed by a deleveraging campaign, she said, policymakers are in no mood to further raise the cost of funding for banks.

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