Explainer: How China's new interest rate reforms will
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[August 19, 2019] By
Winni Zhou and Kevin Yao
SHANGHAI/BEIJING (Reuters) - China's
central bank pushed out long-awaited interest rate reforms on Saturday
by establishing a reference rate for new loans issued by banks to help
steer corporate borrowing costs lower and support a slowing economy.
The following explains how China's new Loan Prime Rate (LPR), a central
part of the reforms, will work.
WHAT IS THE LPR?
The LPR, originally introduced by the People's Bank of China (PBOC) in
October 2013, is an interest rate that commercial banks charge their
best clients and was intended to better reflect market demand for funds
than the benchmark the PBOC sets.
However, the LPR's moves since its launch have generally not reflected
those market dynamics with lenders typically reluctant to cut into their
profit margins with lower rates and was little-watched by the markets.
The one-year rate, for example, is currently just below the benchmark
one-year lending rate of 4.35%.
(Graphic: China policy rates, credit growth link: https://tmsnrt.rs/2NfNtsI).
Under the reforms announced on Saturday, the new LPR will be linked to
rates set during open market operations, namely the PBOC's medium-term
lending facility (MLF), which is determined by broader financial system
demand for central bank liquidity. Setting the LPR slightly higher than
MLF rate will in theory give borrowers access to funds at rates that
better reflect funding conditions in the banking system, providing a
smoother policy transmission mechanism.
HOW DOES THE NEW LPR WORK?
The new LPR will be announced at 9:30 a.m. on the 20th of every month,
starting this month. The rate has up until now been set using quotations
from 10 contributing banks. These banks will be joined by another eight,
which include two foreign institutions.
Banks will submit their LPR quotations, based on what they have bid for
PBOC liquidity in open market operations, to the national interbank
funding center before 9am on the day.
If the reporting day falls on a weekend or a holiday, the rate will be
published on the following working day.
In addition to the existing one-year LPR, the central bank will also use
contributing bank quotations to publish similar reference rates for
benchmarks of five-years and beyond. Banks will retain discretion as to
how they price rates for loans maturities of less than 1-year and within
The LPR will be a reference rate only for new loans issued by banks.
Existing loans will still be based on the PBOC-set benchmark rate.
WHY IS PBOC READY REFORMING ITS BENCHMARK NOW?
China has a long history of using two interest rate tracks to drive its
lending sector - a market-based rate and a benchmark bank rate.
Although China has in recent years given commercial banks more leeway in
setting lending rates, the benchmark lending rate remains a key
reference for them to price loans, hampering the central bank's bid to
lower corporate funding costs. The PBOC has pledged to "merge" the two
tracks and reiterated this commitment several times this year.
[to top of second column]
People walk past the
headquarters of the People's Bank of China (PBOC), the central bank,
in Beijing, China September 28, 2018. REUTERS/Jason Lee
Beijing has vowed to lower average funding costs for small companies by 1
percentage point this year to spur growth in the economy, amid weak demand
domestically and a year-long trade war with the United States.
WHAT ARE THE LIMITATIONS?
The latest move is widely interpreted by the market as an official attempt to
revive growth and effectively cut financing costs in the real economy.
But some analysts argue that the move could shift commercial banks to become
more risk averse in their lending due to growing financial and economic risks.
"We expect the PBOC to have more incentive to lower MLF rates and other
quasi-policy rates, but we believe the PBOC's capability to reduce banks'
lending rates is quite limited due to restraints on credit growth as well as
banks' vulnerability," said Lu Ting, chief China economist at Nomura in Hong
"In our view, the PBOC will likely have to walk a tightrope between lowering
borrowing costs and maintaining financial stability," Lu added.
Luo Yunfeng, an analyst at Merchants Securities in Beijing said the impact on
corporate borrowing costs will be felt over the long-term and could be far more
modest than benchmark rate cuts, which affect both new loans and the outstanding
Investors now await Tuesday's LPR publication with many market participants
expecting the new rate to be cut by 10 to 15 basis points from the current
Ming Ming, head of fixed income research at CITIC Securities in Beijing, expects
the first new rate to be set lower to narrow the yield gap between LPR and
interest rate on the MLF, which is now 3.3% for one-year loans. That gap is
currently 101 bps.
"If the U.S. Federal Reserve continues to cut its interest rates, chances for
lowering MLF to drag down borrowing costs will be relatively high," he said.
Tommy Xie, head of Greater China research at OCBC Bank in Singapore said the
move is a "half step" towards interest rate liberalization, and the link to the
medium-term lending rate may only be temporary.
"In the longer run, China may also need to loosen the setting of deposit rate,"
(Reporting by Winni Zhou in SHANGHAI and Kevin Yao in BEIJING; Editing by Sam
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