Most central banks govern the price of money in an economy via the rate which banks are charged to borrow cash over short time periods. In China, that approach is divided into two steps. The PBOC sets a rate that prices mortgages, business loans and other commercial lending -- the one-year lending rate. The one-year rate is a relic of the command economy, and isn’t connected very well to conditions in financial markets. The PBOC wants to change that.
The one-year rate is too blunt a tool for a modernizing economy that’s got a problem with excess debt. Cutting that slashes borrowing costs everywhere and risks the re-inflation of property-market and financial bubbles. Raising it risks choking growth and throwing borrowers into distress. The PBOC has therefore recently preferred to try to let the financial sector play a bigger role as the middleman to get money to enterprises in need. It has provided more and cheaper funding to banks to help bring down inter-bank rates, which should then reduce the cost of loans to enterprises and households. The last link on that reaction chain hasn’t happened yet, partly because the two-track system impedes effective transmission. The reform will eventually see the central bank abolish the current one-year benchmark, reducing the number of tools it uses to control the price of money and make interest rates be decided more by markets.
3. How do other central banks do it?
Eventually, the PBOC wants to influence the entire economy and financial markets via the price of its short-term loans in the open market. That will be a similar approach to other major central banks. The Federal Reserve targets the cost of short-term inter-bank loans to control borrowing costs in the broader economy, raising it or lowering it to affect the cost of loans for homes, businesses and financial products. Other central banks such as the Reserve Bank of Australia or the Bank of England have similar policies, but with the advent of quantitative easing and negative rates in Japan, the European Union and elsewhere, the policy-setting tools of global central banks have become more complex.
4. What’s the new system?
The bank will replace the benchmark lending rate with a new reference rate for bank loans, to be announced each month. The new loan prime rate, or LPR, will be calculated based on the interest rate for one-year loans that 18 separate banks offer their best customers. Those banks will submit this rate each month in the form of a spread on top of the interest rate of the PBOC’s medium-term lending operations, linking the LPR and MLF rates together. Banks will then “mainly” use this new LPR as the basis for new loans to households and businesses, and this can “achieve the effect of lowering the real interest rate for loans,” the central bank said. The PBOC will also introduce a LPR for loans longer than five years. PBOC Governor Yi Gang said previously that the benchmark deposit rate - the price banks offer to households or companies for their deposits - will be kept in place for the time being.
5. What are the difficulties?
China’s $44 trillion financial sector is mainly composed of banks, and two-thirds of the country’s aggregate financing are bank loans. Overhauling the system of interest rates can be a potential threat to banks’ profitability and the well-being of the banking sector. The reform increase the chances of a cut in the rate for open-market operations to reduce funding costs for banks, China International Capital Corp.‘s Eva Yi and Hong Liang wrote after the PBOC announced the reform. In addition, financial regulators will have to ensure there are enough derivative products linked to the LPR to help hedge risks. Policy makers will also have to make sure when the borrowing costs are lowered, the funding doesn’t flow into the housing and stock markets to rekindle the bubbles. The reform of the LPR will not be used to price mortgage loans at the moment, according to CICC.
6. How will we know if it’s working?
In an ideal scenario, once the reform starts, bank loans will be priced with reference to the LPR, which is cheaper than the current benchmark. That would naturally guide the lending rate lower, stoke domestic demand, and stabilize economic growth. In real life, the costs of implementing such a profound reform could offset any short-term boost to economic growth. Credit risk concerns around small and private firms will remain, and banks may still see lending to state firms and local governments as better bets. More fundamentally, the challenge comes from changing a mindset inherited from the era of a centrally planned economy, when paternalistic officials make decisions for markets.
7. And the bottom line for banks?
Among the government’s policy goals for 2019 are administrative edicts asking major banks to increase lending to small firms by 30%, and lower the average lending rate by 1 percentage point from 2018. Banks may have to bear some of the cost, and their net interest margin and profitability will likely decline. (Citigroup analysts expect the reform to weigh on Chinese banks’ net interest margin by about 3.1 basis points for 2020, assuming LPR is 25 basis points lower than the benchmark.) On the other hand, banks’ overall profit may stay flat if the reform does stimulate demand as planned.
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