China’s central bank struggles to transition to new rate system
The People’s Bank of China is struggling to move to a new policy benchmark interest rate replacing the old lending cap made obsolete and non-binding since the completion of the interest rate liberalisation in October.
In three essays by various department heads in the past week, China’s central bank has highlighted its focus on building the rate mechanism as a policy priority this year, alongside targets to complete the exchange rate mechanism for yuan that will support its efforts to open up the capital markets.
Ma Jun, chief economist at the People’s Bank of China, said in an essay that banks, financial market players and corporate customers have been unwilling to switch to loan pricing and pricing of financial products with market rates for reference because of volatility fear. Instead, most are sticking to the old benchmark lending rate.
READ MORE: Here’s what interest rate liberalisation means for China
“If this situation [reluctance] does not change, it will be difficult to set up a policy benchmark rate and an effective rate transmission mechanism – the restructuring of the monetary policy framework will be stuck in a bottleneck,” he observes.
China’s monetary policy targets have changed from the M2 broad money supply to M3 total social financing as the central government since October has drawn a line under its past focus on supply.
Under the new framework, the PBOC is focused on influencing markets by price rather than money supply. The new focus makes it essential for the central bank to provide a credible policy benchmark rate for the market to reference, as the US Federal Reserve and the European Central Bank do.
“Monetary policy effectiveness is smoother in these countries in normal economic cycle – our research has found China’s rate transmission mechanism has only half the impact compared to the US’s.”
Chen Xingdong, China chief economist at BNP Paribas said: “China’s banks’ pricing power against corporates are still relatively low. You can’t get a man to run after having him tied up for years. You can treat China as a child that is stumbling and falling as it learns to walk. It may be five or 10 years before this process can be completed.”
If the central bank succeeds in implementing the framework for its policy benchmark through an interest rate corridor, the PBOC will be able to implement monetary policies simply by adjusting the floor and ceiling rates, instead of going through frequent open market operations, which will help lower inefficiencies in implementing monetary policies, added Judy Zhang, director of China financials at BNP Paribas.
That would give financial institutions a better idea about future money supply, making it easier to estimate the funding cost ceiling, Zhang said. She estimates banks will enjoy a profitable spread through the ‘interest rate corridor’ of some 203bps.
Banks will also have the flexibility to lend more into the economy while not needing to maintain bulky reserves.
“Ultimately, the goal is to develop a rate for the market to anchor. All central banks in the world, from the Fed to Taiwan, have their own version. China is not an exception,” said Raymond Yeung senior economist at ANZ.
Among more optimistic analysts, Sophie Jiang, head of Hong Kong and China banks equity research at Nomura, said she expects it will take just three years for market rates to permeate into banking and financial markets.
“Rate liberalisation finished policy-wise in October 2015, though we expect to see the impact playing out gradually in the next three years.”
