Reformist PBOC makes a pragmatic start to interest rate unification

The People's Bank of China, the Chinese central bank, started an interest rate reform on Aug 20, which we regard as a pragmatic start to unifying the "dual tracks" of interest rates - one for rates in the money market and the other for lending rates.

Under the reform, the PBOC has improved the formation mechanism of the loan prime rate (LPR) - the price of loans banks offer their best clients - and use the LPR as the reference rate for business and household loans. The earlier reference rate, the one-year benchmark lending rate, will be replaced in the future.

As the start in interest rate unification, the reform can help ease the financing woes faced by small and medium-sized enterprises, act as a prelude to more interest rate reforms, and give clues to China's macro policy-setting pattern.

Let's take a closer look at these three major implications.

To begin with, the reform will have an actual and timely impact on facilitating financing of SMEs.

Despite the lowering of the average money market rate since the second half of last year, SME loan growth has not picked up substantially. This is mainly because unlike large enterprises, SMEs in many cases do not have access to bond financing, where interest rates correlate with money market rates.

In other words, SMEs have been discriminated against under the rate signal transmission mechanism, where changes in policy rates set by the authority are first transmitted to money market rates, which are in turn transmitted to changes in the bond yield curve and therefore lending rates. This means that the authority's moves to reduce money market rates can hardly loosen credit condition faced by SMEs.

To address this problem, the reform took a double action.

On the one hand, the LPR was delinked from the one-year benchmark lending rate but linked up with the medium-term lending facility or MLF rate, which is flexibly adjusted by the PBOC and represents the cost that commercial banks should pay for borrowing from the PBOC.

LPR shall be the major pricing reference for banks' new loans, resuming the function of LPR as the lever to adjust lending rate.

Via the reformed LPR, policy rate signals can reach lending rates smoothly, preventing SMEs from being discriminated against in the traditional rate signal transmission mechanism.

On the other hand, the reform allowed eight more banks - including city commercial banks, rural commercial banks, foreign banks and private banks - to submit rate quotations monthly for the determination of LPR. Only 10 nationwide banks were qualified as quoting banks before.

The quoting banks are allowed to float the quotation rates up by certain percentage points above the MLF rate. As the newly-added quoting banks focus more on serving SMEs than nationwide banks, SMEs' loan demand can be more effectively reflected in LPR.

Since the middle of the year, the growths in M2 or broad money supply and total social financing have turned volatile again, while industrial enterprises see continuous earnings pressure. This has posed both external and internal financing woes on manufacturing investment.

The reform served as a timely measure to tackle such economic downward pressure, especially considering that traditional monetary policy tools have limited wriggle room as inflation pressure and macro leverage stay high.

Though the reform is an ice-breaking start, there is still a long way to go to finally unify the "dual tracks" of interest rates. Future reforms may follow these two directions.

First, measures to help small and medium-sized financial institutions replenish equity may be on the horizon, leading to continuous decrease in real interest rate.

The implementation of LPR reform may add pressure to small and medium-sized financial institutions in terms of asset and liability management. Multiple measures to supplement equity of these institutions are expected to lend a hand, such as enhancing the efficiency of perpetual bond issuance, and lowering the standards of issuing preference shares and convertible bonds.

With a strengthened capital base, operation of small and medium-sized financial institutions will become more stable. This will help reduce their cost of funding for internal use and lay foundation for future unification of deposit rate tracks, both making more room for further decrease in real interest rate.

Second, the PBOC may take actions to coordinate the adjustment of long-term and short-term interest rates.

The reform made the LPR with maturities longer than five years available. This signals that the central bank may use MLF rate to adjust LPR and lending rates, transmitting rate policy signal from long-term rate to short-term rate.

This will complement the other policy signal transmission mechanism where the PBOC uses reverse repo rate to adjust money market rate, transmitting rate policy signal from short-term rate to long-term rate.

These two pathways, converging at the bond yield curve, require coordinated policy signals from both sides. In the medium run, the PBOC is likely to construct a mechanism to strengthen the coordination of long-term and short-term rate policy signal in terms of direction, strength and sequence.

From a broader perspective, the first step of interest rate track unification highlights policymakers' mindset to resort to reforms when dealing with internal and external pressures, and provides new clues to China's economic policy outlook.

First, rate cuts may take on a new look. As LPR is becoming the new rate reference, the function of benchmark deposit and lending rates will falter. Both rates may not be used as rate cut tools. Instead, sometime toward the end of this year, MLF rate and open market operation rate may be chosen as the lever to cut rate.

Second, the regulatory principle that "houses are for living, not for speculation" will remain the keynote. Though the new form of rate cut may more effectively loosen credit conditions, it cannot eliminate the effect of real estate in crowding out loans to other sectors. Therefore, regulatory tightening on the real estate market will remain on course. Authorities may further narrow the channel of loan resources flowing to property markets so that SMEs can secure funding more easily.

Third, the central bank will be less pressured to loosen the money market after the reform and may focus more on promoting credit segmentation, or to gradually increase credit risk premium and decrease the risk-free rate in the long term.

Cheng Shi is the managing director, head of research and chief economist of ICBC International Holdings Ltd. Qian Zhijun is a senior economist of ICBC International Holdings Ltd.