By Indrani De, CFA, PRM, and Zhaoyi Yang, FRM
While high inflation is seen almost everywhere, the Chinese central bank, PBoC is more anxious about meeting the economic growth target. This unique inflation versus growth trade-off in China, different from most other G7 countries, enables the Chinese central bank to follow pro-growth easier monetary policies.
Year to date, it has been keeping policies supportive by cutting some of its key interest rates, including the medium-term lending facility (MLF) rate and loan prime rates (LPR), most recently in August. One could easily become confused, when reading updates like these about the various interest rate tools utilized by Chinese policy makers vs the better-understood Fed funds rate. Therefore, it would be informative to look at key interest rates in China and their impact, also considering its economic weight in the global economy and growing international participation in its financial markets.
First, interest rates are generally categorized into two types in China, policy interest rates and market interest rates, and the important ones are shown in Table 2. Policy rates, in both short- and medium- terms, are crucial monetary policy tools in the PBoC’s toolkit to convey signals on regulations, and to guide interest rate levels in China’s financial market.
With policy rates set, borrowers like banks, non-financial institutions, or individuals, are able to fund their capital needs at costs that are offered by commercial banks based on policy rates. These costs are often referred to as the market interest rates. Both policy and market rates help to establish the market-based interest rate system, which functions subject to money supply and demand in the market, and to build up the interest rate transmission mechanism via banking system.
Next, let’s zoom in to look at the interest rates that were trimmed by the PBoC in 2022.
Like other central banks, such as the Federal Reserve, the People’s Bank of China hosts open market operations (OMO) – the purchase and sale of securities in the open market - as a key tool to implement its monetary policy, and to control money supply and interest rates in the market, on a short-term basis.
The PBoC buys or sells securities to inject or withdraw liquidity in the market, respectively, through OMOs. Although the exact amount and the actual rate of the operations are both communicated to the public, more attention should be paid to the interest rate, i.e., the price of the money, to forecast the short-term market rates, rather than the size of the operations, according to the Monetary Policy Department of the PBoC.
Conducted in the middle of the month, MLF operations are perceived as one of the most important monetary policy tools by the nation’s central bank. Commercial banks and policy banks (e.g., China Development Banks, the Export-Import Bank of China) may borrow from the central bank at the MLF rate, for their medium-term funding, so that loans would be made to the real economy at borrowing costs guided by the central bank.
Lower MLF and reverse repo rates this year could have partially explained the collapse of the Chinese onshore sovereign bond yields, particularly on the short end of the yield curve, as Chart 1 shows, with the same pattern back in early 2020 when the central bank cut interest rates upon the COVID outbreak. Longer-dated bond yields reflect expectations on future growth.
Since the reform in August 2019, the LPRs have been instrumental in guiding and influencing the lending rates in the market for household and enterprise loans. With Chinese lending growth slowing down significantly since Q4 2020, measured by loans’ year-on-year growth, it is hoped that the lower loan prime rates this year will boost credit loans, and therefore the economic activities. In particular, the 1-year LPR is quoted based on 1Y MLF rate, as shown in Chart 2, acting as an intermediary between the policy rate and the market rates at which institutions and residents could borrow. Similarly, 5-year LPR is referenced as a benchmark by loans with a period of longer than 5 years, e.g., mortgage loans.
While both 1-year and 5+ year LPR serve as a part of the interest rate transmission mechanism, they could move at different paces or to different degrees, depending on economic conditions. Chinese real estate sector, is critical to the Chinese economy development (taking up roughly 7% of China’s GDP growth in recent four years vs 4% twenty years ago), has been struggling with liquidity problems due to falling sales and tighter regulatory requirements. Therefore, a larger interest rate cut was applied on the 5+yr LPR (down by 35bps) than the 1yr LPR (down by 20bps) YTD.
Lastly, the Chinese government bond yield curve remains in a normal shape, with a positive slope, unlike the inverted US curve or the much flatter UK curve, as shown in Chart 3. Perhaps this will tie in the different inflation pictures, different policy responses and future expectations from the different yield curves.
Given that the country’s economy was shaken by Covid lockdowns in the first half of the year, it’s likely that the Chinese policy makers stick to their own monetary policy to meet the growth target, independent from the other major central banks (like those of G7). But much clearer guidelines regarding longer-term COVID measures, anticipated in the upcoming national congress in October, hopefully, could lead a way out of the trough of the growth.
 YI Gang. China’s Interest Rate System and Market-Based Interest Rate Reform. Journal of Financial Research (Issue 9, 2021).
 5+ year LPR is the benchmark interest rate of residential mortgage loans and corporate medium- & long-terms loans.
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