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.

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“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.”