Why China’s central bank is liberalising its interest-rate system
- As part of liberalising its interest-rate system from August, the PBOC replaced the benchmark lending rate with two new reference rates for bank loans
- The PBOC wants to influence the economy and financial markets via the price of its short-term loans in the open market – an approach similar to other central banks
The People’s Bank of China is liberalising its interest-rate system in another milestone in the landmark reforms started four decades ago to boost the role of markets in the economy. The overhaul might also help lower the cost of borrowing for companies and households in the short term, as the economy grapples with its own downward forces and the US-China trade war.
How did it work before?
Most central banks govern the price of money in an economy via the rate that banks are charged to borrow cash over short time periods. In China, that approach had been divided into two steps. First, the PBOC guided prices for funding in the interbank market via its reverse repurchase agreements and medium-term lending facility. Then, it set the benchmark rates that were used to price mortgages, business loans and other commercial lending – the one-year and five-year lending rates. That was a relic of the command economy and the PBOC wanted to change it.
What was the problem?
The one-year rate is too blunt a tool for a modernising economy that’s got a problem with excess debt. Cutting it slashes borrowing costs everywhere and risks fuelling property and financial bubbles. Raising it risks choking growth and throwing borrowers into distress. The PBOC wants the financial sector to play a bigger role as the middleman for channelling money to enterprises in need. To that end, the central bank provided more and cheaper funding to banks to help bring down interbank rates – a move intended to reduce the cost of loans to enterprises and households. That didn’t happen, however, partly because the two-track system blocks the rates banks pay from being freely passed on to the public.
How does the new system work?