China has taken a key step towards interest rate and monetary system reform, but caution will rule

The new lending reference rate is an important piece of reform for Chinese banking, as Beijing tries to lower funding costs and help the economy

But it will be keen to avoid the mistakes of other nations on liberalising deposit rates

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Yi Gang, governor of the People’s Bank of China, has signalled that the country is reforming its dual-track interest rate system. Photo: Bloomberg

Published: 4:00pm, 28 Aug 2019Updated: 10:27pm, 28 Aug 2019

The People’s Bank of China (PBOC) is pushing banks to link lending rates to its loan prime rate, an important move towards refining the country’s monetary system and unifying the dual-track interest rate regime.

China has long had two tracks of interest rates. One track, consisting of money market rates and long-term bond yields, generally moves in line with market forces but could be influenced by the central bank’s open-market operations and monetary policy communication. The other track involves bank deposit and lending rates, which are tightly controlled and priced against the official rates. While banks can, in reality, price loans slightly above or below the official rates, these deviations are too small to fully reflect borrowers’ risk characteristics.

Although the dual-track regime has served China well in its transition from a quantity-based to a price-based monetary system, there is now an urgency to merge the two tracks and reform interest rates.

Moreover, the dual-track system has hindered monetary policy transmission, at a time when Beijing is trying to lower funding costs and improve the economy.

While the PBOC has lowered market interest rates by cutting banks’ reserve requirement ratios and injecting liquidity through the medium-term lending facility, the average bank lending rate is little changed. Effectively, little relief has trickled down to borrowers of bank loans.

So, how can a new system rectify the situation?

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