Caixin Explains: Why and How China’s Overhauling Monetary Policy (Part 2)

China’s central bank, the People’s Bank of China (PBOC), is undergoing a significant transformation in its approach to managing monetary policy, aligning more closely with practices seen in major economies like the U.S. and European Union [para. 1]. This change was highlighted by Governor Pan Gongsheng in a June speech where he emphasized the need for better market communication, to improve transparency and manage policy expectations [para. 2]. Pan outlined three major changes: de-emphasizing quantitative targets like total social financing and M2 money supply in favor of interest rates, refining the current interest rate system, and trading government bonds in the secondary market to manage liquidity [para. 3].

The PBOC's current interest rate system is problematic. The bank focuses on too many rates, resulting in poor transmission from major policy rates such as the seven-day reverse repo rate and the medium-term lending facility (MLF) rate to benchmark and market rates. This impairs the PBOC's ability to influence interest rates across money, credit, and bond markets effectively [para. 5]. Analysts agree that the plethora of policy rates contributes to market confusion, as the linkage between central bank policy rates and market reactions is unpredictable [para. 6][para. 7]. For instance, the interest rate corridor—a range within which short-term market interest rates are guided—remains too wide and complex, and might need narrowing for better effectiveness [para. 8].

Historically, market-based interest rate management has been part of the PBOC's toolkit, evolving as China moved away from a planned economy towards private sector growth and private consumption [para. 12]. The government aims to shift from a dependence on indirect finance (bank lending) to direct finance (capital markets), with interest rates playing a key role in pricing capital [para. 13]. Effective transmission of monetary policy is crucial for this, helping to manage economic cycles efficiently [para. 14]. Currently, the PBOC operates with two policy rates: the seven-day reverse repo rate and the medium-term lending facility (MLF) rate, which influence other rates and help manage liquidity [para. 15][para. 21]. Despite these measures, the complex interest rate system has led to inefficiencies and distorted lending and deposit rates [para. 28][para. 29].

The interest rate transmission mechanism also encounters practical issues. Ideally, policy rates guide benchmark rates, which in turn guide market rates. However, this linkage has often failed in practice, notably with the MLF. The one-year MLF rate has failed to consistently influence the one-year and five-year loan prime rates (LPRs), benchmarks for commercial bank interest rates [para. 29]. Discrepancies in rates, such as a February instance where one rate dropped while another stayed unchanged, highlight the transmission gap [para. 30]. Additionally, with ample interbank liquidity, banks prefer interbank borrowing over MLF, reducing the latter's efficacy [para. 32][para. 33][para. 34].

To simplify the system, the PBOC plans to consolidate operational practices, focusing on a single short-term policy rate—the seven-day reverse repo rate [para. 40]. This rate will guide all other borrowing costs, ensuring smoother transmission of interest rates from short-term to long-term [para. 42]. The MLF rate’s role will be minimized, potentially severing its link with the LPRs [para. 43]. Additionally, the PBOC is narrowing the interest rate corridor to strengthen control over short-term rates [para. 45]. For example, the PBOC operates a 235-basis-point corridor, compared to narrower corridors of other central banks like the Bank of Canada [para. 46]. Starting temporary afternoon reverse repos can also help the PBOC manage interbank liquidity more effectively and cement the seven-day reverse repo rate as the main policy rate [para. 48].

Contributors to this discussion include Nerys Avery and Xia Yining, with a forthcoming part three exploring the role of government bonds in secondary market trading [para. 50][para. 52].