China Spotlight: The Interest Rate Toolbox and Transmission
The PBoC is easing its monetary policy by lowering RRR (required reserve ratio) and interest rates, such as the 7D re- verse repo rate and MLF (medium-term liquidity facility) rate. The 1-year LPR (loan prime rate) has dropped by 15 bp since mid-December. This note explains the interest rate tools at PBoC’s disposal and China’s interest rate transmission mechanism.
The open market operation & policy rate corridor
PBoC currently conducts daily open-market operations (OMO), using 7D reverse repo to provide short-term liquid- ity and send policy rate signals. The OMO rate is constricted by an interest rate corridor, with the IoER (interest rate on excess reserves) as the floor and the SLF (Standing liquidity facility) rate as the ceiling (Chart 1). The SLF provides short- term liquidity needed by financial institutions. Money mar- ket rates, such as 7D interbank repo (i.e., DR007), are an- chored around the OMO rate. The OMO rate was cut by 30 bp in 1Q2020 amid the Covid outbreak, then cut by 10 bp to 2.1% in Jan 2022.
The MLF rates
The MLF rate has become the PBoC’s policy rate for 1-year funding. In 2019, the PBoC began to conduct monthly MLF operations to make the rate more regular and transparent, with each operation occurring in the middle of the month. The MLF now anchors the medium-term bank funding costs such as the interbank CD (certificate of deposit). MLF rate was cut by 35 bp in late-2019 and 1H2020, then another 10 bp in Jan 2022 (Chart 2).
The relending rates
The PBoC also sets several other minor interest rates directly. The relending facility is a funding-for-lending scheme for the PBoC to channel credits to the desired sectors. It was actively used in 2020-21 to support poverty relief, rural development, micro/small businesses, financial stability, Covid control,
Chart 1. Short-term policy rate & interest rate corridor
and clean energy. The PBoC lowered rural/MSB relending rates in February/July 2020 and December 2021 by 75 bp in total, down to 2.0% for 1-year funding. The financial stability and clean energy relending rates were set at 1.75%. The re- lending rates were all lower than the MLF rate. The relend- ing schemes are primarily for industrial policies and emer- gency relief, and less so for monetary policy.
The interest rate on reserves
Interest rates on bank reserves are not normally used as counter-cyclical policy tools. One significant reform in April 2020 was to lower the interest rate on excess reserves (IoER) by 37 bp (Chart 3). By cutting the IoER to the same level as the demand deposit rate at 0.35%, this convergence elimi- nated banks’ incentives to arbitrage by taking and parking demand deposits as excess reserves at the PBoC.
The LPR
The LPR (loan prime rate), revamped in August 2019, is the average best lending rate quoted by banks based on the pre- vailing MLF rate, risk premium, liquidity condition, and other bank funding costs. Set by commercial banks, not the PBoC, the LPR is a benchmark rate, not a PBoC policy rate. The 5 bp drop of LPR last December was triggered by RRR cuts and thus better liquidity, before the PBoC’s policy rate cuts. In the past two years, all new loans were priced by add- ing risk premia on the quoted LPR. Thus, the chain of MLF, LPR, Loan Rates has markedly improved the PBoC’s interest rate transmission. Corporate loan rates and bond yields are consequently better converged.
SHIBOR
Shibor (Shanghai interbank offer rate) is the average uncollateralized interbank lending rate quoted by qualified banks, spanning from overnight to one year. Shibor has become the reference rate for various bonds, derivatives, and money market instruments.
Policy rates – benchmark rates – market rates
The PBoC now sets its policy rates using the 7D OMO and 1Y MLF. These policy rates, in turn, pull strings on benchmark rates, including DR007, Shibor, LPR, and sovereign bond yields. Finally, the market interest rates are set by adding risk, liquidity, and term premia to the benchmark rates. Chart 4 illustrates this interest rate transmission mechanism. Helped by the improved interest rate transmission, China’s yield curves have become more meaningful (Chart 5). The short-term yields have risen from their lows amid the Covid outbreak in 1Q2020. Therefore, there is still a need for the PBoC to further ease the monetary condition to lower the overall credit costs.
Interest rate is but one compartment of the PBoC’s extensive toolbox. However, an improved interest rate transmission allows the PBoC to further pivot its monetary policies from quantity tools to rate tools.
