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Why China’s Central Bank Could Become More Like the US Federal Reserve - Bloomberg
Economics
Why China’s Central Bank Could Become More Like
the Fed
By Bloomberg News
June 30, 2024 at 6:00 PM CDT
Updated on July 9, 2024 at 1:30 AM CDT
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A bold step forward looms in the decades-long reform of how China
conducts monetary policy, with Governor Pan Gongsheng leading the
central bank to explore changes that would move it closer to how global
peers including the Federal Reserve operate. Under the proposals laid out by
Pan in a June speech, the People’s Bank of China would switch to using just
one key short-term policy rate and start trading government bonds to
manage liquidity. While crucial differences with Western peers would
remain — there’s no claim of independence from the government and China
remains opposed to quantitative easing — the shifts would mark the next
step in a journey that began in the 1990s with market forces rather than
communist cadres steering borrowing costs.
1. How does China set monetary policy now?
Currently, the PBOC uses a handful of rates. They include the most-watched
one-year policy loan to commercial lenders, the medium-term lending
facility and the seven-day reverse repurchase, a shorter-term policy loan.
There’s also the loan prime rate, which is based on the MLF rate and
published by the PBOC, and the standing lending facility rate, which is
considered the upper bound of the interest-rate corridor, within which the
PBOC guides market interest rates.
PBOC's Multiple Rates Weaken its Policy Signals
Governor Pan says central bank can consider using just one policy rate
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1-year MLF rate
7-day SLF rate
7-day reverse repo rate
1-year LPR
Five-year LPR
5%
4
3
2
1
2020
2021
2022
2023
2024
Source: People's Bank of China
In terms of adding base money to the economy, the PBOC over the past
decade has relied on lending to banks — including via the MLF — as well as
lowering the required reserve ratio, which frees up money from reserves for
banks to lend or invest. It has a broad target for the expansion of money and
credit extended each year, which is to match the nominal economic growth
target of around 8% this year.
2. What’s wrong with the current set up?
Ding Shuang, chief economist for Greater China and North Asia at Standard
Chartered Plc, says the multitude of rates leads to “messy policy signals.”
One consequence of that is that market interest rates have significantly
deviated from policy rates. For instance, the loan prime rate, which was
introduced in 2019 and is supposed to reflect what commercial banks charge
their best customers for loans, is increasingly unable to do that. The average
rate on new loans issued has declined much faster than the LPR in recent
years. That’s because the LPR’s movement has been restricted by the MLF
rate, which the PBOC is wary of lowering to protect the nation’s currency in
the face of US dollar strength.
The deviation of market rates from the MLF rate has hindered the PBOC’s
ability to pump enough cash into the economy. Because it’s now cheaper for
banks to borrow from each other than from the PBOC via the MLF funds,
their demand for the latter has languished. The PBOC faces a similar
predicament with another policy loan called pledged supplemental lending.
The misalignment between PBOC policy rates such as the MLF rate and PSL
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rate and market rates has led to a shrinkage of the central bank’s balance
sheet, “complicating China’s deflation fight and weakening central bank
policy communication effectiveness,” according to Tommy Xie, head of Asia
macro research at Oversea-Chinese Banking Corp.
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3. What will the new policy benchmark be?
To achieve the shift, the PBOC will need to help the market recognize just
one policy rate. That’s widely expected to be the cost of the seven-day
reverse repo — a daily tool that allows banks to borrow from the PBOC
against their bond holdings. Currently, market rates are more in line with
that rate rather than the MLF rate. Targeting just one rate would be a step
closer to how other major central banks work — for example, the Fed uses
open-market operations to influence the cost of short-term interbank loans,
and changes are transmitted via transactions to the cost of loans for homes,
businesses and financial products. The PBOC would also downplay targets
for credit and money expansion rates.
4. How is the PBOC paving the way for the new benchmark?
The PBOC on July 8 announced a new mechanism to influence short-term
borrowing costs. The central bank will conduct bond repurchase operations
between 4 p.m. and 4:20 p.m. on weekdays as needed, in addition to its
traditional morning operations. The term of the ad hoc repos and reverse
repos will be overnight, and rates will be set at 20 basis points below and 50
basis points above the seven-day reverse repo rate, respectively. The move is
aimed at “ensuring reasonable and sufficient liquidity in the banking system,
and to improve the precision and effectiveness of open market operations,”
the PBOC said. Economists say it will effectively narrow the corridor within
which short-term rates can fluctuate and strengthen market expectations for
the seven-day repurchase rate to become the new benchmark.
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5. What about the plan to trade government bonds?
Bond trading would give the PBOC a new tool that’s seen as more effective in
managing liquidity than its current instruments, because it impacts a
broader swathe of market participants. It can be used by the PBOC more
flexibly. That’s in contrast to the MLF, which depends on banks’ appetite and
is conducted only once a month. The PBOC has signed agreements with
major financial institutions to borrow government bonds, and said it would
sell them depending on market conditions. China’s bonds have surged as
investors snapped up the notes amid pessimism over the economy, and the
PBOC has been pushing back against the rally.
The trading of bonds would also bolster the central bank’s ability to help the
government raise money to fund investment and other spending to support
the economy. That’s needed now more than ever as local authorities’
finances become increasingly strained, crimping their ability to help an
economy challenged by deflation and a property downturn.
The new afternoon repo mechanism (described in section 4) will help ease
any investor concerns that the planned bond sales will lead to short-term
liquidity crunches. That helps close “a gap in the PBOC’s defences,” says
Bloomberg Economics’s David Qu.
But China remains reluctant when it comes to quantitative easing. Pan,
when announcing his proposed reforms, sought to dispel the idea the PBOC
was embarking on massive stimulus. “Including government bond buying
and selling into the monetary policy toolbox doesn’t mean we’ll do
quantitative easing,” said Pan, referring to the once-unorthodox central
bank policy of buying government bonds to stimulate the economy.
6. What are the benefits of the proposed new framework?
It could better meet the economy’s ever-growing demand for liquidity.
Trading government bonds gives the PBOC a powerful tool to ensure the
market has enough funds to provide financing to private borrowers as well
as the government. The tool could theoretically allow the PBOC to influence
bond yields by selling or buying bonds till the yields are in line with its
preference. To be sure, the revamp won’t necessarily address immediate
challenges faced by the economy, such as the longest deflation streak since
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the 1990s and the fact that borrowing demand remains sluggish. It also
won’t solve the problem of the PBOC’s multiple and sometimes competing
objectives — for example, it’s facing constraints on rate cuts due to its goal of
stabilizing the yuan.
7. What is the long-term goal of interest-rate liberalization?
More efficient allocation of credit and capital to the most productive areas of
the economy, meaning less wasteful debt. It could give a boost to the
economy’s growth potential, which is needed as longer-term headwinds
such as demographic aging and global trade tensions mount.
“The impact is more on the longer term, because the monetary and financial
system needs to evolve along with the broader economy, which is going
through more market-based reforms,” said Le Xia, chief Asia economist at
BBVA. “The monetary policy operation will shift toward the model of
advanced economies, as central banks like the Fed have a mature practice of
controlling the short-end rates and allowing the market to form longer-end
rates via transactions.”
8. When will the proposed reforms happen?
The proposed changes aren’t likely to come in overnight. Pan made clear
that the central bank is still studying the measures and cautioned that bond
trading will be a gradual process. Some analysts said a possible window for
the PBOC to start trading bonds could be after a key Communist Party
meeting on reform to be held later in July, while others say the move may
not come so soon.
“From the longer-term perspective, the MLF rate may become increasingly
unimportant, but it won’t happen overnight. In Pan’s speech, his wording on
the changes are mostly to study or to consider them in the future,” said
Standard Chartered’s Ding.
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