China took another step on Saturday towards liberalizing the country’s labyrinthine financial system.
Starting next month, financial institutions will cease to use the benchmark lending rate as a reference for pricing credit, shifting instead to the revamped loan prime rate (LPR). Over the course of the six months from March to August, existing loans will be converted to the new base as well.
For those who need a refresher, recall that China moved to simplify its two-track rate regime this year in a bid to bring down average borrowing costs. That effort culminated in a new LPR compiled from bank submissions representing the prices they charge their most credit-worthy clients expressed in basis points over open market operation rates, with an emphasis on the medium-term lending facility.
The PBoC, of course, plays a role in setting the rate too. Just like anything else in Chinese markets, they can “guide” it. The actual formula is: LPR = MLF rate + adjustment factors [banks’ funding costs + market supply and demand + risk premia and other parameters].
The LPR rate is published on the 20th of each month. The first revamped print came in August, and it represented a cut versus the old benchmark. There have been a total of three cuts since the summer: That inaugural revamped print, September and November.
The one-year tenor is now 4.15%, representing a 20bps discount to the old benchmark.
As noted above, the LPR is priced off the MLF rate, which was cut early last month, paving the way for November’s eventual LPR cut. Beijing also cut the 7-day repo rate for the first time since 2015 in November.
That’s a pattern that many analysts think will continue. “After this episode, we should just expect the PBoC to keep adopting this combination in future easing: lowering the 7-day reverse repo rate and 1-year MLF in lock-step, accompanied by step-up in liquidity injections through RRR and/or targeted RRR cuts to push down market rates”, SocGen’s Wei Yao remarked late last month.
The explicit directive for banks to price everything off LPR should (and we emphasize “should”) ensure the monetary policy transmission channel doesn’t remain clogged. If financial institutions are forced to use LPR, it means borrowing costs for businesses should theoretically always reflect the central bank’s dynamic efforts to lower the cost of funds (because the LPR is priced off the MLF rate). Or at least that’s the idea.
Another obvious side effect of this is a gradual squeeze on bank margins, but that’s a small price to pay if it means bringing down stubbornly high weighted average borrowing costs on an economy-wide basis. Financial institutions in China hold some 152 trillion yuan in loans, according to Bloomberg.
For what it’s worth, the PBoC said Saturday that “nearly 90% of newly issued loans have been priced with reference to LPR”. The problem, again, is that the existing stock of floating rate loans are still priced based on the benchmark rate. That, the PBoC says, means those loans “cannot reflect changes in market interest rates in a timely manner, which is not conducive to protecting the rights of both borrowers and lenders”.
This comes at a time when Beijing has shown a higher tolerance for defaults amid slowing growth and external pressure for China to speed the liberalization process. Some fret that moving too quickly could prove destabilizing for a system built on a command economy foundation.