How new interest rate reforms in China will work

On Saturday, the Central Bank of China canceled the long-awaited interest rate reform and instead set the base rate for new loans issued by banks to reduce corporate borrowing costs and support the slowing economy.

The new Chinese loan rate for first-class borrowers (LPR) is a central part of the reforms. The LPR rate was initially introduced by the People’s Bank of China (PBOC) in October 2013 and represents the interest rate that commercial banks provide to their best customers. It was planned that it would reflect the market demand for funds better than the PBOC benchmark.

As announced on Saturday, the new LPR will be tied to the rates set during open market operations, namely, the interest rate of the medium-term lending facility (MLF) of the PBOC, which is determined by the broader demand of the financial system for central bank liquidity. After the LPR is set slightly higher than MLF, borrowers, in theory, will have access to funds at rates better reflecting the financing conditions in the banking system, ensuring a smoother policy transfer mechanism.

The new LPR base rate will be announced at 9:30 a.m. on the 20th of every month, starting from August 2019. The rate has so far been set based on the quotes of 10 participating banks. Eight more will join these banks, among which there are two foreign institutions.

The LPR rate will be the basis only for new loans issued by banks. Existing loans will still be guided by the base rate set by the PBOC.

For a very long time, China used two types of interest rates to manage its credit sector — the market rate and the basic bank rate. Although over the past few years, China has provided more opportunities for commercial banks to set loan rates, the benchmark loan rate remains a crucial source of price loans for them, which does not allow the central bank to reduce corporate financing costs. The PBOC promised to “combine” the two rates and confirmed this intention several times this year.

Beijing announces a reduction in average financing costs for small companies by one percentage point this year to stimulate economic growth amid weak domestic demand and ongoing trade confrontation with the US during the year.

The market mostly perceives this step as an official attempt to revive growth and effectively reduce financing costs in the real economy. However, according to some analysts, this step can make commercial banks more risk-averse in their lending due to growing financial and economic risks.

Luo Yunfeng, an analyst at Merchants Securities in Beijing, believes that the impact on corporate borrowing costs will be felt in the long run and can be much more modest than lowering the base rate, which will affect both new and existing outstanding loans.

Now investors are waiting for the first publication of the LPR rate. It is expected that the new rate will be reduced by 10-15 basis points compared with the current level.