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Central bank reports its progress of interest rate liberalization since 2017
China's "real interest rate is slightly lower than the potential actual economic growth rate, and the gap is reasonable...with room to maneuver."
The Monetary Policy Department of the People’s Bank of China published the article 深入推进利率市场化改革 Deepening the Reform of Interest Rate Marketization in the latest issue (the second half of September 2022) of 中国金融 China Finance, a biweekly publication of the central bank.
The 20th National Congress of the Communist Party of China is taking place next month so it’s not unusual that this official summary of China’s interest rate liberalization for the past five years - since the 19th National Congress in 2017 - is out now.
Below is the full translation.
Deepening the Reform of Interest Rate Marketization
The interest rate marketization reform is one of the most important reforms in the financial field. Since the Party's 19th National Congress (2017), the People's Bank of China has continued deepening the reform of interest rate marketization in accordance with the decisions and arrangements of the Party Central Committee. We have focused on promoting the reform of the loan prime rate (LPR), establishing a market-based adjustment mechanism for deposit interest rates, and pushing down the real loan interest rate significantly through reform. We have improved the central bank's policy interest rates and fostered a relatively more comprehensive market-oriented interest rate system. At the same time, we have stuck to the natural interest rate as the anchor to implement the inter-cycle interest rate management, enabled the market to play a decisive role in the formation of interest rates, and created a suitable interest rate environment for high-quality economic development.
Promoted the further marketization of loan and deposit interest rates
Promoted the reform of the loan prime rate (LPR) in the loan market. In August 2019, the People's Bank of China promoted the reform and improvement of the LPR quotation formation mechanism. The reformed LPR is formed by the quotation bank's market-based quotation based on the medium-term lending facility (MLF) interest rate, taking into account factors such as cost of capital, market supply and demand, risk premium, etc. based on the loan interest rate actually implemented for the best quality customers. At present, the LPR has become the pricing benchmark for the interest rates of bank loans, and most loans of financial institutions have been priced with reference to the LPR. The LPR is based on banks’ quotes, which can more fully reflect the changes in market supply and demand and has a higher degree of marketization, and contributes to the reduction of the effective loan interest rate against the background of the overall downward trend of the market interest rate. Since the LPR reform, the interest rate for corporate lending dropped from 5.32% in July 2019 to 4.05% in August 2022 - the lowest ever recorded.
Established a market-oriented adjustment mechanism for deposit interest rates. In June 2021, the People's Bank of China guided the 市场利率定价自律机制 market interest rate pricing self-discipline mechanism to optimize the formation of the deposit interest rate self-discipline cap, change the formation of the deposit benchmark interest rate, eliminate the leverage effect of the deposit interest rate cap, and optimize the term structure of the interest rate of fixed deposits. In April 2022, the member banks of the self-regulatory mechanism were urged to reasonably adjust the deposit interest rate with reference to the bond market interest rate represented by the 10-year Chinese treasury bond yield and the loan market interest rate represented by the 1-year LPR. With the gradual improvement of the market-oriented mechanism for deposit interest rates, in mid-September 2022, state-owned banks took the initiative to lower their deposit interest rates, leading other banks to follow suit, and many of them also adjusted the 存款挂牌利率 board interest rates for deposits for the first time since October 2015. That was an initiative taken by the banks to strengthen the management of assets and liabilities and stabilize the cost of liabilities, indicating that the reform of deposit interest rate marketization has taken an important step forward.
Improved the formation and transmission mechanism of market-oriented interest rates
Kept improving the central bank's policy interest rate system. The central bank adhered to the daily 7-day reverse repo to carry out open market operations and carried out medium-term lending facility (MLF) operations in the middle of each month in improving the transparency, regularity, and predictability of monetary policy operations and in releasing signals on short-term and medium-term policy interest rate to the market. The central bank improved the interest rate corridor mechanism, realized the full-process electronization of the Standing Loan Facility (SLF), and gave full play to the role of the SLF interest rate as the upper limit of the interest rate corridor and the 超额存款准备金利率 excess deposit reserve interest rate as the lower limit of the interest rate corridor. At present, China has formed a central bank policy interest rate system with the open market operation interest rate as the short-term policy interest rate, the MLF interest rate as the medium-term policy interest rate, and the effective operation of the interest rate corridor mechanism.
Built a relatively complete market-oriented interest rate system and interest rate transmission mechanism. After nearly 30 years of continuous promotion, China's market-oriented interest rate system has been continuously improved. China has fostered the rates for pledge-style repos and the Shanghai Interbank Offered Rate (Shibor) as the benchmark interest rate in the money market. The yield curve of government bonds has become mature, and the degree of marketization of deposit and loan interest rates has also been increasing. Under such circumstances, the People's Bank of China adjusts the liquidity in the banking system through monetary policy instruments and releases the signal of policy interest rate adjustment and control. With the aid of the interest rate corridor, the central bank guides the market benchmark interest rate to fully reflect the changes in market supply and demand, and finally transmits it to the loan and deposit interest rates through the banking system, forming a market-oriented interest rate formation and transmission mechanism, adjusting the supply and demand of funds and the allocation of resources, to achieve the monetary policy objectives.
Taking Natural Rate of Interest as Anchor to Implement Cross-cycle Interest Rate Management
Interest rate is the price of capital and an important macroeconomic variable, which determines the flow of capital and has important guiding significance for macroeconomic balance and resource allocation. In theory, the natural rate of interest is the real interest rate when the total supply and demand of the macro-economy reach equilibrium. In the medium and long term, the real interest rate in the macro sense should basically match the natural rate of interest. In practice, the "golden rule" is generally adopted to measure the reasonable interest rate, i.e. the real interest rate (r) adjusted by inflation should be approximately equal to the real economic growth rate (g). If the real interest rate continues to exceed the potential growth rate, it will lead to high financing costs and difficult business operations, which is not conducive to economic development. The real interest rate is lower than the potential economic growth rate, which is conducive to debt sustainability and can give the government some additional policy space. However, if the real interest rate remains significantly lower than the potential economic growth rate, it will distort the allocation of financial resources and cause problems such as over-investment, overcapacity, inflation, asset price bubbles, and funds circulating within the financial sector without entering the real economy, which would be unsustainable in the long run. China's monetary policy has always been 以我为主 keeping the initiative to itself and 以静制动 making moves as opportunity matures, thus guiding the market interest rate to decline upon steadiness. It has achieved relatively good results. At present, China's fixed deposit interest rate is about 1% to 2% and loan interest rate is about 4% to 5%. The real interest rate is slightly lower than the potential actual economic growth rate, and the gap is reasonable. It is the best strategy, with room to maneuver. At present, China's monetary policy targets such as economic growth, prices, employment situation, and balance of international payments all operate within a reasonable range, which has fully verified the actual effect that China's current interest rate level is generally within a reasonable range.
Insist on enabling the market to play the decisive role in the formation of interest rates
To push forward the reform of interest rate marketization, the market must always play the decisive role in the formation of interest rates. In terms of loans, the People's Bank of China fully respects the banks' 对贷款利率的定价权 pricing power in loan interest rates and 利率的浮动权 the power to float the interest rates within a certain range, and the banks negotiate with borrowers to determine the loan interest rates by comprehensively considering factors such as the borrower's risk and the term of the loans. At present, the degree of marketization of loan interest rates in our country is relatively high, and differentiated pricing of loans is relatively common. For small and micro enterprises, due to the high-risk premium and credit management cost, the loan interest rate is generally higher than that of large enterprises based on commercial principles, which is beneficial to motivate the banks to support small and micro enterprises. At the same time, the People's Bank of China actively promotes the explicit clarification of the annualized interest rates of loans, requiring banks to mark the annualized interest rates of loans in a uniform method of calculation, so as to show borrowers clear and comparable borrowing costs, making loan interest rates more open and transparent, fully protecting financial consumers' right to know and their own choices, and enhancing the competition of the market for loans.
In respect of deposits, the People's Bank of China also follows the principles of marketization and rule of law, with banks setting their own prices. With the change of deposit interest rate from administrative control to marketization, deposit products have also changed from simplification to differentiation. Beyond the traditional demand deposits and time deposits, banks have developed different deposit products, such as certificates of deposit and structured deposits, based on factors such as the type, term, and amount, to meet the needs of different customers. The pricing of deposit interest rates varies in banks, products, and terms. Under the guidance of the People's Bank of China, the interest rate self-discipline mechanism closely monitors the pricing of deposit interest rates. Through industry self-discipline, banks are urged to regulate pricing behavior and prevent irrational competitive behaviors such as some banks' blind pursuit of the scale of deposits or high-interest rates for filling liquidity gaps. That has achieved relatively good results.
In the next step, the People's Bank of China will continue to push forward the interest rate marketization reform, continuously release the benefits of the LPR reform, strengthen the supervision of deposit interest rates, give full play to the important role of the deposit interest rate marketization adjustment mechanism, promote the enhancement of interest rate liberalization, improve the formation and transmission mechanism of market-oriented interest rates, optimize the central bank's policy interest rate system, enable the interest rate lever to play the adjusting role (in the market), promote the optimal allocation of financial resources, and create a good environment for high-quality economic development, in welcoming the convening of the 20th Party Congress with practical steps. (Enditem)
UPDATE after publication: Professor Michael Pettis with Peking University wrote a thread of tweets commenting on the report and China’s economy