China rate reform all set to lower borrowing costs

Bloomberg

China took a major step towards reforming its system of interest rates, in a move aimed at pushing down the cost of borrowing by households and companies as the economic growth slows.
From August 20, new loans must be priced “mainly” with reference to a revamped benchmark that tracks the price of credit to banks’ best customers, the so-called Loan Prime Rate. In turn, that rate is linked to the price the People’s Bank of China charges lenders for cash over one year.
The changes push China’s financial system further towards being truly market-led, and away from the Communist-era command economy where officials set both the price and quantity of credit. By unifying market and official rates, the PBOC also intends to bring down the stubbornly high cost of borrowing and aid pass-through of future changes in policy rates.
“As the transmission channel will to some extent be improved, the PBOC may be more willing to cut quasi policy rates to drive down the LPR,” Lu Ting, chief China economist at Nomura International in Hong Kong wrote in a note. “We expect riskless rates and government bond yields to drop further as the PBOC catches up with other central banks in rate cutting.”
Bank stocks slipped on Monday as analysts predicted lower rates will make lending less profitable. Industrial & Commercial Bank of China Ltd. fell as much as 2.2 percent, Bank of China Ltd. lost 1.4 percent, and Agricultural Bank of China Ltd. dropped 1.2 percent.
Until now, China has held off reducing its historical benchmark rate, the 1-year lending rate, as such a step would have immediately re-ignited the frothy property market and accelerated debt growth.
The central bank said that commercial lenders submitting prices for the calculation of the new LPR will report in terms of a spread on top of the interest rate of the PBOC’s medium-term lending operations, currently at 3.3%. As the current benchmark 1-year lending rate stands at 4.35%, new loans priced from the LPR could carry a significant discount.
Officials have said that the 1-year lending rate, which sets borrowing costs economy wide, will ultimately be abolished. For now, interest rates on existing loans and mortgages won’t be changed, according to the central bank.
The reform will make the “overall lending rate for the real economy move downward, which will achieve an effect similar to that of cutting interest rates,” Li Qilin, chief economist at Lianxun Securities Co., wrote in a note. Its effectiveness can only be seen in the pricing on Tuesday, he said.
The reform centers on making the one-year and five-year LPRs more reflective of actual lending. The number of banks participating in the pricing will be increased to 18 from 10, with the types of lenders expanded to include city and rural commercial lenders, foreign lenders with operations in China, and privately-owned lenders, the central bank said. Citibank China Co Ltd. and Standard Chartered Bank China Ltd. are the two foreign lenders on the panel.
China’s economy weakened more than expected in July after a brief bounce in the previous month, and the effects of the trade war with the US are expanding into finance and the currency. While the PBOC has been providing liquidity to the banking system to reduce inter-bank borrowing costs, the easing has only passed through into the real economy to a limited extent.
“It’s likely that small and micro-sized quality companies will benefit more” than others from the reform, former central bank official Sheng Songcheng wrote in an article posted on the PBOC-backed Financial News. He also said the use of the MLF rate in forming the new LPR will be temporary, and the PBOC will continue to cut the amount of money banks have to set aside as reserves in the future.
Ultimately, China may move toward a system where the short-term lending rate to banks is the PBOC’s main monetary tool, though officials haven’t yet spelled that out. For the time being, banks may be reluctant to immediately pass through large reductions in borrowing costs, as margins are under pressure as the economy slows.
“Policymakers are walking a very fine line this year, aiming to ease corporate borrowing costs but not fueling housing prices or compromising financial stability,” economists including Robin Xing at Morgan Stanley in Hong Kong wrote in a note. “These measures are defensive in nature and may not fully offset the growth drags. We thus continue to see downside risks to growth in 2H.”