Why China’s Central Bank Could Become More Like the Fed

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.

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 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.

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. 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.

It 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.

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.

5. What are the benefits of the proposed new framework?

It could better meet the economy’s ever-growing demand for liquidity, as 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 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.

6. 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.”

7. 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.