Analysis: China’s Interest Rate Reform Will Be an ‘Arduous, Long’ Process According to Reuters

By Kevin Yao

BEIJING – China’s central bank aims to shift its monetary policy framework to focus on the cost of credit rather than its volume. However, liquidity risks and a lack of alignment with market dynamics are complicating efforts to move away from state-directed bank lending.

The aspiration to enhance the role of markets in resource allocation was reiterated at a significant Communist Party leadership meeting in July, and the People’s Bank of China (PBOC) is expected to be key in these reforms.

Recently, the PBOC has initiated steps to establish a more market-oriented interest rate curve and is anticipated to implement further adjustments to ensure that credit demand better aligns with monetary policy changes.

In the long run, regulators hope these adjustments will foster the development of capital markets as alternative financing sources, thereby minimizing the risk of inefficient investments arising from a state-centric banking system.

Nonetheless, with the economy experiencing a slowdown and heavily depending on state-led infrastructure investments for growth, liquidity requirements remain substantial. Markets may be hesitant to provide funding in ways that the PBOC views as beneficial for national development goals.

In a recent situation involving the PBOC and bond markets, a shift towards safe-haven flows pushed government debt yields down to levels that indicate a bearish outlook on China’s growth prospects.

“The PBOC will continue to gradually reform its monetary policy framework towards that adopted by major central banks globally. However, these changes will be slow,” commented Louis Kuijs, Asia Pacific chief economist at S&P Global Ratings.

The PBOC has recently targeted the short end of the interest rate curve and proposed plans to progressively enhance bond trading to influence long-term borrowing costs, though further steps are needed to enhance policy transmission.

“We are heading towards developing market-based interest rates, but it’s a challenging endeavor and the journey is long,” said a government adviser, speaking on the condition of anonymity due to restrictions on interacting with the media.

Future reforms are expected to phase out liquidity supply mechanisms, including credit guidance, as highlighted by analysts and policy advisors.

Credit guidance and similar quantitative tools prompt banks to lend regardless of market demand. This has led to inefficiencies, with excess funds circulating within the financial system as borrowers often deposit money back with banks or invest in asset management products.

However, eliminating these tools presents risks. Debt levels are approximately three times the annual economic output, and ambitious annual growth targets—set at around 5% for this year—require continuous liquidity injections.

Xing Zhaopeng, senior China strategist at ANZ, estimates that the central bank needs to inject roughly 2 trillion yuan annually to sustain economic momentum.

The PBOC has indicated that the Medium-term Lending Facility (MLF) will be the first mechanism to see a reduction in its monetary policy role. However, outstanding funding through MLF stood at 7.07 trillion yuan, about 5.6% of GDP, at the end of June.

“I don’t anticipate an abrupt cessation of the MLF as it remains quite crucial for longer-term financing,” noted Lynn Song, chief economist for China at ING. “It will be a gradual process.”

Market preferences for safe assets over other investments could lead to an inverted yield curve if the central bank were to liberalize interest rates too soon. Generally, a situation where long-term borrowing costs fall below short-term rates signals an impending recession, which could weaken the yuan and trigger capital flight.

“Once you fully liberalize interest rates, intervention becomes impossible,” Xing stated. “It’s a contradiction: allowing the market to operate leaves less room for action.”

Increasing the role of capital markets in financing growth also necessitates deep structural changes in the economy alongside interest rate reform. China’s stock markets are dominated by retail investors and often compared to a “casino” due to low liquidity, while the debt markets are led by government-owned issuers, with banks as the main investors.

Relatively low household incomes compared to the overall economy mean that private pension and insurance markets are underdeveloped, resulting in few institutional investors in stocks and bonds, which creates a shallow capital pool for these assets.

Foreign investment flows are also restricted due to China’s tight management of its capital account, with limited public discourse on addressing these constraints on capital market development.

“What the PBOC is doing regarding long-term interest rates doesn’t seem to align with the long-term reform agenda,” remarked Kuijs of S&P Global Ratings.