PBOC Puts Interest Rate Pricing at Centre of Monetary Policy

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Changes in the economy and financial sector have prompted the People’s Bank of China to shift from quantitative money supply indicators to interest rate guidance in its deployment of monetary policy.

While the 2018 Government Work Report said that monetary policy would be kept steady and neutral this year, it broke from precedent by omitting any specific targets for growth in the broad M2 money supply.

Peng Xingyun (彭兴韵), chair of the monetary theory and monetary policy research office of the China Academy of Social Sciences, said to the People’s Bank of China’s Financial News that structural changes in China’s finance sector have diminished the significance of quantitative indicators such as monetary supply.

One of the key changes has been an increasing diversification of financial channels for sectors in society that are in need of funds, which is shrinking the importance of conventional bank loans.

“Aside from conventional bank loans, the status of bonds, stocks and trust companies has already risen greatly… when it comes to use of funds by those with a surplus, the status of deposits is continually diminishing, as securities investment funds and various types of wealth management and trust products are increasingly preferred due to their comparatively high returns.

“As a consequence, traditional quantitative money supply indicators are no longer capable of reflecting the diversified structure of finance, and their level of correlation with economic and financial activity is on the decline.”

Peng points out that while the growth rate of the broad M2 money supply has eased steadily since the start of the decade, market interest rates have undergone marked periods of decline and increase over the past seven years, which shows that the relationship between the two is diminishing.

By contrast any shifts in market rates have a heavy impact upon non-depository financial products, thus affecting the allocation decisions of investors, as well as the financing costs of borrowers.

“Compared to a quantitative index like M2, a price-based index like interest rates is having an increasingly pronounced impact upon the economy and financial markets,” said Peng.

“Diversification has also made controlling the money supply more difficulty, and it’s often the case that the actual growth rate of the money supply isn’t higher, but is in fact markedly lower than policy targets.

“For this reason, it’s actual role as a monetary policy target has fallen significantly.”

Peng sees this as the reason for the Chinese central bank’s ongoing shift towards the use of interest rates as a means of controlling the monetary system, starting in the 1990’s with the launch of interest rate liberalisation reforms.

“[We] have not only basically removed the upper and lower threshold on deposit and lending rates, but are also deeply driving market reforms of the financial structure, raising the independent operating capability and risk pricing capability of financial institutions, as well as strengthening the capital adequacy and liquidity management of commercial banks, and the ability of their capital to absorb losses….this sets an excellent micro-foundation for market-based interest rate mechanisms.

“In actuality the central bank is attempting to actively guide market interest rates as well as strengthen risk management of market rates.”

Peng points out that since 2015 the Chinese central bank has made increasing use of the interbank bond 7 day repo rate benchmark, given that bond market yields closely follow changes in 7-day repo rates, which can in turn directly affect bond coupons, and thus financing costs and investment demand.

“In 2017 the rise in bond market yields caused bond coupons to lift in tandem, and the overall rates for non-financial corporate bond issuance to exceed the weighted average interest rates for standard bank loans,” said Peng. “This one of the key reasons for the sizeable decline in corporate bond net financing growth rates in 2017.

“This means that there are definite real conditions for the central bank to use adjustments to market rates to control corporate debt financing…in 2017, when the US Fed announced rate hikes on three occasions, the People’s Bank of China made direct, corresponding increases in its open market repo operations, and the rates for medium-term lending facilities.

“The result was that domestic bond yields saw a corresponding increase, complementing the macro-theme of deleveraging…this is a concrete example of stable and neutral monetary policy.”

While conditions in the Chinese economy and financial sector may now be ripe for the changes in the way monetary policy is implemented, PBOC still needs to undertake considerable reform measures before interest rate adjustments can be applied more effectively.

“While China has not yet set a clear interest rate intermediate target, the central bank is already attempting to establish monetary policy operating targets,” said Peng.

“However, in abandoning broad money supply as an index, and making interest rates the core of the monetary policy system, we need to cultivate benchmark interest rates that serve as the intermediate target of monetary policy as soon as possible.

“This is of the utmost importance to future refinements of the monetary policy framework.

“Of course, in future we will also need to further raise the level of correlation between bank loan benchmark rates and money market rates, as well as the sensitivity of weighted interest rates for bank loans to changes in money market rates.

“Only by doing this will it be possible to further improve monetary policy transmission mechanisms, and better employ the active role of monetary policy.”

 

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