China's interest rate transition to be 'hard, protracted' process: Report

PBOC credit shift: China’s central bank, the People’s Bank of China (PBOC), is working to shift its monetary policy focus from the quantity of credit to its cost. This aims to enhance the responsiveness of credit demand to policy changes, but the transition is proving to be difficult due to liquidity concerns and market resistance.

In July, during a Communist Party leadership meeting, the emphasis was placed on allowing markets a larger role in resource allocation. The PBOC is set to be pivotal in this reform process. Recent efforts include adjusting interest rates to better reflect market dynamics and influencing long-term borrowing costs.

Economic slowdown hinders reform

However, China's economic slowdown and reliance on state-led investments complicate the situation. The ongoing need for liquidity, coupled with the challenges of modernising its industrial sector, has made it tough for markets to align with the PBOC’s objectives.

The PBOC's efforts have faced resistance, particularly from bond markets, where safe-haven investments have pushed down government debt yields. According to Louis Kuijs, Asia Pacific Chief Economist at S&P Global Ratings, "The PBOC will continue to gradually reform its monetary policy framework towards the globally adopted models. However, the process will be slow."

While the PBOC aims to gradually shift focus to the short end of the interest rate curve and increase bond trading, more structural reforms are needed to enhance policy transmission. The process is described as “arduous” by a government adviser who spoke anonymously.

Liquidity and market challenges

Credit guidance and quantitative tools have traditionally pushed banks to lend regardless of market demand, leading to inefficiencies in the financial system. Removing these tools poses risks, as China requires substantial liquidity to meet its economic growth targets. ANZ’s senior China strategist, Xing Zhaopeng, estimates the PBOC needs to inject about 2 trillion yuan ($281 billion) annually to support economic growth.

The PBOC has suggested reducing the role of the Medium-term Lending Facility (MLF) first. As of late June, outstanding MLF funding stood at 7.07 trillion yuan ($994.6 billion), representing roughly 5.6% of GDP. ING’s chief China economist, Lynn Song, anticipates a gradual reduction rather than an abrupt cut.

Market concerns and structural needs

The market's preference for safe assets could lead to an inverted yield curve if interest rates are liberalised prematurely, potentially weakening the yuan and causing capital flight. ANZ’s Xing warns that fully liberalising interest rates could limit the PBOC’s ability to intervene effectively.

To increase the role of capital markets in financing growth, China needs deeper structural reforms. Currently, the stock market is dominated by retail investors and characterised by poor liquidity, while the debt market is largely government-owned with banks as primary investors. The limited size of private pension and insurance markets, combined with tight capital account controls, restricts institutional investment and hampers capital market development.

According to Kuijs of S&P Global Ratings, the PBOC’s approach to long-term interest rates does not fully align with the long-term reform agenda, highlighting the complexity of China's financial reform journey.

(With Reuters Inputs)