A Chinese flag floats amidst traditional lanterns in the streets of Beijing, China.
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China's central bank has changed the way commercial lenders set interest rates on loans – a move that is likely to cut borrowing costs at a time when the Chinese economy needs a boost.
Growth slows in China The US trade war is likely to worsen over the coming months. Chinese authorities have taken both monetary and fiscal measures to boost economic activity, but analysts say certain sectors may need more help.
"This is a welcome move to cut borrowing costs, especially for smaller companies, and comes at an important time as China's GDP growth could fall below 6% in 2020 as US tariffs for Chinese goods continue increase." Analysts at United Overseas Bank in Singapore wrote in a Monday bulletin:
The International Monetary Fund predicted Chinese growth of 6.2% in 201
Interest Rate Reforms
Unlike the US Federal Reserve, the Chinese Central Bank – the People's Bank of China – does not have a single primary monetary policy instrument. Instead, the PBOC uses several methods to control the money supply and interest rates in the world's second largest economy.
One of these instruments is the loan rate – or the rate that banks charge their most creditworthy customers. Beijing announced on Saturday that the LPR will be revised from this month.
The changes include:
- Encourage commercial lenders to use benchmark rates instead of benchmark rates as a reference for the price of new loans.  Increase the number of financial institutions that can participate in the submission of LPR offers from 10 to 18 companies.
- Setting the interest rate on loans on the 20th of each month instead of daily.
- Encouraging Panel Banks to link their loans to LPR rates on the Medium Term Loan Facility (MLF), a financing facility that PBOC also offers to commercial lenders.
The key interest rate introduced in October 2013 was supposed to better reflect the market demand for funding than the prime rate interest rate – but that did not work out.
One reason for this is that many banks have declined to rate their loans much lower than the benchmark rate, which has not been adjusted to protect their profit margins since October 2015. As the lending rate is calculated for the best and lowest risk clients becomes the unofficial minimum interest rate for bank loans in China.
Cheaper Bank Loans
The PBOC has specified the implicit floor of The lending rates of banks are "a big reason" for the fact that borrowing costs in China have not dropped overall, although other interest rates are more sensitive to demand and supply of the market, have declined.
Another instrument of the Chinese central bank to adjust monetary policy is the medium-term interest rate on credit facilities. It is considered more focused on supply and demand dynamics in China's money markets.
The annual interest rate for the MLF was recently around 3.3% – lower than the central bank's interest rate of 4.35%.
The new interest rate on the loan over the medium-term lending rate is expected to lower the LPR, leading to a decrease in overall borrowing costs.
This already has some implications. On Tuesday, the first day of the new reforms, the new one-year lending rate was set at 4.25% after 4.31% previously; The newly introduced five-year interest rate on loans was set at 4.85% – below the five-year indicative rate of 4.9%.
This should theoretically lead to lower interest rates on new bank loans for businesses and households.
] More effective monetary policy
Beijing has been trying for many years to change the way interest rates work in its economy. It aims to better comply with the practices of central banks in large economies, which mainly adjust interest rates on short-term funds to influence the cost of borrowing in the economy as a whole.
China maintains a so-called command economy – or a central plan economy, in which the central bank dictates where interest rates on bank loans and deposits should be set.
With the opening up of the Chinese economy and increasing integration into the global market, PBOC has given commercial lenders more leeway over the years, setting interest rates.
Nonetheless, banks preferred to use PBOC's benchmark interest rates as a benchmark for pricing their loans – which limited the flow of monetary policy changes into the economy as a whole. However, recent interest rate reforms could lead to more effective monetary policy support at a time when the Chinese economy is being challenged by the US trade war.
"This change does not automatically result in a rate cut, but is the basis for the PBoC to do so," analysts at French bank Societe Generale wrote in a Sunday note. "We believe PBoC's new system will seek to lower interest rates as the economy needs more monetary support."