Analysis-China’s interest rate reform will be a ‘hard, long’ process By Reuters

By Kevin Yao

BEIJING (Reuters) – China’s central bank wants to change its policy framework to target the cost of credit rather than its size, but liquidity risks and uncooperative markets are making it difficult to transition the economy away from state-led bank credit.

The aim to give markets a more prominent role in resource allocation was reaffirmed at a roughly twice-a-decade Communist Party leadership meeting in July, and the People’s Bank of China (PBOC) is expected to play a major role in the reforms.

In recent months, the PBOC has taken steps to create a more market-based interest rate curve and is expected to make further changes to make credit demand more responsive to monetary policy moves.

In the longer term, regulators hope these changes can also lead to the development of capital markets as an alternative source of funding, reducing the risk of wasteful investment by a state-dominated banking system.

But a slowing economy, still heavily dependent on state-led infrastructure investment for growth and in the midst of modernizing its industrial complex, has significant liquidity needs. Markets may be unwilling to provide financing in ways that the PBOC deems beneficial to national development goals.

In a recent tussle between the PBOC and bond markets, safe-haven flows have pushed government debt yields to levels that signal bearish bets on China’s growth prospects.

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

The PBOC shifted to targeting the short end of the interest rate curve and announced plans to gradually increase bond trading to influence long-term borrowing costs, but more steps are needed to improve its policy transmission.

“We are moving in the direction of developing market-based interest rates, but it is a tall order and the road is long,” said a government adviser who spoke on condition of anonymity because they are not authorized to speak to the media.

Future reforms are likely to involve phasing out liquidity-providing levers, including credit guidelines, analysts and policy advisers say.

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LIQUIDITY NEEDS

Credit guidance and other quantitative tools encourage banks to lend regardless of market demand.

This has created inefficiencies, with idle funds pooling around the financial system as borrowers often park money back at banks in deposits or asset management products.

But phasing out these tools carries risks.

Debt levels of around three times annual economic output and ambitious annual growth targets – this year’s are set at around 5% – require larger injections of liquidity year after year.

Xing Zhaopeng, ANZ’s senior China strategist, estimates the central bank needs to inject about 2 trillion yuan ($281 billion) in fresh liquidity annually to support the economy.

The PBOC has indicated that the MLF will be the first to see a reduced role in monetary policy.

But at the end of June, outstanding financing through the MLF stood at 7.07 trillion yuan ($994.6 billion) – about 5.6 percent of GDP.

“I don’t expect the MLF to be cut off suddenly as it remains quite important for long-term financing,” said Lynn Song, chief China economist at ING. “It will be a gradual process.”

MARKET PROBLEMS

The market’s preference for safe assets over other types of investment could lead to an inverted yield curve if the central bank were to release interest rates prematurely, ANZ’s Xing said.

Long-term borrowing costs falling below short-term rates usually signal recessions. In China’s case, this could weaken the yuan and trigger capital flight.

“Once you fully liberalize interest rates, it would be impossible to intervene,” Xing said. “It’s a contradiction: if you let the market work, you have less room to maneuver.”

Increasing the role of capital markets in financing growth also requires deep structural changes in the economy, alongside interest rate reform.

China’s stock markets are dominated by retail investors and frequently described as a “casino” due to poor liquidity, while debt markets are dominated by government-owned issuers, with banks being the main investors.

Low household incomes relative to the size of the economy mean that private pension and insurance markets are small, limiting the number of institutional investors in stocks and bonds and resulting in a reduced pool of capital for these assets.

Foreign financial investor flows are also limited because China manages a limited capital account.

There is little public debate about how to address any of these limitations to capital market development.

“What the PBOC is doing on long-term interest rates is clearly not in line with the long-term reform agenda,” said Kuijs of S&P Global Ratings.

($1 = 7.1086)