PBOC takes major step towards liberalizing rate regime

The new policy is a result of positive and negative factors.

It is part of a wider effort by Beijing’s current team of macroeconomic managers to reform interest rates, which have previously played a role in misallocating capital and feeding inflation.

It is also the result of economic slackening; thanks to slowing exports and foreign direct investment, the PBOC no longer needs to focus on draining money, foreign exchange in particular, from the market.

In the absence of overwhelming inflows of fresh liquidity from abroad, the financial system has become more dependent on liquidity provided by PBOC, increasing the leverage it has over the interest rate system, even as the yuan exchange rate has reached what appears to be a temporary equilibrium.

Freed from the need to micromanage the yuan against the dollar, Beijing therefore turned to tweaking the domestic money market. It has moved steadily away from tools that produce long-term changes to the base money supply in favor of shorter-tenored instruments.

The People’s Bank of China (PBOC) pledged to use open market operations as a key tool to guide interest rates, and reverse repos have become key components in those operations since May.

Thus, traders told Reuters that trading institutions are increasingly regarding the officially set rate for seven-day reverse bond repurchase agreements (the most frequently issued tenor of reverse repo) as guidance, setting an effective floor under other money rates.

“The pattern of PBOC’s market operations have completely changed,” said a trader at a Chinese state-owned bank in Beijing.

“Banks now have to take hints from the PBOC for potential money market rate movements, reversing the previous trend during which the central bank had to give good rates to attract bill buyers in order to sterilize foreign exchange inflows.”

The new environment is a reversal for banks that were previously so flush with funds that they could refuse to deal with the PBOC entirely, instead parking their cash in whatever product offered the highest returns, in some cases including opaque but high-yielding wealth management products.

But now the PBOC can more effectively impose its will on general interest rates simply by keeping a grip on cash flows in and out of the interbank market, and that grip has grown increasingly tight.

For example, the central bank has not issued a single bill this year. Most bills issued in market operations take a year to mature, and thus bills issued last year continue to mature this year, causing cash injections.

But the halt in issuance means that the central bank will no longer have to manage the impact of maturing bills on the money supply, because there won’t be any, making it even easier for the bank to “fine-tune” the money supply through short-term reverse repos, as it has done since May this year.

At the same time, regulators have kept banks’ required reserve ratios (RRR) at 20 percent, just 1.5 percentage points short of the record high of 21.5 percent it held for four months in 2011.

Because of the PBOC’s adept moves in the interbank market, interest rates have not spiked despite this high ratio, even as holding the line on the RRR cut has successfully kept a lid on consumer price inflation, although some economists believe Beijing should be getting more worried about preserving growth.

“The PBOC’s injection of short-term liquidity via reverse repos, and its decision to keep the seven-day reverse repo rate stable, has helped stabilise short-term funding costs in the money market,” said a trader at an Asian bank in Shanghai.

During open market operations in August, the PBOC kept the rate of its seven-day reverse repos unchanged at 3.35 percent up until August 21, when it rose 5 basis points.

Taking cues from the PBOC rates for reverse repos, China’s benchmark traded money rate, the weighted average seven-day repo, last month showed its lowest volatility since April 2010. Traders now say that most deals based on the benchmark are now being executed within 20 to 30 basis points of the PBOC rate.

But this liberalisation is still cramped by the lack of significant progress in other areas, most notably sustained government controls on bank-offered deposit and lending rates.

“The PBOC’s reverse repo rate is still far from a Western-style benchmark, because the Chinese central bank continues to rely on officially set interest rates to control banks’ lending and savings rates,” said the Beijing trader.

PBOC chief Zhou Xiaochuan said in March that conditions for market-oriented interest rate liberalisation were ripe, but progress has been slow.

Earlier in June, the PBOC made a small step on the long road towards market-determined interest rates. In addition to cutting the official rates on loans and deposits on June 7, the central bank widened the bands around the official rates, allowing banks more flexibility.