China Debuts Improved Interest Rate Mechanism Tuesday

The Beijing headquarters of the People's Bank of China

The Beijing headquarters of the People's Bank of China

China's new lending reference rate was set slightly lower on Tuesday in the first publication of the benchmark since the central bank announced interest rate reforms created to lower corporate borrowing costs.

From Tuesday, new loans must be priced "mainly" with reference to the new LPR, which is linked to the price the People's Bank of China charges lenders for cash over a year.

The one-year LPR announced Tuesday was lower than the 4.31-percent rate from the previous mechanism, and also lower than the 4.35-percent benchmark lending rate.

She also expects a 5-10 basis point cut in the 1-year MLF rate.

The new above-five-year LPR was 4.85 percent.

"The LPR reform marked a step forward in China's push towards interest rate liberalization", said a research note by China International Capital Corporation Limited.

No surprise there since the central bank already said in its August monetary policy statement, it would make lower adjustments to rates "if needed".

The move by the PBOC is created to steer corporate borrowing costs lower and support a slowing economy. "A decline of only a few basis points is small and, unlike a benchmark lending rate cut, it will only feed through to borrowing costs on new loans, not outstanding ones".

The central bank wants to liberalize the way commercial banks set interest rates and wants to cut loan rates for companies, which economists from investment bank UBS Group AG described as killing two birds with one stone.

Asian stocks trade higher on China's bank new loan prime rates news. Up until now, banks have referred to the benchmark interest rates when setting loan rates, but have a hidden lower limit that may be some multiple of the benchmark rate. It last cut the one-year lending rate in 2015. MLF rates are usually seen as the rates banks pay for their investment and are decided by the central bank's open market activities bidding procedure. "By allowing the rate to float, they are basically allowing interest rates to fall".

The LBR was originally created to allow commercial banks to offer more favorable interest rates to their best customers, like the USA prime rate.

The MLF rate is now 3.3 per cent, 95 bps below the new reference rate. If these loans are rolled over, the PBOC could lower the rate, opening the door to an LPR cut. The new rate is set on the 20th day of every month.

"There is little evidence so far that LPR, since it came into being in 2013, followed short-term market rates, especially 7-day repo rates, closely", Bank of America economists Helen Qiao and Miao Ouyang wrote in a note. He said that if the U.S. Federal Reserve cuts interest rates on September 18, the PBOC is likely to lower the MLF rate by 15-20 bps, which would in turn push LPR rates lower.

That said, banks may need to do some "national service" by lowering their average loan rates, but then might try to make up for their lower profits by increasing the price of riskier loans to private firms and SMEs, according to economists at Nomura International (Hong Kong) Ltd.

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