Analysis | How China’s Interest Rate Toolbox Is Evolving and Why

1. What are the current benchmarks?

The PBOC has been adding to its toolkit to manage monetary policy. In the open market, there’s the 7-day reverse repo and the Medium-term Lending Facility (MLF), two pivotal policy rates set by the central bank for its loans to commercial banks. For lending to the real economy, there’s the new Loan Prime Rate (LPR), introduced last year in part to help lower borrowing costs of companies and households.

2. How is the DR different?

It’s used in the interbank market, where financial institutions sell yuan between themselves, and is based on actual trades. Started in 2014, it is the daily, weighted average of pledged repo transactions, where a borrower pledges bonds in exchange for a loan. In 2020, about 48% of the average daily trading in the interbank repo market was based on the DR, indicating it’s been well-received by investors. The PBOC described it as a “barometer” for liquidity in the banking system last month, and said it will work to “innovate” and “broaden” the use of DR in financial products and make it a benchmark for monetary policy and financial market pricing.

3. Where else could DR be applied?

For the PBOC, a key area is floating-rate bonds, where the coupon rate is adjusted regularly along with the benchmark rate. The stock of such products is only 1.1 trillion yuan ($162 billion), or 1.06% of the total bond market, so there is substantial room to expand. Another is in interbank lending and deposits, in particular pricing floating-rate interbank certificates of deposit. Broader use of the DR could help transmit the PBOC’s policy changes faster to bank’s borrowing costs, and make interest rates more market-derived — part of a decades-long effort to dial back on the command economy.

4. What’s the Libor connection?

With the deadline to drop Libor looming at the end of 2021, central banks in major economies have decided to use so-called risk-free rates (RFRs) as an alternative. These are based on trades of securities that have a minimal risk of defaulting, such as government or quasi-government bonds. They are considered to be more “robust,” or resistant to manipulation, than Libor because “they are anchored in active, liquid underlying markets,” the international Financial Stability Board wrote in a 2018 report.

The PBOC is following that trend with its preference for DR, which is closer to RFRs than current Chinese Libor equivalent, the Shanghai Interbank Offered Rate (Shibor). Similar to Libor, that’s based on a quote mechanism, so it can diverge from actual transaction rates. The unsecured lending market where Shibor is used is less developed than the DR-dominated repo market, so the scope for its application is limited. While some in the market believe the two rates can coexist, others including Xing Zhaopeng, an economist at Australia and New Zealand Banking Group Ltd., predict that DR will gradually replace Shibor in pricing financial products.

5. How does the DR compare?

There are 11 different DR tenors ranging from overnight to one-year, so compared to some RFRs overseas which are only overnight, it may be better suited to underpinning a wider range of financial products. At the moment the most actively traded are the overnight and the 7-day rates.

6. What are its prospects?

The yuan still has a long way to go to become a widely used reserve currency, and the PBOC needs time to solidify the DR’s benchmark status. China is in the midst of an effort to improve its overall interest-rate system while also handling the transition from Libor for Chinese banks that are exposed to foreign currencies. The PBOC also needs to think about ways to motivate financial institutions to embrace the new benchmark and issue more DR-referenced financial products.

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