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China’s announcement of key interest rate reforms over the weekend has fuelled expectations of an imminent reduction in corporate borrowing costs in the struggling economy, boosting share prices on Monday.

The People’s Bank of China (PBOC) unveiled the long-awaited reforms on Saturday to help steer borrowing costs lower and support businesses hurt by weak demand at home and a year-long trade war with the United States.

While the rate overhaul has been in the works for some time, the announcement came days after data showed the economy stumbled more sharply than expected in July, raising questions over whether more rapid and forceful stimulus may be needed.

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Analysts believe the revamped loan prime rate (LPR), which debuts on Tuesday, will be lower than the current level of 4.31%, but are divided over how much funding costs will come down and how quickly.

While China has pushed plenty of liquidity into the financial system over the past year to shore up growth and guided short-term rates down, loan demand and fresh investment has been relatively subdued amid weakening business confidence and banks’ worries of more bad loans.

Under the new mechanism, bank lending rates will be linked to the loan prime rate, which will be linked to the PBOC’s medium-term lending facility (MLF) interest rate, and that should establish a relatively smooth policy transmission mechanism, said Ma Jun, a policy adviser to the central bank.

“In the future, if the policy interest rate falls, the loan interest rate will also fall, which will help to reduce the financing cost of enterprises,” he said in remarks published on the website of state radio on Monday.

China and Hong Kong stocks rose on expectations the move will ease corporate financing pressures. China’s benchmark equity index jumped over 2%, while an index tracking start-ups - potentially the biggest beneficiaries from lower rates - surged 3.5%.

However, some analysts cautioned the reform may not be equivalent to cuts in bank’s actual lending rates, as banks could still charge higher rates on riskier loans to smaller, private firms.

Still, Chinese banking shares far underperformed the broader market amid worries of lower profitability for lenders. Reactions in the bond and the yuan markets were muted.

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“The new system itself doesn’t guarantee the actual lending rate will be lower,” Goldman Sachs said in a report.

“But given the current situation with weak activity growth, heightened trade war risks and a strong desire by the senior leadership to lower rates, we do expect actual lending rates to go down.”

Australia and New Zealand Banking Group estimates that the reform is equivalent to making a 45 basis point (bps) loan rate cut. Societe Generale believes the reform could lead to a more modest 10-25 bps cut in the new benchmark lending rate.

Under the changes, banks must set rates on new loans using the new LPR as the benchmark for floating lending rates, rather than the PBOC’s benchmark bank lending rate.

The market’s focus will be on where the new LPR is set on Tuesday. Rates will be published on a monthly basis.

Ming Ming, head of fixed income research at CITIC Securities in Beijing, said he expects the first new rate will be set lower to narrow the yield gap between LPR and interest rate on the MLF, which is now 3.3%. That gap is currently 101 bps.

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Some analysts believe the central bank could cut the one-year interest rate on the MLF in order to guide borrowing costs lower. A batch of one-year MLFs with a value of 149 billion yuan ($21.15 billion) is set to expire next Monday.

“We see chances for China to lower its MLF rate in the coming months,” said Tommy Xie, economist at OCBC Bank.

“However, we don’t see the urgency for China to cut its MLF rate in August as China may want to take a wait-and-see approach to see how markets react and digest the latest liberalization.”


The PBOC launched the LPR in 2013 to reflect rates that banks charge their best clients. But the LPR reacted little to market demand and supply, with the one-year rate hovering just under the benchmark one-year lending rate of 4.35%.

Ma said the LPR reform will help it better reflect changes in market rates and help lower corporate funding costs.

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Chinese banks’ new LPR quotations will be based on open market operations, the PBOC said over the weekend. The national interbank funding center will publish the reference rate from Tuesday and on the 20th day of each month thereafter.

Banks will set rates on new loans by adding a spread to the new LPR reference rate, the central bank said.

But existing loans will still follow the original contracts that were signed in line with the benchmark lending rate. China’s outstanding local-currency loans were at a staggering 147 trillion yuan ($20.87 trillion) at the end of July.

A massive 28 trillion yuan in long-term mortgage loans are exempt from the new scheme, analysts at Nomura note.

OCBC’s Xie said the move is a “half step” towards interest rate liberalization, and the link to the medium-term lending rate may only be temporary.

“The current liberalization focuses only on the lending rate while the deposit rate was left untouched... In the longer run, China may also need to loosen the setting of deposit rate.”

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