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The Million-Dollar Question: Did China Raise Interest Rates?

By Wang Yuqian

(Beijing) — Has China’s central bank raised interest rates or not?

The answer depends on whom you ask. But the question is important, not only because it illustrates how markets and policymakers can view the same events differently, but because it sheds light on the conundrum faced by the central bank.

The People’s Bank of China needs to curb capital outflows and rein in asset bubbles, goals that require higher interest rates. But it also needs to prevent debt from ballooning and bringing down the economy — which means it cannot raise interest rates.

The question over interest rates made headlines in China this month after the People’s Bank of China (PBOC) charged higher rates on short-term loans it made through reverse repo agreements to large commercial banks, which in turn lend the funds to other depository institutions.

Some analysts have interpreted the move as the PBOC’s raising interest rates, but the central bank’s research bureau chief, Xu Zhong, disagreed. He told the media that the PBOC did not raise interest rates because it did not change the national benchmark interest rates on bank deposits and loans.

As conflicting as the remarks may appear, both sides were actually correct, depending on how narrowly “interest rate hike” is defined. The PBOC’s way of influencing market interest rates has changed over time, meaning policymakers and analysts are more likely to disagree on whether rates have changed and on the indicators they choose to measure general debt costs.

In the United States, a central bank interest rate hike refers to when the Federal Open Market Committee sets a higher target for the interest rate at which a depository institution can lend the funds they maintain at the Federal Reserve to one another overnight. This “federal funds rate” serves as a benchmark because it acts as a reference for all other interest rates in the U.S. economy.

Banks in China also lend their excess reserves with the central bank to one another, but the interest rates on these loans are not nearly as influential as the federal funds rate in providing reference to other interest rates in the country.

Instead, benchmark interest rates in China are those set by the PBOC on deposits that banks take and loans they make to their customers. There used to be limits on how far banks’ real interest rates could deviate from the benchmarks, but the last of those restrictions was removed in October 2015.

Traditionally, an interest rate change made by the PBOC referred only to a resetting of those benchmark interest rates. That’s why the PBOC research official said the central bank did not raise interest rates.

But this notion has been challenged by analysts who say those reference rates are no longer an apt measure of overall debt costs in China. Some have argued that the PBOC has effectively raised the overall level of funding costs through open market operations, which include repo and reverse repo agreement and various lending facilities.

The PBOC has increasingly relied on open market operations to influence market interest rates, making the so-called benchmark less of an indicator of actual debt costs, according to those analysts.

Higher interest rates on PBOC open market operation tools can translate into greater debt burdens for ordinary bank loan borrowers, analysts say. This connection does not always hold true, but it has been apparent this time, according to Haitong Securities.

On Feb. 3, the PBOC raised the interest rate on seven-day reverse repos from 2.25% to 2.35%, the first hike since October 2015. The interest rates on loans of longer maturities were also increased.

Recent discussions have centered on how this interest rate hike suggested the beginning of a new credit tightening cycle. But researchers at Haitong Securities said the tightening already started last year. That’s when the PBOC increased the use of 14-day and 28-day reverse repos that carried higher interest rates than seven-day contracts.

According to Haitong Securities, the implied interest rates on six-month bankers’ acceptance bills have increased from about 2.4% in November to more than 4% in early February. Bonds yields have also increased significantly. Interest rates on mortgages and corporate loans are expected to grow under the circumstances because if they don’t, banks would be enticed to reduce loans and use the money to buy more bonds.

In January, the national average of interest rates on first-home mortgage loans edged up to 4.46%, marking the third straight monthly increase from October, the securities firm’s report said, citing statistics from industry data provider Rong360. Before that, the interest rate had declined for eight straight quarters.

The growth in mortgage loan interest will continue, the report said. “Similarly, bank loans to companies would be affected, resulting in higher interest rates.”

So why did the central bank official make it a point to emphasize the PBOC did not raise interest rates? This is part of the central bank’s strategy of telling the market it has no intention of actually causing interest rates on long-term bank loans to increase, according to Haitong Securities.

Many economists agree that China will not resort to more-radical measures to raise interest, such as changing the benchmark for bank lending rates. Many have argued that given the size of existing mortgages and corporate loans, even a small increase in loan interest rates may destabilize the banking system.

Yang Weimin, deputy director of the Leading Group for Financial and Economic Affairs, the ruling Communist Party’s top economic policy-making body, emphasized again in December the necessity to reduce corporate-sector debt. The cost of servicing existing debt alone exceeded 4 trillion yuan ($580 billion) at the least, he said, more than the entire growth in GDP from 2014 to 2015.

The PBOC is entering uncharted territory with its new way of influencing loan costs, researchers from Shenwan Hongyuan Securities said.

It is trying “for the first time in history” to guide interest rates using market-driven pricing tools, according to the company’s report. “The past offers no comparison” as to how the market may react and what follow-up action is required of the central bank, the report said.

Contact reporter Wang Yuqian (yuqianwang@caixin.com)


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