Opinion: The Time is Right to Deepen Interest Rate Marketization

The People's Bank of China (PBOC) has highlighted the ongoing progress in interest rate marketization reform within its Second Quarter 2024 Monetary Policy Execution Report. This report underscores the priority placed on deepening interest rate marketization, revealing that two of its five columns focus directly on this subject, indicating the strategic importance the monetary authorities assign to it [para. 1].

Interest rates, as the price of capital, play a crucial role as a market signal. Without market-based interest rates, efficient resource allocation becomes difficult. This fundamental stance was reaffirmed at the 20th Third Plenary Session. Over the past 30 years, substantial progress has been made in this area, but a framework enabling a high-level socialist market economic system remains essential to fully leverage these reforms [para. 2].

Initially viewed as incremental, interest rate marketization reform was outlined during the 14th Third Plenary Session of the Communist Party of China. It has since progressed through various key milestones: lifting caps on lending rates and floors on deposit rates in 2004, removing controls on lending rates in 2013, and finally abolishing controls on deposit rates in 2015. These steps reflect a gradual and well-regulated approach to reform [para. 3].

The market-based pricing of deposit and lending rates has been largely achieved. Institutions now independently set these rates, with deposit rates primarily adjusted by the institutions themselves and lending rates forming the loan prime rates (LPRs), the main pricing benchmark for floating-rate loans. These achievements have led to the general marketization of commercial loan rates [para. 4].

Despite this progress, the reform journey continues, with evolving macroeconomic conditions necessitating continuous effort from policymakers [para. 5]. The current macroeconomic context, characterized by insufficient effective credit demand and low net interest margins for banks, suggests that further marketization will not likely trigger instability in deposit and lending rates [para. 6].

A key focus of ongoing reforms is transitioning from a quantity-based to a price-based monetary policy approach. Central to this is the policy rate status of the 7-day reverse repo rate used in open market operations, which will now adopt a fixed-rate quantity bidding system. Additionally, improving the LPR mechanism is targeted to enhance interest rate transmission and reduce the policy implications of the medium-term lending facility (MLF) [para. 7].

The report also emphasizes the need to dismantle outdated competitive restriction policies, urging financial institutions to enhance their pricing capabilities while promoting self-regulation, standardizing market competition, and maintaining market order [para. 8].

Emerging challenges, such as the macroeconomic implications of a downturn in long-term rates and risks in an asset-short market, must be managed. Regulatory authorities aim to mitigate sharp short-term price signal declines through regulation while addressing market conditions than enhance the effectiveness of market price formation mechanisms [para. 9][para. 10].

Market participants must become modern enterprises with clear property rights, responsibilities, and scientific management to accurately reflect the supply and demand of funds. Clarifying the market-government relationship and eliminating soft budget constraints are essential to ensure smooth transmission from policy rates to market rates [para. 11].

The deepening of interest rate marketization reform has driven other reforms over the past three decades. However, these reforms require more systematic and profound changes to continue progressing [para. 12]. The central bank's renewed focus on this reform as a key priority indicates a commitment to embedding reform within regulatory practices, ensuring continuous advancement toward building a high-level socialist market economy [para. 13].