China: A Major Step to Modernizing the PBoC’s Policymaking

While fiscal policy is widely expected to play a more vital role in reviving China’s economy, China’s monetary policy framework is undergoing a substantial transition towards a Western-style system that hinges on short-term policy rates.

This is not an abrupt transition, as the People’s Bank of China (PBoC) has taken a series of steps over the past year to de-emphasize the use of the one-year medium-term lending facility (MLF) as a policy tool, with the seven-day open market operations (OMO) reverse repo rate becoming the dominant policy rate.

Under the previous two-tier policy rate system, which featured the seven-day OMO reverse repo rate as the short-term policy rate and the one-year MLF rate as the medium-term policy rate, policy signals to markets were occasionally excessive or confusing.

To better guide short-term interbank rates moving around the policy rate and deliver unambiguous policy signals, a new and narrower interest corridor is being established, with interest rates for temporary overnight repo and reverse repo being the floor and ceiling, respectively, of the corridor. DR001, the overnight repo rate for depositary institutions, appears to have become a new targeted short-term interbank rate.

Moreover, the limitations of the MLF as a liquidity management tool have become too significant to overlook. Operating as a “pledged repo”, the MLF locked a substantial amount of CGBs at the PBoC, which has limited the supply of tradable bonds in markets and impeded the development of China’s bond markets.

Against this backdrop, the PBoC resumed its trading of Chinese government bonds and launched outright reverse repo to reduce its reliance on MLF for liquidity management.

With a clear short-term policy rate and narrower interest rate corridor, China’s interest rate corridor is starting to resemble those of Western economies, especially that of the euro area leading up to the global financial crisis. This transition is helping to modernize the PBoC’s policymaking.

Still, China’s monetary policy framework has much room for improvement. First, although the lower bound of the interest rate corridor is effective, the PBoC does not explicitly commit to unlimited lending at the ceiling of the corridor.

Second, the transmission from the policy rate or short-term interbank rates to bank lending and deposit rates remains unclear, and window guidance via setting major commercial banks’ deposit rates is still crucial for policy transmission.

Third, the PBoC’s open market operations are still in a formative stage, evidenced by its suspension of CGB purchases just months after its resumption.