China to base new lending benchmark on medium-term rates; shares rally on rate cut hopes

(Adds Moody's comment)

By Kevin Yao and Samuel Shen

BEIJING/SHANGHAI, Aug 19 (Reuters) - 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.

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 has guided down short-term rates, 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 banks' actual lending rates, as they could still charge higher rates on riskier loans to smaller, private firms while giving state firms better terms.

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.

"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.

Despite economic growth nearing 30-year lows, analysts believe the PBOC is reluctant to cut interest rates system-wide due to fears of a further surge in debt and possible property bubbles. It last cut the one-year lending rate in 2015.

The market's focus will be on where the new LPR is set on Tuesday. The national interbank funding centre will publish the reference rate on the 20th day of each month thereafter.

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.

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."

MARKET-BASED REFORMS

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%.

Chinese banks' new LPR quotations will be based on open market operations, the PBOC said over the weekend.

Banks will set rates on new loans by referring to new LPR rate, but existing loans will still follow the original contracts that were signed in line with the benchmark lending rate, the central bank said.

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 liberalisation, and the link to the medium-term lending rate may only be temporary.

"The current liberalisation 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."

Rating agency Moody's said in a report on Monday that the rate reform could be negative for Chinese banks' profitability due to narrower lending margins.

"Because of current market conditions, the implementation of the new LPR loan pricing mechanism will directly weigh on bank rates on new loans and lower their net interest margins," Moody's said.

"We expect that the banks with large loan exposures due for re-pricing in the near-term will be more immediately exposed. " ($1 = 7.0464 Chinese yuan)

(Additional reporting by Beijing Monitoring Desk, Winni Zhou and Luoyan Liu; Editing by Sam Holmes & Kim Coghill)

First Published: 2019-08-19 07:59:22
Updated 2019-08-19 12:49:33


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