Is China's Central Bank Losing its Monetary-Policy Mojo?

A widening gap between official and market interest rates in China is making it harder for Beijing to use a key policy tool to manage the world's second-largest economy.

Short-term interest rates in China's money market have persistently been above those set by the central bank in the past year, as investors and banks spooked by the government's crackdown on the country's high levels of leverage have charged more to lend both to each other and external borrowers.

Following a relatively calm summer, the gap has started widening again in the past two months.

The interest rate the People's Bank of China sets on its benchmark seven-day repurchase agreements, its de facto policy rate, has stayed unchanged at 2.45% since March. Meanwhile the corresponding repurchase agreements, or repo, rate that banks charge each other for their own seven-day loans, has risen to 2.93%, from 2.57% just before the PBOC's last rate increase in March.

In the U.S. and other major Western economies, central banks set their policy rates on similar money-market loans, usually made to major financial institutions. These then feed through to the rest of the economy, indirectly determining the interest rates on deposits, mortgages, corporate loans and bonds.

If market rates persistently stay unhinged from policy rates, as is happening in China now, it can weaken a central bank's ability to effectively convey its monetary policy. For example, if market actors are charging much higher interest rates than the central bank wants, it can slow down the economy.

The rising borrowing costs in China have come against the backdrop of an economy that has been cooling in recent years from its once-breakneck growth rates. Inflation in the country, meanwhile, is relatively tame as well.

"If you are a bank in China, you don't really know which rate you will be able to borrow at in three months' time. The PBOC is creating unnecessary volatility of funding costs," said Julian Evans-Pritchard, a Singapore-based economist at Capital Economics.

Some observers say China's central bank has in the past tried to keep market interest rates closer to its intended policy rate by actively managing the supply of cash in the financial system. If market interest rates rose too high, for example, it would flood the system with extra cash by way of a daily auction of repo loans--ranging from seven to 28 days in duration--to a select group of large banks and brokerages.

The central bank was particularly active in trying to tame market interest rates in the 12 or so months after October 2015, economists say, when China was reeling from a series of sudden stock market crashes.

That period of stability lasted until September 2016, when Beijing started intensifying efforts to reduce financial risk in the economy. That in turn drove up borrowing costs for small banks and brokerages, which had been borrowing aggressively to speculate on the country's bond market.

The central bank responded to the increase in market rates by raising its official seven-day repo rate in February and March. In a rare statement explaining its decision in March, the central bank said the deviation of market rates from official rates could create "unfair" opportunities for banks to profit from the rate gap.

"In a normal system, the central bank's policy rate ought to be the ceiling of market rates and it would prevent the latter from rising above it by unleashing an unlimited amount of liquidity," said Zhou Hao, a Singapore-based economist at Commerzbank AG.

Economists say the PBOC appears caught in a bind. It is reluctant to raise the official repo rate again due to the strong policy tightening signal such a move carries. Beijing's effort to cut financial risk also doesn't allow it to push rates back down by flooding the markets with liquidity as it did before.

"I do think we've seen a step backward in the way PBOC conducts monetary policy... It's more ambiguous now and it's difficult to judge PBOC's intention just by looking at the movement of interbank rates," said Capital Economics' Mr. Evans-Pritchard.

The widening rate gap has also worsened the anomaly that the PBOC criticized in the March statement: interest-rate arbitrage by banks.

Because only a select group of banks and brokerages have access to PBOC's cheap repo loans, they can easily profit by re-lending those funds to smaller banks, brokerages and fund managers at much higher rates.

A review of third-quarter financial results shows that five of China's top six banks have increased the amount of their repo loans to other money-market participants to varying degrees. China Construction Bank Corp., which was the most aggressive, more than doubled the outstanding value of its repo loans from a year ago to 207.70 billion yuan ($31.43 billion) as of Sept. 30. The Agricultural Bank of China Ltd.'s repo lending jumped by 68% in the same period.

Even smaller banks that don't have access to the PBOC's repo loans can still borrow from fellow banks for seven days at about 2.93% and lend to nonbank institutions at a lucrative 4.04%.

"As long as they use bonds as collateral, we are willing to lend to the likes of brokerages. It's a great business," said a senior executive at a rural bank based in the northeastern city of Dandong.

Write to Shen Hong at

(END) Dow Jones Newswires

November 30, 2017 06:26 ET (11:26 GMT)