China's LPR Reform and Its Significance

China's LPR Reform and Its Significance – Pan Deng's Notes on Macroeconomics

Two Reforms of LPR

LPR: The lending rate charged by commercial banks to their best customers

LPR has undergone two reforms in my country, one in 2013 and one in 2019

	year 2013	2019
Quotation basis	Loan benchmark interest rate	MLF
quote line	10	18
Calculation	Weighted average	Arithmetic mean
term variety	1-year LPR	1-year, 5-year LPR
Quote frequency	daily	per month

The LPR reform in 2013 was not thorough, because at that time, in order to stabilize the market, the loan benchmark interest rate existed for a period of time, but each quotation bank still referred to the loan benchmark interest rate, so LPR and loan benchmark interest rate were highly correlated, market-oriented The level is not enough, even equal to the benchmark loan interest rate;

In the LPR reform in 2019, the benchmark loan interest rate has been cancelled. LPR is generated by adding points to the MLF (Medium-term Lending Facility). At the same time, two city commercial banks, rural commercial banks, foreign banks and private banks have been added; at the same time, the frequency of quotations has been reduced. Increased quotation varieties; and incorporated the application of LPR into MPA (macro-prudential assessment system)

Why LPR reform is needed

The transmission path of interest rates in my country, due to the obstruction of the transmission of inter-bank interest rates to loan interest rates, has been guiding the loan interest rate through the loan benchmark interest rate, so that the loan benchmark interest rate and the policy interest rate have formed a dual-track system, and the LPR reform is to break this dual-track system;

Let’s talk about the poor transmission of inter-bank interest rates to loan interest rates. Let’s first look at the process of smooth transmission

• For enterprises, there are two financing methods (one is to borrow from the bank, and the other is to issue bonds in the bond market)
• When the bank's overnight lending rate falls, banks are more willing to use funds to buy bonds in the bond market instead of lending to other banks, so that the yield in the bond market will drop, and the cost of financing with bonds will drop, and companies will choose bond financing instead of lending to other banks. Bank loan;
• The number of enterprises borrowing from banks decreases, and the loan interest rate naturally decreases;

This is the process of smooth transmission of interest rates, but the possible reasons for the poor transmission of interest rates in my country

• The bond market is not developed enough, and companies cannot issue bonds in the bond market at will. Even if the inter-bank interest rate falls, the number and amount of loans to enterprises will not change, and the loan interest rate will remain high.
• But inter-bank interest rates can affect bond market yields, but bond market yields cannot react to loan interest rates

Significance of LPR Reform

1. Accelerate the promotion of interest rate liberalization
2. Dredge the currency transmission mechanism and reduce loan interest rates
   • The traditional LPR was launched as early as 2013, but because it refers to the benchmark lending rate, its trend is highly related to the benchmark lending rate. If the central bank does not lower the benchmark lending rate, the LPR will remain unchanged. The traditional LPR has not been marketized, which led the central bank to lower the policy interest rate in the past, but it could not drive down the loan interest rate. After the LPR reform, the reduction of the MLF interest rate by the central bank can lead to the reduction of the LPR, which in turn leads to the reduction of the financing rate.
3. Maintain a prudent monetary policy and no longer flood the monetary policy
   • In the past 10 years, when faced with economic recession and choosing to stimulate the economy, monetary policy has basically been flooded with ideas, such as lowering the benchmark interest rate, which is a comprehensive and substantial interest rate cut. But loose monetary policy is not a panacea, and the sequelae of large-scale loosening are becoming more and more obvious. For example, the bubble in the real estate market has led to high debts of residents and squeezed residents' consumption.
4. Isolate mortgage interest rates and achieve "asymmetric interest rate cuts"
   • Usually, when the economy goes down, the real estate market is loosened. The real estate regulation is also tight for two years and loose for three years, but this time the rhythm of the real estate regulation is obviously different. After the LPR reform, a new 5-year LPR interest rate is added, which can achieve asymmetric interest rate cuts. The five-year LPR lowers interest rates significantly less than the one-year LPR. This can effectively prevent and control the flow of funds to the real estate market and avoid stimulating real estate again.
5. Increase competition in the financial market and reduce financing costs for enterprises
   • Eight new commercial banks of various types have been added to the LPR quotation, making the LPR quotation interest rate more market-oriented, promoting competition among financial institutions, thereby reducing the financing cost of real enterprises, and enabling the financial system to better support the development of the real economy.
6. Improve the operation and management capabilities of commercial banks, and strengthen the transformation and upgrading of banks
   • The future purpose of the central bank is very clear. How to reduce the financing rate of the real economy in the future? On the one hand, the central bank has taken the initiative to lower policy interest rates, and on the other hand, commercial banks are required to lower their interest rate margins. This will force commercial banks to improve their operational management capabilities, improve bank efficiency, and accelerate the transformation and upgrading of banks.