PBOC Announces Elimination of the Original Lending Rate Floor

The People’s Bank of China (PBOC) announced the elimination of the original lending rate floor of 30% discount to benchmark, allowing banks to lend at any discount to benchmark lending rates as they see fit. The PBOC scrapped the cap on lending rates in 2004, and this move will fully liberalize lending rates for banks. Greater pricing flexibility will enable the banks to retain their privileged corporate customers in the wave of financial disintermediation.

However, given the gradual trend of liquidity tightening and the presence of substantial unmet credit demand, we expect the removal of the lending rate floor will have limited shortterm impact on the banking sector.¬†As Chinese banks scale back informal lending in response to the tougher policy stance and economic slowdown after the Shibor episode in June, we saw slowing credit growth and tightening liquidity in the market. Meanwhile, as we have yet to see meaningful progress in fiscal and financial reform to expand financing channels for corporate and local governments, credit demand from those unprivileged or unqualified borrowers remain underserved, thus boosting banks’ bargaining power over borrowers

On the other hand, banks have little incentive to lower lending rates significantly in the face of rising funding costs. Take one-year deposit and lending rates for example. Banks are offering one-year deposits at rates ranging from 3.2% to 3.24%, implying an 8% to 10% float above benchmark to compete with each other for funds. Returns on wealth management products (WMPS), which banks use as an effective tool to retain depositors and steal new deposits from rivals, stand at 4.5% on average, roughly on par with the one-month Shibor.

This is especially the case when many banks are reluctant to lend due to limited room to expand their loan books at the same time as dealing with tough capital ratios and loan-to-deposit requirements. It’s worth noting that even quality corporate customers are currently finding it difficult to negotiate lower bank lending rates as bond markets become more expensive.

After checking current market yields of over 200 corporate bonds trading on the Shanghai Stock Exchange, we found that bonds with yields lower than 4.2% (more than a 30% discount to the 6% lending benchmark rate) only account for 2% of total transaction volume, while bonds with yields between 4.2% and 5.4% (implying a 10% to 30% discount to benchmark) and bonds with yields between 5.4% and 6.6% (implying a 10% discount to the 10% premium to benchmark) represent 25% and 55% of total transaction volume, respectively. We believe the higher required return on investors’ capital is due to the public’s low investment confidence and inflation expectations in the face of a slowing economy and long-time heady credit growth. This is the primary reason why only a few corporate bonds trade at rates equivalent to more than 30% discount to benchmark.

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