PBoC lowers SLF rates in move to build a new policy framework

The PBoC cut its overnight and 7d SLF rates in a move to anchor market interest rate expectations ahead of the resumption of IPOs next week. The central bank announced yesterday that it would lower the rate charged by its standing lending facility (SLF), effective 20 November. Introduced by the PBoC in 2013, the SLF is a targeted liquidity management tool the PBoC uses to provide short-term loans to banks during times of tight liquidity and spikes in interbank rates. More effective SLF operations should help to reduce interest rate volatility and prevent liquidity risks. By lowering the SLF rates, the PBoC is signaling that it is committed to keeping short-term rates stable and low ahead of the resumption of IPOs next week, which have been suspended since the July stock market crash.

The move has more signaling value than real impact; the cuts mostly catch up the decline in market rates. The SLF rate cuts lower the overnight SLF rate to 2.75% from 4.5%, and the 7d SLF to 3.25% from 5.5%. It is believed that the PBoC has not conducted any SLF operations since March 2015, so the seemingly significant cuts to SLF rates were necessary to bring them into line with the policy rate and market rates, which have fallen notably. For example, the 7d reverse repo rate has been guided down to 2.25% in October from 3.75% in March, and the 7d repo rate, has fallen more than 200bp, to 2.3% currently from ~4.5% in March.

The cuts also mark the PBoC's latest effort to build a new monetary policy framework. The PBoC has been trying to build a market-based, short-term policy interest rate in recent years as it gradually liberalizes bank lending and deposit rates. The final lifting the deposit rate ceiling in October meant that the 1y benchmark rates will be more indicative than effective tools to conduct monetary policy. With the PBoC transitioning to a new monetary policy framework, the SLF cuts represent its latest efforts to create a more effective ceiling for an interest rate corridor.

"We believe the PBoC's new regime could consist of a key policy rate and an interest rate corridor, similar to the ECB. The corridor would center on an implicit or explicit short-term policy rate (eg, the 7d repo rate), with the SLF rate acting as the ceiling, and the interest rate on banks' excess reserves (currently at 0.67%) as the floor.  We expect the PBoC to undertake  further efforts to improve its SLF and RRR operations as it refines the ceiling and the floor of the interest rate corridor", says Barclays.

A recent PBoC working paper suggests three steps in developing the "interest rate corridor."  On 17 November, the PBoC research department published a working paper recommending that China set up an interest rate corridor to reduce interest rate volatility, better guide market expectations and reduce the banks' liquidity hoarding. The paper outlined a three-step approach: 1) set up a de facto rate corridor around an implicit policy rate without announcing the rate itself; 2) narrow the corridor so that the market gradually builds expectations that one short-term rate will become the policy rate and banks start to price from that rate; and 3) abolish benchmark lending and deposit rates and announce the new policy framework pegged to a short-term policy rate.

"We continue to expect more cuts in the benchmark interest rates in the coming months. Before the new regime is fully implemented, we think benchmark rates remain important in guiding the cost of financing lower. Therefore, we continue to forecast two more 25bp benchmark rate cuts in H1 16, given that we expect GDP growth to slow towards 6%. In view of October's disappointing data, we believe a December reduction in benchmark rates cannot be ruled out if November economic data (to be released on 12 December) deteriorate more than expected. We also look for one more 50bp cut in bank' reserve requirement ratio in Q4 15 and two further RRR cuts in H1 16, given our expectation of persistent capital outflows and the PBoC's preference to try to stabilise USDCNY",added Barclays.