The new LPR is calculated by taking an average of submitted rates from a number of contributing banks — not unlike Libor and its family of benchmark rates.
But those contributions and their average are expressed as a spread to another benchmark rate to give the final LPR. Critically, the People's Bank of China (PBoC) sets that underlying benchmark rate, called the medium-term lending facility (MLF).
For years, Chinese banks had only one benchmark rate for pricing loans: the PBoC's one-year lending rate. However, the rate has not changed from 4.35% since October 2015 when the central bank started to guide interest rates through open market operations.
As a result, China has developed two interest rate systems, operating out of sync with each other. One, the PBoC sets, which is unresponsive to market conditions; the other, a fluctuating market-based system that the banks use and over which the PBoC has little influence.
This has led to two related problems. The first is that there has been no market-based benchmark rate in the PBoC's arsenal. That in turn has made it difficult for the PBoC to transmit its monetary policy into the real economy through the banking system.
When the PBoC has lowered the MLF in an effort to stir up real economy lending, nothing happened. The MLF stands at 3.3% but most banks still will not offer loans for less than 90% of the one-year lending rate.
It is hoped that by abolishing the one-year lending rate and forcing banks on to the LPR, the PBoC will gain a useful monetary policy tool that bears some relation to what is going on in the lending market.
By basing the LPR rate on the MLF, the central bank has unblocked the transmission channel between monetary policy and market interest rates. Should the PBoC lower the MLF rate, which analysts agreed that it would soon do, the LPR should also move lower and bank lending rates with it.
Changing the MLF is easier than it was to change the one-year lending rate too. An alteration to the latter required the PBoC to embark on a long process of winning approval from the State Council, something it does not need in order to change the MLF, GlobalRMB understands from talking to onshore bankers.
While the PBoC has taken steps to ground one of its key policy rates in the real lending market, it should not be lost that it has also taken a much firmer grip on making sure its monetary policy aims are met.