A Chinese flag hovers in the middle of traditional lanterns in the alleys of Beijing, China.
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China's central bank has changed the way commercial lenders set interest rates on loans – a move that is expected to lower borrowing costs at a time when the Chinese economy needs a boost.
Growth in China is declining as the US trade war appears to intensify in the coming months. The Chinese government has used both monetary and fiscal measures to boost economic activity, but analysts say certain parts of the economy can use more help.
"This is a welcome move to lower the cost of borrowing especially for smaller businesses, and it comes at an important time as China's GDP growth is likely to fall below 6% in 2020, as US tariffs on Chinese goods repeatedly is increasing, ”wrote analysts from Singapore’s United Overseas Bank in a Monday note.
The International Monetary Fund has estimated China's growth to be 6.2% in 201
Interest rate reforms
Unlike the US central bank, China's central bank – People's Bank of China – does not have a single primary monetary policy tool. Instead, PBOC uses several methods to control the money supply and interest rates in the world's second largest economy.
One of these tools is the loan interest rate – or the interest rate that banks require their most creditworthy customers. Beijing announced on Saturday that LPR will be revamped this month.
The changes include:
- Forcing commercial lenders to use the loan interest rate, instead of the reference loan rate, as a reference to the price of new loans.  Increase the number of financial institutions that can participate in submitting LPR offers, from 10 to 18 units.
- Set the loan price on the 20th of each month, instead of daily.
- Requires panel banks to link their LPR quotes to the medium-term lending facility (MLF), a financing facility PBOC extends to commercial lenders.
The mortgage interest rate, which was introduced in October 2013, was intended to reflect the market demand for funds compared to the reference rate – but this was not the case.
One reason is that many banks, in an attempt to protect their profit margins, refused to price their loans much lower than the reference lending rate – which has not been adjusted since October 2015. Given that the loan rate is charged to the best and least risky customers, became the unofficial minimum interest rate on bank loans in China.
Cheaper bank loans
PBOC has said the implicit undercutting of the bank's lending rates is "an important reason" that overall loan costs in China have not gone down, although other rates that are more sensitive to market demand and supply have moved down.
Another tool the Chinese central bank uses to adjust monetary policy is the medium-term lending facility. It is considered to be more aligned with the demand dynamics in China's money markets.
The one-year interest rate for the MLF was most recently around 3.3% – lower than the central bank's reference loan rate of 4.35%.
Linking the new loan rate to the long-term lending rate is expected to reduce the LPR, leading to a fall in overall loan costs.
It already has some effect. On Tuesday, the first day of the new reforms, the new one-year loan rate was set at 4.25% – down from 4.31% earlier; while the recently introduced five-year loan rate was set at 4.85% – below the five-year benchmark index of 4.9%.
It should theoretically lead to lower interest rates on new bank loans for businesses and households.  More effective monetary policy
For many years, Beijing has sought to change the way interest rates work in the economy. It wants to be more in line with the central banks' practice in large economies, which mainly adjusts the interest rates on short-term funds to influence borrowing costs in the broader economy.
China maintains a so-called command economy – or a centrally planned economy, where the central bank dictates where the interest rates for bank loans and deposits should be.
But as the Chinese economy opens up and increasingly connects to the global marketplace, PBOC has over the years given commercial lenders more leeway in setting interest rates.
However, banks preferred to use PBOC's reference rates as a reference to price their loans – and limited the flow of monetary policy changes to the broader economy. But recent interest rate reforms could make monetary support more effective at a time when the Chinese economy is being challenged by the US trade war
"This change does not automatically reduce interest rates, but it sets the stage for PBoC to achieve it," French analysts wrote the bank Société Generale in a Sunday note. "We believe that PBoC will try hard to get lower interest rates through the new system because the economy is in dire need of more monetary policy support."