Summary and Policy Implications

2.5.1 Major findings

Section 2.4 provides detailed answers to our research questions. The empirical results indicate 2-3 structural changes in the SHIBOR and interbank repo rates at June 2008, January 2011 and June 2013 respectively. The structural change in 2008 was likely related to the 2007-2008 global financial crisis, while the structural changes in 2011 and 2013 could be attributed to the PBOC’s announced or unannounced operational changes during these years. The four interbank interest rates reacted differently to the PBOC’s

deposit benchmark rate and RRR adjustments following each structural change, but remained unresponsive to OMOs even after the most recent structural change, except for their volatility. Following the structural break in June 2013, the linkage between the interbank rates and the deposit benchmark rate weakened and the linkage between the interbank rate and RRR strengthened. The discrepancies between the overnight rates and the 7-day rates in terms of their reactions to the policy instruments mainly presented before the January 2011 structural change, while the discrepancies between SHIBOR and the repo rates of the same maturity mainly appeared after the January 2011 structural change. Particularly since the 2013 structural change, the negative spread between SHIBOR and the repo rates widened whenever the deposit benchmark rate was lower by the PBOC.

2.5.2 Key implications for policy makers

a. Any insights provided by empirical studies on China’s interbank interest rate based on pre-2011 data should be viewed with caution in guiding current or future policies due to structural changes.

b. The PBOC’s benchmark interest rates seem to be an effective tool to guide the interbank interest rate, but their impact dropped significantly following the relaxing of restrictions on the interest rates of bank loans and deposits. As the PBOC eventually raises the deposit rate ceiling to an extent that it is no longer a binding restriction for banks, the deposit benchmark rate might become obsolete, which is a sign of progress for the transition of the interest system. It also means that the PBOC will have to rely more on the remaining instruments such as RRR and OMOs to maintain control over the short-term interest bank interest rates. Currently, RRR seems to be the preferable instrument to guide the interbank interest rate, because the interbank interest rate became more responsive to changes in RRR since the implementation of variable reserve requirement in 2011 and the “SHIBOR shock” in 2013. Yet, using RRR as the primary instrument to influence the

interbank interest rate has its own limitations. According to Ma, Yan and Liu (2011), the range the PBOC can adjust RRR depends heavily on the scale of its foreign exchange interventions, because RRR is its main foreign exchange sterilization tool. Meanwhile, according to the same study, increasing RRR adds cost to financial intermediation, because it is an implicit tax burden imposed on banks. In order for OMOs to become a price signal for the interbank market rather than merely a remedy for market volatility, the PBOC may need to explicitly specify a rate target for its OMOs. For example, it can

choose a SHIBOR rate of a specific maturity as its target rate. He and Wang (2012) found that certain market interest rates were responsive to the PBOC’s repo issuance rates. Yet,

it is difficult to use the interest rate on the PBOC-issued repos as a direct price signal, because the PBOC repos have different maturities and their rates can be determined by either a price auction based on a preset quantity or a quantity auction based on a preset interest rate.

c. The 7-day SHIBOR and interbank repo rates seem to be preferable to the overnight rates for the role of market benchmark rates. After the structural change in January 2011, the 7-day rates generally moved in the same direction as the PBOC’s policy instruments, making them better signals for the PBOC’s policy intentions. However, the rather high

volatility in the 7-day rates might make them too noisy to serve as benchmark rates, which demands further attention from the PBOC.

d. The widening negative spread between SHIBOR and the repo rates as well as the discrepancies between their responses to adjustments in the deposit benchmark rate after the structural changes in 2011 and 2013 signaled increased market segmentation between two interbank markets as well as strengthened market power of the large state-owned banks. This situation could be a threat to China’s finance sector and a complication for the PBOC’s monetary transmission via interest rate channel. The negative risk premium of

the SHIBOR over the repo rate indicated that the risks in the two interbank markets were not priced correctly, potentially resulting in extensive price distortions among the debts and financial assets that track the SHIBOR or repo rates. Meanwhile, substantially different or even opposite reactions between SHIBOR and repo rates to the deposit

benchmark rate adjustments since 2011 suggested that the PBOC’s price signals might be transmitted unevenly in the two interbank markets, making it more difficult for the PBOC to achieve its policy goal with the benchmark rate instrument. Cassola and Porter (2013) suggested that removing the divisions in the bond market, strengthening existing standing facilities and liberalizing financial prices could address the anomalies between the unsecured and secured rates. There are also other potential measures to eliminate the interbank market segmentation and counter the market power of large banks, such as allowing more financial institutions to participate in the unsecured market and removing the deposit rate ceiling for small regional banks before doing so for the large national banks.