The dynamics of the banking system in China have been evolving, especially in how deposit and loan rates are regulated and adjustedOne significant factor that has emerged in recent discussions among economists and policymakers is the relationship between deposit rates, the Loan Prime Rate (LPR), and the Medium-term Lending Facility (MLF). As China remains within a monetary policy easing period, it has become increasingly vital to explore various tools for stimulating domestic demand and supporting the real economy.

At its core, China's interest rate system comprises two primary frameworks: the deposit and loan rate system, which involves banks as intermediaries, and the financial market interest rate system, which is influenced more broadly by market conditions and central bank policiesTraditionally, banks have relied on attracting deposits to fund their loan portfolios, adhering to set parameters governing both deposit and loan rates

However, recent reforms have aimed to enhance the market-driven nature of these rates, allowing banks greater freedom to set their own rates based on supply and demand.

The reform of interest rates began earnestly in the early 2000s, prompted by the 2003 meeting of the sixteenth Central Committee of the Communist Party, which called for a gradual shift toward a market-oriented interest rate formation mechanismThis process has unfolded in three distinct phases:

The first phase marked a significant liberalization in October 2004, allowing financial institutions to independently set the upper limit for loan rates while maintaining a lower limit for deposit ratesThis shift set the stage for more competitive practices within the banking sector.

In the second phase, which began in July 2013, a move toward self-regulation replaced administrative controls

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Banks were empowered to set their own loan rates, with some exceptions for certain types of loans like home mortgagesThis marked the cessation of the regulatory constraints that had previously characterized the sector, enabling a more fluid response to market conditions.

The third phase introduced the LPR in August 2019, which served as a benchmark for loan pricingThis reform was significant as it included the establishment of two key periods for LPR quoting, allowing for more responsive banking practices that better reflected the overall economic climateRates for loans were restructured to correlate with market trends, which included a shift to monthly updates and a broader range of quotation banks.

Despite these reforms, deposit rates have not been as responsive to changes in the LPR or MLF rates

For instance, the MLF is a critical tool for the People's Bank of China (PBOC) to manage liquidity and influence market ratesHowever, the interdependence between the MLF and the LPR is complexWhile MLF reductions typically lead to adjustments in the LPR, there have been instances where the LPR has shifted independently, suggesting that banks are also weighing their funding costs, demand for loans, and market conditions beyond what the MLF dictates.

For example, throughout 2023, banks made several reductions in deposit interest rates in a bid to restore profitability and maintain net interest margins amid tightening spreads between loan and deposit ratesThe six major state-owned banks adjusted their one-year fixed deposit rates below the benchmark in a landmark movement, reflecting a significant change in response to the ongoing economic environment and rising deposit demand among consumers.

As of early 2024, interest rates on loans adjusted downwards in response to the shifting dynamics of deposits, with the one-year LPR reducing to 3.45% after multiple adjustments

The significant distance between the deposit and loan rates highlights the broader challenges facing the banking sector as it attempts to navigate the current economic landscape.

Further complicating this scenario is the role of the financial market interest rate system, which includes various components such as bond and money market ratesMLF rates, for example, offer insight into the fundamental cost of borrowing for banks, while government bond yields serve as critical benchmarks that directly influence how banks establish their lending ratesIn practical terms, this single point of reference can significantly impact both the deposit and lending operations within banks.

Moreover, the emergence of financial instruments such as repurchase agreements and interbank loan rates has contributed to a more intricate and fluid banking environment

Institutions engage in these transactions not only to secure immediate liquidity but also to benchmark their rates against the prevailing market conditionsUnderstanding these relationships between different rates helps ascertain the overall health and stability of the financial system.

Moving forward, analysts argue that reducing deposit rates might be more effective in influencing the LPR more than adjustments in the MLFEvidence suggests that a modest reduction in deposit rates could yield significant savings in overall interest expenses for banks, far outpacing the effects of MLF rate cutsWith the expectation that stable loan demand will continue, banks may feel incentivized to lower their LPR quotes even in scenarios where MLF rates remain unchanged.

Nonetheless, the necessity of continued MLF reductions as a means to support LPR adjustments persists