How China's new interest rate reforms will work

China’s central bank pushed out long-awaited interest rate reforms on Saturday by establishing a reference rate for new loans issued by banks to help steer corporate borrowing costs lower and support a slowing economy.

The following explains how China’s new Loan Prime Rate (LPR), a central part of the reforms, will work.

WHAT IS THE LPR?

The LPR, originally introduced by the People’s Bank of China (PBOC) in October 2013, is an interest rate that commercial banks charge their best clients and was intended to better reflect market demand for funds than the benchmark the PBOC sets.

However, the LPR’s moves since its launch have generally not reflected those market dynamics with lenders typically reluctant to cut into their profit margins with lower rates and was little-watched by the markets. The one-year rate, for example, is currently just below the benchmark one-year lending rate of 4.35%.

Under the reforms announced on Saturday, the new LPR will be linked to rates set during open market operations, namely the PBOC’s medium-term lending facility (MLF), which is determined by broader financial system demand for central bank liquidity. Setting the LPR slightly higher than MLF rate will in theory give borrowers access to funds at rates that better reflect funding conditions in the banking system, providing a smoother policy transmission mechanism.

• Reuters