China’s monetary policy is undergoing a significant shift toward a Western-style system that focuses on short-term policy rates, even as fiscal policy is expected to play a larger role in boosting the economy.
This change is gradual. Over the past year, the People’s Bank of China (PBoC) has reduced reliance on the one-year medium-term lending facility (MLF) as a key policy tool. Instead, the seven-day open market operations (OMO) reverse repo rate has become the main policy rate.
Previously, China used a two-tier system with the seven-day OMO reverse repo rate for short-term policy and the one-year MLF rate for medium-term policy. This sometimes caused confusion and mixed signals in the markets.
To provide clearer guidance for short-term interbank rates, the PBoC is introducing a narrower interest rate corridor. This corridor uses overnight repo and reverse repo rates as the floor and ceiling. The DR001 overnight repo rate for depositary institutions has also emerged as a key short-term rate.
The MLF’s role as a liquidity tool has shown limits. Because it operates as a “pledged repo,” it locked many Chinese government bonds (CGBs) at the central bank, reducing tradable bond supply and slowing bond market growth.
In response, the PBoC resumed trading CGBs and launched outright reverse repos to manage liquidity more flexibly and reduce reliance on the MLF.
With a clearer short-term rate and a narrower corridor, China’s interest rate system is starting to resemble those of Western economies, like the euro area before the global financial crisis. This marks an important step toward modernizing PBoC’s policymaking.
However, challenges remain. First, while the lower bound of the corridor works well, the PBoC does not promise unlimited lending at the upper bound. Second, the connection between policy or interbank rates and actual bank lending and deposit rates is still unclear. Banks still rely heavily on “window guidance,” where the PBoC influences lending through direct instructions on deposit rates. Third, the PBoC’s open market operations are still developing, as shown by its recent pause in CGB purchases shortly after resuming them.
