In recent years, the dynamics of monetary policy in China have mirrored those of the European Central Bank (ECB) during periods of reserve scarcityAnalysts are closely observing the potential for the People's Bank of China (PBoC) to narrow the width of its interest rate corridor, which could lead to significant shifts in the country’s financial landscapeThis article delves into the evolution of interest rate corridors in major economies, examining their implications for China's own monetary policy framework.
In June 2024, at the Lujiazui Forum, PBoC Governor Pan Gongsheng highlighted the initial formation of an interest rate corridor in ChinaCurrently, the upper boundary is represented by the Standing Lending Facility (SLF) rate, while the lower boundary is determined by the rate on excess reserve deposits
Governor Pan indicated that a more refined approach to interest rate regulation may necessitate a moderate narrowing of this corridorThis move has sparked vigorous discussions in the financial community, especially following the establishment of temporary repos and reverse repos by the central bank on July 8, which some see as an attempt to explore new avenues in managing interest rates.
To grasp the significance of an interest rate corridor, it's essential to understand its frameworkSince the 1980s, central banks of major economies have shifted their monetary policy mediation goals from merely targeting money supply towards managing short-term interest ratesThis transformation has led to the establishment of explicit or implicit interest rate corridors, through which central banks guide short-term rates towards their target policy interest rates
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An interest rate corridor is defined by a permanent deposit tool and a permanent lending tool provided to commercial banks, establishing a reasonable interest rate range between the deposit tool rate and the lending tool rate to stabilize market rates.
The operational dynamics of this corridor are fascinatingWhen the market interest rates fluctuate within the corridor—specifically between the rates of SLF and excess reserve deposits—the central bank provides a stable supply of reserves to meet demandsHowever, once the rates reach the corridor boundaries, the central bank can supply or withdraw liquidity indefinitelyFor example, during times when demand for reserves is lower than the upper limit rate, the supply curve of reserves remains vertical, irrespective of the interest rate level.
Historical context further illustrates these dynamics
The ECB established its interest rate corridor mechanism upon its inception in June 1998, with a formal introduction in January 1999. The corridor's upper and lower limits were created through the deposit facility and the lending facility rates, respectivelyDuring the period leading up to the subprime crisis of 2008, the ECB's policies fostered an environment of reserve scarcity, allowing it to control liquidity through open market operations, keeping the market interest rates oscillating around its main refinancing rate.
In the U.S., a similar evolution occurred post-2008. The Federal Reserve raised its discount rate over the federal funds target rate, which adjusted the role of discount windows to manage only short-term needs, thus becoming an upper limit for their interest rate corridorUntil the financial crisis, the Fed didn't pay interest on excess reserves, meaning that the lower limit was effectively zero
This landscape drastically changed after the Fed introduced unconventional monetary policies, leading to a regime of ample reserves.
As liquidity surged post-2008, the Federal Reserve began to see shifting dynamics in their interest rate corridorThe introduction of interest on excess reserves incentivized banks to keep funds in reserve rather than lend them out, shrinking effective control over short-term interest ratesThe effective federal funds rate, therefore, began to breach the lower boundary of the corridorIn response, the Federal Reserve created new policy tools, such as the overnight reverse repurchase agreement, which established a new framework for the interest rate corridor.
The trends observed in these advanced economies present relevant lessons for China as it navigates its own monetary policy landscape
Currently, China's excess reserve deposit rate stands at a mere 1.5%, placing the country firmly within a regime of reserve scarcityThis correlates closely with the ECB's situation during its reserves-limited phaseWhile China made strides towards establishing its interest rate corridor after 2014, challenges such as excessive corridor width and weak adherence of policy rates to benchmark rates lingerIn the years from 2016 to 2023, the width of China's corridor fluctuated between 245 to 285 basis points, contrasting sharply with the relatively stable 200 basis points maintained by the ECB during its earlier years.
In a bid to refine its monetary policy management, the PBoC has initiated new repos and reverse repos in July 2024. The adjustment of the seven-day reverse repo operations to a fixed interest rate and quantity tender format is expected to enhance the precision of liquidity management, thus allowing better alignment of market interest rates with policy goals