China Plans To Liberalize Interest Rates And What This Means For The Yuan
The Chinese government, through the People's Bank of China (PBOC), recently announced that it plans to liberalize its interest rate system possibly before the end of 2019.
The decision to liberalize interest rates is part of a long-term effort aimed at reducing the level of government control on the Chinese economy. It, in turn, aims to hand over most of the control to the markets.
Central banks in most countries have significant control over the value of money in their economy by controlling the interest rates. For example, the PBOC sets a one-year lending rate that governs commercial loans, business lending, and mortgages.
It also has a 7-day reverse repo interest rate that controls interbank borrowing. The Chinese government wants to do away with this system.
How China plans to phase out interest rate control
China's government believes that a one-year rate is an outdated tool for steering the modern economy, which is characterized by excess debt. Measures such as interest rate cuts lead to increased risks of other economic problems such as financial bubbles, property market bubbles, and more inflation.
The PBOC now wants to give the financial sector a chance to steer the direction of the economy.
The PBOC will eliminate the current one-year lending rate, but the benchmark deposit rate will remain. Sun Guofeng, the director of the monetary department at PBOC, believes that the prime rate might offer a better yardstick for determining bank loan costs.
The impact of the interest rate liberalization on the Yuan
The interest rate liberalization process could lead to the introduction of freely-quoted interest rates that banks will offer to customers. Consequently, this will get China closer to achieving a free-floating yuan.
FXStreet analysts do not believe that the introduction of an interest rate system, that is based on bank competition, will heavily influence the USD/CNY performance.
The USD/CNY still relies on daily fixing for guidance, and the analysts do not see a need to change their current estimates about the currency pair. The analysts expect the USD/CNY to close 2019 at 7.10.
Investors have responded to the announcements about China's interest rate liberalization based on the USD/CNY currency pair’s performance. The currency pair closed Friday’s trading session at 7.0429 and opened on Monday’s trading session at 7.0393.
However, the currency pair then embarked on a bullish trend that saw the price surge to a high of 7.0507 by noon.
The bullish charge on Monday might be attributed to investor sentiments that the move by the PBOC will contribute to the Yuan’s further decline.
The announcement about the interest rate liberalization also comes amid the ongoing trade war between China and the U.S. The failure of the two companies to agree on a trade deal has also been a significant factor affecting the currency pair's performance.
The recently announced changes may further weigh in on the Yuan’s weakness due to the ongoing uncertainty about how the changes will affect the Chinese economy and the local currency.