China Insight: New LPR Mechanism is Bullish For Government Bonds

PBOC finally officially announced on 17th of August interest rate reform using the LPR (Loan Prime Rate) as a benchmark for new loans.

As per the announcement, eighteen banks are selected as LPR quoting members and each of them are required to submit one LPR quote for a 1-year period and one for a 5-year period to the National Interbank Funding Centre (NIFC) on the 20th of each month.

The submitted 1-year and 5-year LPR quotes must be in the form of basis points above 1-year MLF rate. NIFC will take the arithmetic average of the LPR quotes as the LPR fixings (one for 1-year and one for 5-year) after eliminating the highest and lowest quotes.

PBOC requests all commercial banks to use the LPR fixings as yardsticks to price their new lending and as the benchmark rates in floating rate loan contracts going forward.

The intention of the reform is to lower funding costs, thus we're not surprised by the arrival of first LPR fixings at 4.25% for 1-year and 4.85% for 5-year on 20 August, which were 10bp below the 1-year benchmark lending rate (or 6bp below previous LPR) and 5bp below 5-year benchmark lending rate (chart 1).

Given the growing risk of further economic slowdown, second LPR fixings will likely come in at lower levels.

In our view, PBOC will be lowering the funding costs by cutting MLF rates (which LPR fixings are based on) and coercing the eighteen LPR quoting banks to compress the premiums expressed as the submitted LPR quotes.

In our 17th July China Insight publication, we had already cited PBOC Governor Yi Gang as saying in late May that his colleagues are now investigating the possibility of not publishing the benchmark lending rate anymore. As such, we think the establishment of the market-based LPR mechanism implies PBOC's bias towards fading out the benchmark deposit/lending rates in the future.

In regard to Chinese onshore government bonds, we are confident that the downtrend of their yields will resume very soon because of two reasons:

1. We reiterate our view given In the 31 July issue of our China Insight publication: "Linking LPR to MLF or SLF rate will improve monetary policy transmission and lower SME borrowing costs. Obviously, it is aimed at helping SMEs get access to lower-cost funding. However, given SMEs' relatively weak credit quality, we think commercial banks eventually will invest more in bonds rather than substantially increasing loans supply to the SMEs".
2. A deputy PBOC governor has already stressed that the establishment of the new LPR would not help lower mortgage rates and that policymakers intend to maintain the mortgage rate at current level via window guidance to commercial banks. This message means commercial banks may have no choice but to pour more funds into the bonds as demand for home mortgage loans continued to be constrained in a falling interest rate environment.

We are bullish on China government bonds and expect the CGB 10-year yield (seen at 3.02% on Fri 23rd) will reach 2.85% before the National Day on 1 October (chart 2).

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