Illustration: Luo Xuan/GT

The People's Bank of China (PBC), China's central bank, has decided to improve the formation mechanism of the loan prime rate (LPR), which was launched in 2013. The rate reforms aim to lower the financing cost for businesses and promote a market-oriented interest rate. Many have painted it as another monetary easing measure under a different name. 

Indeed, the rate reform is expected to lower the real lending rate to some extent since the new LPR quotation will be based on the PBC's open market operations - especially the medium-term lending facility (MLF), which is at around 3.3 percent for the one-year MLF - then adding certain percentage points. In contrast, the PBC's one-year benchmark lending rate, which has not been changed since October 2015, is 4.35 percent; the LPR rate followed closely at 4.31 percent until Friday. 

However, it does not mark the opening of the floodgates. Against the backdrop of an economic downturn and monetary easing worldwide, the US Federal Reserve cut the short-term interest rate by a quarter of a percentage point at the end of July. There have been heated debates over whether the central banks in the UK, the EU and Japan should lower interest rates accordingly. 

China is also under pressure from the global easing cycle, but the PBC has been keeping a prudent monetary policy. The one-year LPR was quoted at 4.25 percent and five-year LPR was quoted at 4.85 percent on Tuesday, which was a mild change. Moreover, it would be risky for the central bank to let out a great deal of liquidity, as the consumer price index has been increasing for five consecutive months. The LPR is conducive for lowering the lending rate and channeling liquidity to small and medium-sized enterprises (SMEs) to stimulate the real economy. To make sure that the liquidity goes in the right direction and will not get out of hand, China has reiterated putting a tight grip on the housing market. 

To better represent various demands, the PBC expanded the quotation banks from 10 to 18 and further diversified the members, including urban commercial banks, rural commercial banks, foreign-backed banks and private banks. The move will not only introduce broader participation by multiple players in the banking industry; it will also inject vitality into the market. 

There is no doubt the LPR reform is good news for mobilizing the stock market. The LPR reform together with the postponed tariffs on the US side and newly released guidelines for  building Shenzhen into a pilot demonstration area of socialism with Chinese characteristics pushed A shares up on Monday.

However, the performance of banking stocks on the A-share market suggested the LPR has put some weight on banks, with the expectation they will lose some profit to enterprises. 

Almost six years have passed since the LPR was first introduced. The rate has followed the PBC's benchmark rate closely since then, which indicates the commercial banks' lack of motivation to quote according to their situations. 

Small commercial banks are mostly following the benchmark rate or taking concerted actions through setting up an interest rate floor to keep the rate high for the borrowers. The new LPR, which is set to replace the benchmark interest rate, leaves more leeway for the market to play its role in forming lending rates. This might benefit large banks and those with sufficient capital. 

After several bailout cases like Baoshang Bank, Bank of Jinzhou and Hengfeng Bank, small commercial banks have gained more awareness of their liquidity situation and become more risk averse. Some urban and rural commercial banks may face a dilemma over whether to lower the rates.  

The rate reform is also being launched to boost the efficiency of monetary policy transmission, so that the financing difficulty faced by SMEs will be assuaged. 

In order to achieve the goal, the LPR has to be up for further improvement. The loan rates are closely related to the yield on deposits. The MLF is not based on the deposit interest rate and is distorted. When the deposit interest rate changes, a question will arise as to whether or not the LPR reflects the change.

The rate reform is an important step toward a more market-oriented interest rate. Its effects for boosting the economy are clear, given the expectations of lower interest rates. It will help SMEs with their financing and make monetary policy more effective, but efforts are needed to further improve the LPR. Other measures, such as fostering private banks and refining the system for the private firms to issue bonds, should also be considered to address SMEs' financing difficulty.

The author is a reporter with the Global Times. bizopinion@globaltimes.com.cn