China's Central Bank Embarks on Historic Monetary Policy Overhaul

China's central bank is planning a major shift in its monetary policy, moving towards a more internationally aligned system based on interest rates, the Financial Times reports. This move aims to bring China's monetary policy closer to the practices of central banks like the US Federal Reserve and the European Central Bank.

In comments to the Financial Times, the People's Bank of China (PBoC) indicated that it would likely cut interest rates from the current level of 1.5 percent "at an appropriate time" in 2025. Furthermore, the PBoC intends to prioritize "the role of interest rate adjustments" and phase out "quantitative objectives" for loan growth. This represents a significant departure from China's traditional monetary policy approach.

Unlike most central banks, which primarily utilize benchmark interest rates to influence economic activity, the PBoC has historically employed a broader range of policy instruments, including setting numerous interest rates and providing informal guidance to banks on loan expansion. While this approach was instrumental in driving economic growth in sectors like manufacturing, technology, and property, PBoC officials now recognize the need for reform.

"Rate reform is likely to be the true focus of the PBoC in 2025," said Richard Xu, chief China financial analyst with Morgan Stanley, to the Financial Times. "China's economic development urgently needs to shift from a mindset focused solely on expanding the market size [of banks' loan books]."

The PBoC's decision to prioritize interest rates stems from several factors, including the prolonged slowdown in the property market, which has led to a sharp decline in credit demand. The central bank is also concerned that credit growth targets encourage indiscriminate lending, potentially leading to long-term financial risks.

"Aligning with the requirements of high-quality development, these quantitative targets have been phased out in recent years," stated the central bank. "The PBoC will pay more attention to the role of interest rate control, and improve the formation and transmission of market-oriented interest rates."

This shift towards a more interest-rate focused policy could help curb overcapacity issues in China that have contributed to bad debts and disrupted global industries. However, the PBoC faces challenges in implementing this change, as the government continues to prioritize lending to high-tech and manufacturing sectors, which is easier to manage under the old system.

Despite the planned shift, the PBoC remains under pressure to stimulate China's economy, having already cut key interest rates twice in 2024 as part of a broader stimulus package.

The central bank is also taking steps to align its policy with international practices, such as purchasing government bonds in the open market to inject liquidity, a practice similar to the Fed's actions. However, analysts note that the PBoC still lacks certain elements essential for a fully interest-rate based system, such as a clear schedule for policy decision-making meetings.