China's central bank wants to shift its policy framework to target the cost of credit rather than its size, but liquidity risks and uncooperative markets are making it difficult to transition the economy away from state-directed bank lending.
The goal of giving markets a more prominent role in allocating resources was restated at a roughly twice-a-decade Communist Party leadership meeting in July and the People's Bank of China (PBOC) is expected to play a major role in the reforms.
In recent months, the PBOC has taken steps towards creating a more market-driven interest rate curve, and it is expected to make further changes so that credit demand is more responsive to monetary policy moves.
Longer-term, regulators hope these changes can also lead to the development of capital markets as an alternative source of financing, reducing the risk of wasteful investment by a state-dominated banking system.
But a slowing economy, still heavily reliant on state-led infrastructure investment for growth and in the middle of modernising its industrial complex, has significant liquidity needs. Markets may be unwilling to provide funding in ways the PBOC considers beneficial for national development goals.
In a recent tug-of-war between the PBOC and bond markets, safety flows into bonds pushed down government debt yields to levels that signal bearish bets on China's growth outlook.
"The PBOC will continue to gradually reform its monetary policy framework towards the type adopted by major central banks globally. However the changes will be slow," said Louis Kuijs, Asia Pacific chief economist at S&P Global Ratings.
The PBOC has shifted towards targeting the short end of the interest rate curve and announced plans to gradually increase bond trading to influence long-term borrowing costs, but more steps are needed to improve its policy transmission.
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