Chinese banks set for mass loan repricing

This is China’s Libor moment: lenders are preparing to reprice millions of loans across China, and this month the market will gain access to options to help them manage the interest rate risk.

The country’s central bank has already been pushing banks to price new floating rate loans using the country’s loan prime rate (LPR) – which was reformed last August – but from March financial institutions will have to begin the arduous task of switching over their existing floating rate loans to the new benchmark. And they will have only a few months in which to do so: the process must be completed by the end of August.

“It’s a huge task for many of the local regional banks and it’s going to focus everyone’s attention on the need to manage their risk,” says a manager at a brokerage firm that has worked with a number of Chinese rural banks on the forthcoming switchover.

It is difficult to estimate what proportion of these loans will need to be relinked to the LPR, since some conversion may already have taken place and, besides, not all of these loans may be floating rate. Counterparties will also have the option of renegotiating floating rate loans as fixed rate, rather than relinking to the LPR.

Previously, the lending rate was set by the People’s Bank of China and linked to the central bank’s one-year medium-term lending facility, but last year the authorities started encouraging lenders to use the more market-based LPR, which was first introduced in 2013. Since December, financial institutions have been required to price at least 50% of new loans using the LPR; from March this will rise to 80%. The LPR now underpins more than 90% of new loans, officials say.

“China has started to change its previous two-tier benchmark system; the country will soon have all the corporate lending by banks – which accounts for more than 80% of the nation’s lending – on market-based benchmarks,” says CG Lai, chief executive of BNP Paribas China. “Once China completes liberalisation of the domestic interest rate system then you will see the domestic interest rate becoming the largest instrument to be used in the days to come.”

Hedging needed

The LPR is typically lower than the fixed lending rate, so the transition benefits borrowers. But a fluctuating market-based rate also puts greater pressure on hedging interest rate risk.

With this in mind, the China Foreign Exchange Trade System, a regulatory body within the People’s Bank of China, will launch LPR interest rate options on February 24. Products will include swaptions, caps and floors linked to the one-year and five-year LPR rate.

“Going forward, as authorities seek to develop the reputation of the LPR benchmark, there will be an increasing need for more hedging products to create ways of managing this exposure,” says Stephen Chiu, an Asia forex and rates strategist at Bloomberg research.

Significant liquidity has built up in the LPR swaps market over the past six months. William Shek, head of credit and rates for Asia-Pacific at HSBC, says notional trades of 200–300 million yuan are becoming increasing common, and offloading risk of 50,000 DV01 (the sensitivity to a one basis point move in the underlying rate) in a single day is now relatively easy to do.

“There is continued discussion to improve LPR fixing, but the LPR curve has now become very visible and heavily traded in the market,” says Shek. “Obviously, you cannot yet compare the Chinese swap market to the more developed markets, but you can see how fast the pace of development has been in terms of the build-up of liquidity.”

Market participants expect the launch of the options market to further build on this liquidity.

Repricing all the loans in the country will prompt widespread corporate hedging of the domestic interest rate

CG Lai, BNP Paribas China

Under the previous two-tier rate system, where a fixed benchmark existed alongside a market-based rate, corporates were unwilling to hedge interest rate exposure because of the basis risk between the two rates, says Lai at BNP Paribas.

“Everything we did in interest rate hedging was in US dollars,” he says. “Repricing all the loans in the country will prompt widespread corporate hedging of the domestic interest rate.”

Others, though, believe it may take more time to convince corporates of the need for better managing their interest rate risk.

“People in China are still learning about the use of derivatives to hedge exposure rather than just for speculation – not just in the rates space, but also when it comes to currency positions,” says Chiu at Bloomberg. “The Chinese authorities clearly want to head in this direction, but it is taking quite a while to educate the market. Things need to happen step by step.”

Beyond hedging, the introduction of interest rate options may also lead to changes in the structured products market.

In a low interest rate context – China’s bank lending rate has been bumping along at historic lows since 2016 – investors have been searching for ways to enhance yield. One popular way is to invest in bonds and gain additional credit exposure. Interest rate options offer another potential source of yield, says HSBC’s Shek.

Dealers in Asia have been marketing quanto structures, which allow investors to access overseas assets settled in their own currency. With the emergence of options trading some of these structures may be replaced by more onshore vehicles.

“Creating an option on top of the new benchmark allows local investment deposits – which previously were mostly quanto products – to be in the future an instrument linked to the domestic interest rate. This will be the real big bang that everyone is looking for,” says Lai.

This story originally appeared in Central Banking’s sister publication, Risk.net.