(Yicai) Aug. 12 -- Sixteen Chinese provincial-level regions have now launched loans benchmarked against the Depository Institutions Repurchase Rate, following Hainan Free Trade Port’s first DR-linked loan on July 21, marking the emergence of a new market-based pricing anchor for the country’s lending rates, according to Yicai research based on incomplete data.

Between July 21 and July 22, branches of Industrial and Commercial Bank of China, China Merchants Bank and Shanghai Pudong Development Bank issued the first batch of DR-linked loans to corporate clients in southern Hainan province, totalling CNY91.7 million (USD13.6 million).

Unlike conventional loans priced against the Loan Prime Rate, these transactions broke with the longstanding practice of using the LPR as the sole benchmark for domestic loan pricing, paving the way toward more market-based credit pricing.

The new type of loan has now reached around 16 provincial-level regions, including Beijing, Shanghai, southern Guangdong province, southeastern Zhejiang province and northeastern Liaoning province. Participants include major state-owned banks, joint-stock commercial banks and local banks servicing a wide range of market entities such as central government-owned enterprises, state-owned enterprises, private companies and foreign-invested businesses.

Pricing Framework

The pricing framework for DR-linked loans is also becoming clearer.

Loan amounts range from CNY1 million (USD148,229) to nearly CNY80 million (USD11.8 million), with one-year short-term working-capital loans accounting for the majority. These loans are aimed at supporting firms’ day-to-day working-capital needs and investments in technological research and development.

Key sectors include technological innovation, advanced manufacturing, modern agriculture, cultural media, logistics, trade, construction, new materials as well as foreign trade and cross-border commerce within the real economy.

The pricing structure accommodates both fixed- and floating-rate loans. The pricing benchmarks are based on the average DR001 rate, which is the overnight repurchase rate, for one, three or six months preceding the pricing date. Loans can be repriced on a daily, monthly, quarterly or semiannual basis, allowing the pricing cycle to better match companies’ individual financing needs.

Dual Benchmarks

As two key benchmarks for loan pricing, the DR and LPR are based on fundamentally different mechanisms.

The DR refers to the bond repurchase rate among deposit-taking financial institutions. The DR001 is an important short-term benchmark in China’s money market. Given its large trading volume and high transaction activity, it can reflect changes in short-term funding supply and demand within the banking system quickly and in real time.

The LPR is a “quotation-based” interest rate formed by quotes from designated banks based on policy rates plus an additional spread. It is updated every month and as such has a stronger policy-guidance component, while its movements tend to be relatively stable and predictable.

The LPR is derived from quotes submitted by designated banks, whereas the DR is calculated from actual transaction data among financial institutions, said Zhang Xu, chief fixed-income analyst at Everbright Securities. As a result, the DR is less affected by the quality of submitted quotations and can provide a more accurate reflection of the supply and demand dynamics in the money market.

Once loan rates are linked to the DR, corporate financing costs will be more sensitive to changes in liquidity conditions and will respond more quickly, said Zhang Lin, deputy director and chief macroeconomic researcher at the Far East Credit Rating Research Institute.

However, DR-based pricing also brings higher interest-rate volatility and more complex management. In particular, firms must be prepared for borrowing costs to adjust dynamically with market liquidity, which requires a certain level of interest-rate risk management capability.

Parallel Pricing

Against this backdrop, Zhang expects the DR to complement rather than replace the LPR. The direction of loan-pricing reform is likely to be a multi-benchmark system in which the LPR and DR operate in parallel.

The DR is better suited to scenarios such as floating-rate, short-term and cross-border financing, while the LPR is expected to continue serving retail customers, longer-term loans and customers with limited tolerance for interest-rate fluctuations.

The use of the DR as a pricing reference will be more prevalent among large companies and short-term loans than among small and medium-sized enterprises and longer-term loans, Zhang said.

Even so, he expects the LPR to remain the reference rate for most loans for an extended period, while the DR and government bond yields are likely to play a more supportive role.

The short-term effect of the broader adoption of DR-based pricing will be manageable and is unlikely to create systemic downward pressure on banks’ net interest margins, industry experts said.

Editor: Kim Taylor