It’s an open secret in the market that the People’s Bank of China (PBoC) is lending up to one trillion yuan (US$162 billion) to China Development Bank (CDB) over the next two to three years to support the reconstruction of shanty towns, the country’s first case of pledged supplementary lending (PSL).

“Although there has been no official confirmation yet, we believe PSL has already been put to work in recent months,” Tao Wang, managing director and head of China economics research at UBS, writes in a research note to clients.

PSL, a collateralized form of on-lending facility, is a new channel of base money supply which the central bank may use as a means to improve credit allocation via targeted liquidity provision, Wang explains.

The injection of one trillion yuan over the next few years is equal to a required reserve ratio (RRR) cut of 100bp, says J.P. Morgan’s chief China economist Haibin Zhu. The RRR for commercial banks in China is now 17.5%-20%, according to Bank of America Merrill Lynch (BoAML) data. “We believe the lending could boost the overall liquidity and offer extra help to the interbank market,” BoAML’s economist Ting Lu comments.

Besides the liquidity impact, another factor hidden behind the PBoC’s latest monetary move is its support to CDB’s evolving role as a policy bank that primarily backs local development.

Domestic support

As one of three policy banks in China, CDB has been granting loans to firms in developing countries for their payments of orders to Chinese exporters. As of end 2013, CDB has US$250.5 billion in outstanding foreign currency loans and 63 billion yuan in outstanding cross-border renminbi loans.

But with the new BRICS bank, or the so-called New Development Bank, and a planned Asia Infrastructure Investment Bank, CDB is expected to play less of a role going forward in such lending. Rather, the bank is expected to be more domestic-focused.

Locally, CDB has been the biggest lender for affordable housing projects, with over 60% of market share. In 2013, it added 162.8 billion yuan new loans to shantytown revamping, according to company statistics.

But CDB’s own funding cost is rising. The policy bank’s five-year bond issuance yield surged to as high as 5.8% in late 2013, where yield-to-maturity is still trading as high as around 5%. “Such unfavourable market conditions have occasionally hampered CDB’s bond issuance capacity,” UBS’ Wang says.

The PSL measure helps. The issuance interest rate on CDB’s five-year bond was 16bp below market expectations the day after the news report reached the market, according to a Barclays research note.

New policy rate

PBoC Governor Zhou Xiaochuan says in a forum in May that “the policy tool could be a short-term policy rate or a range of it”.

PSL is a tool to guide down medium-term rate in a targeted sector. Shantytown redevelopment is an area that usually demands fiscal budget or subsidy in the past, making funding cost a key to the PSL arrangement. Through this instrument, the PBoC could provide liquidity with maturity of three months to a few years to commercial banks for credit expansion, BoAML’s Lu adds.

By anchoring banks’ funding cost, PSL can more directly influence banks’ lending rates. In addition, it can help to better separate the true interbank market (in which banks borrow from each other with the central bank acting as lender of last resort) from the financial and credit market at large (in which non-bank financial institutions and corporates borrow from financial institutions). Unlike money market rates, the PSL rate can be isolated from market shocks to more solely reflect policy intentions, according to UBS’s Wang.

Furthermore, as an alternative tool supplying base money, PSL can become increasingly important in the PBoC’s base money supply should the weakening trend in FX inflow contributions continue (China’s financial institutions saw the first FX outflow in 11 months in June – amounting to US$14.3 billion), Wang adds.

PBoC’s monetary measures were deemed transparent before, whether it was RRR cut or open-market operations. However, with the innovation of more and more new tools such as re-lending, standing lending facility and now PSL, the central bank’s operations are getting opaque, and this is perceived as a “headache” to the market, J.P. Morgan’s Zhu says.

In the future, the indicator that analysts need to focus on is the overall credit growth covering total social financing, bank loans and shadow banking, among others. This can better reflect the monetary tone regardless of how specific tools are implemented, he notes.