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In recent years, the monetary policy landscape in China has drawn intriguing parallels to the European Central Bank's (ECB) interest rate corridor, particularly during times of reserve scarcityAs we look to the future, there's a possibility that China's own interest rate corridor may undergo a modest narrowingBy June 2024, the structure of China’s interest rate corridor is expected to take shape, with the upper limit defined by the Standing Lending Facility (SLF) rate and the lower limit anchored by the rate on excess reserve depositsAs the central bank considers the need for more effective interest rate regulation, it may also look to refine the width of this corridor.

On July 8, a significant development occurred when the People’s Bank of China (PBoC) established temporary repurchase and reverse repurchase instruments

This move sparked debate among market participants regarding the direction and exploration of China's future interest rate corridorAn in-depth analysis of the forms and evolution of interest rate corridors in key global economies reveals valuable insights that may help inform the construction and refinement of China's own interest rate framework.

To understand the context better, let’s examine the definition of an interest rate corridorSince the 1980s, central banks in major economies have been transitioning their monetary policy targets from merely controlling the money supply towards managing short-term interest ratesThis has involved the implementation of explicit or implicit interest rate corridors, designed to help maintain short-term market interest rates close to targeted policy ratesThe central mechanism of an interest rate corridor involves the central bank offering commercial banks a permanent deposit tool alongside a permanent lending mechanism

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By establishing an appropriate interest rate range between the deposit tool rate (id) and the lending tool rate (il), central banks can guide short-term market interest rates towards the desired policy rate.

Under this corridor framework, the reserve supply curve (Rs) is depicted by a yellow curve in illustrative graphsWhen the interest rate lies between id and il, the supply curve remains vertical since the central bank determines the volume of reserve supply independently of the interest rate levelHowever, when the interest rates hit either id or il, the supply curve flattens, signifying that the central bank can inject or withdraw liquidity at these rates without constraints.

Historically, the creation of the ECB's interest rate corridor originated with its establishment in June 1998, culminating in its official implementation in 1999. The deposit facility rate and the lending facility rate formed the two endpoints of this corridor

Concurrently, the ECB announced the main refinancing rate to enhance the signaling effect of interest ratesFrom 1999 until the subprime crisis in 2008, the ECB's provision of overnight credit facilitated an environment of scarce reserves, allowing it to manage liquidity in a way that stabilized market interest rates around the main refinancing rate.

The Federal Reserve of the United States similarly adjusted its discount rate above the target federal funds rate in 2003, positioning the discount window to meet only the short-term, unpredictable borrowing needs of depository institutionsBefore 2008, the Federal Reserve did not pay interest on excess reserves, setting the corridor’s lower limit at zero.

The landscape underwent a transformation following the financial crisis of 2008. Central banks adopted an array of unconventional monetary policy tools that led to an increase in liquidity, transitioning from a mode of scarce reserves to one of abundant reserves

This shift caused the supply curve to expand to the right, whereby interest rates would become less responsive to changes in reserve supply, ultimately gravitating towards the corridor's lower limit – a phenomenon termed the "floor model."

Post-2008, the ECB began witnessing considerable increases in reserve levels within the Eurozone, leading to a divergence of the benchmark rates away from the main refinancing rates towards the lower bounds of the corridorIn 2014, the ECB initiated negative interest rate policies and resumed large-scale asset purchasing in 2015, which further increased interbank market liquidity and spilled over into the non-bank financial sectorsNon-bank institutions, unable to participate in the ECB deposit facility, began experiencing slightly elevated overnight rates beyond the lower limit of the interest rate corridor

In March 2024, revisions to the monetary policy framework were announced by the ECB, leading to a narrowing of the corridor width and emphasizing better alignment of overnight rates around the deposit facility rate.

Additionally, the actions of the U.SFederal Reserve post-2008 saw an even more rapid growth in reservesThe effect of abundant liquidity, coupled with interest payments on excess reserves, diminished banks’ drive to borrow in the federal funds marketGovernment-sponsored enterprises became primary lenders in this market, leading to pressures that caused the federal funds rate to dip below the lower limit defined during the reserve-scarcity period.

Come September 2013, the Fed introduced overnight reverse repurchase agreements aimed at facilitating liquidity for a broader array of market participants

This framework, comprised of two key deposit tools, established a new interest rate corridor, featuring an interest on reserves (IOER) sitting as the upper limit and ON RRP as the lower limit, providing a mechanism for efficiently absorbing excess liquidity from the market.

Turning our focus back to China, the current excess reserve deposit rate is only at 1.5%, indicative of a reserve-scarce mode similar to the earlier stages of the ECB's corridorSince 2014, efforts have been made to develop a formal interest rate corridor in China, which achieved relative stability following a significant cut in PBoC’s SLF rate in November 2015. Despite this development, challenges remain, including the overly wide corridor and the insufficient influence of policy rates on benchmark rates.

Between 2016 and 2023, the width of China’s interest rate corridor oscillated between 245 and 285 basis points, creating a significant contrast with the European corridor's standard deviation of just 0.17% during a comparable timeframe