The key to improving direct liquidity is establishing an incentive mechanism that encourages banks to actively increase their support for the real economy, instead of setting targets and giving orders to boost lending, wrote Sun Guofeng, director of the Monetary Policy Department at the People’s Bank of China, in an article published Monday, The Beijing News reported.

Sun mentioned that there are three major constraints on the supply of bank credit.

First, banks can lack capital. “If banks’ capital is not replenished in a timely manner, it will restrict the credit supply in the next stage,” Sun said.

Second, some banks’ credit expansion is subject to liquidity constraints. The changing foreign exchange situation means China’s banking system faces a large gap in medium- and long-term liquidity, Sun said.

Third, the defective transmission mechanism of interest rates also constrains banks’ credit expansion. Sun said the current upper and lower limits of deposit and loan interest rates have been liberalized, but the central bank still publishes the benchmark interest rate for deposits and loans.

Using both the market interest rate and the benchmark interest rate hinders the interest rate transmission, said Sun.