China’s interest rate liberalization has been likened to a sailboat plowing through rough seas. It could also be compared to a can getting kicked down the road.
The first perspective mirrors the views of People’s Bank of China (PBOC) policymakers, who say interest rate reform is solidly on course yet will need years to reach its destination. The latter reflects the fact that the project has been under way for a decade without a clear timetable, leaving ample room for procrastination.
China did reach a milestone on the liberalization front in July 2013 when the central bank abolished a mandatory floor on lending rates. Previously, it had set a minimum lending rate of 30 percent below the central bank’s 6 percent benchmark rate. The authorities had abolished a ceiling on lending rates back in 2004.
Last year’s move had only a modest impact on markets. Scrapping government restrictions on deposit rates could have much greater consequences for markets, but no one knows when that might happen.
Since mid-2012 the central bank has capped the rate that banks can pay on savings deposits at 3.3 percent a year, barely above China’s 2.6 percent inflation rate for 2013. The low level of rates has fostered a boom in alternative savings vehicles like wealth management products. Some of these wealth products, which are sold by banks and brokerages and are backed by loans to commercial and industrial companies, pay double-digit interest rates. Other nonbank entities have stepped in with money market funds that offer higher rates than the banks do, such as the fast-growing Yu’e Bao fund launched last year by the Internet marketing giant Alibaba.
The success of nonbank savings products that can pay three or more times the bank deposit rate suggests that the Chinese economy could easily bear free-floating savings rates, argues Sun Xingjie, an economist at Jilin University. Yields on wealth management products “to a certain extent reflect the market level of interest rates,” Sun says.
So when will Beijing regulators let the market set bank deposit rates? “One to two years,” was the answer central bank Governor Zhou Xiaochuan offered in March, the first time a government official has suggested a schedule for full interest rate liberalization.
But uncertainty about Zhou’s timeframe quickly surfaced in early April when the bank’s deputy governor, Yi Gang, said the project would not be rushed. That same week an editorial in the state-run People’s Daily headlined “Interest Rate Reform Can’t Be Stopped, Can’t Be Hurried” included a cartoon of a sailboat on the open sea with the word “reform” scrawled on its mainsail.
Economist Yin Zhentao, a financial law expert at the Chinese Academy of Social Sciences, a government think tank, believes Zhou’s reference to a two-year timetable may have been too optimistic.
“The interest rate marketization process is a gradual process that involves every aspect of engineering the system, especially the construction of a basic deposit insurance system and an exit mechanism for [failed] financial institutions,” Yin says. “Therefore it will be an extremely difficult thing to completely realize full interest rate market reform in one to two years.”
Other factors also argue for caution, Yin contends. Freeing up deposit rates might be good for savers, but it would increase competition among banks for deposits and could foster volatility in rates, he says. “It may lead to financial system risk ... due to a mismatch between yields and maturities,” he adds. Increased competition could threaten the health of small banks and force big banks to tighten their belts, he says. Considering the industry’s size — China’s ten publicly listed banks last year reported a combined workforce of 1.93 million — the risk of downsizing could induce caution among policymakers. Rate liberalization also could reduce the flow of credit to state-owned enterprises and government infrastructure projects, posing a further risk to employment, Yin says.
The central government controls China’s eight biggest lenders and three policy banks. Provincial and local governments own dozens of smaller banks. Each extends easy credit to state companies by tapping savers’ deposits.
Lu Zhengwei, chief economist at Industrial Bank Co., a midsize lender based in the coastal city of Fuzhou, says free-floating deposit rates would seriously shake the status quo. “The banking market constraint mechanisms now in place consistently strengthen local governments, state-owned enterprises and policy banks with weak budgetary conditions, making them immortal even though the body may be dead,” says Lu, who is based in Shanghai. Rate controls give unfit entities “financial resources to compete with market players, resulting in pricing distortions and misallocations of financial resources,” he adds.
Although central bankers have spoken only in general terms about how they will steer future rate reform, Lu envision a possible scenario for events leading to full deposit rate reform.
The first stage would foster a deepening of the recently established market for interbank certificates of deposit, says Lu. The central bank has allowed banks to freely set rates on interbank CDs since December; securities firms and companies can invest in these CDs as well. Speculation about liberalization and the PBOC’s policy aims contributed to big spikes in the Shanghai interbank offered rate, or Shibor, in June 2013 and again in December.
As a second step toward deposit rate liberalization, Lu contends that the government should implement financial institution bankruptcy laws and establish a bank deposit insurance system. The government has not said when it would move on either issue.
Third, Lu says the central bank should determine which Shibor maturity — overnight, seven days, one month or three months — it will use to steer benchmark interest rates through open-market operations.
Under Lu’s scenario, once the interbank CD market develops sufficiently, the authorities should launch a pilot program enabling individuals and businesses to buy CDs, thus providing a reference point for setting market-based deposit rates. Once those steps are completed, the government could amend the Commercial Bank Law to repeal all loan-to-deposit ratio regulations, thus ensuring rational pricing for deposit rates. Finally, the central bank would abolish all rate controls on bank deposits.
Lu’s multistep scenario implies that full rate liberalization is a distant prospect. Premier Li Keqiang, who promised in June 2013 to “push for liberalization of interest rates,” has not addressed the issue recently, focusing instead on China’s economic slowdown. Li has told struggling companies to buckle down and accept market discipline without government stimulus. With so much on his plate, weak banks and state companies that benefit from deposit rate controls can feel at ease, at least for now.
Meanwhile, Chinese savers with an appetite for risk can continue to hunt for higher yields in wealth products and money market funds.
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