China Rebalancing Watch: Interest Rate Reform Half Measure
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China Rebalancing Watch: Interest Rate Reform Half Measure


China’s government has a habit of making market-moving economic or financial policy announcements after the close of trading on Friday evenings. This was true in June 2010, when the de facto RMB peg (which had been re-established on the sly mid-2008) was again relaxed. It has also been the case during several adjustments to the People’s Bank of China’s (PBOC) Required Reserve Ratio (RRR) over the years.

It was the same formula on Friday evening when the PBOC moved to liberalize part of its interest rate regime. For those of us keeping an eye on China’s ongoing rebalancing process, this was an important move. As previously covered in The Diplomat, interest rate reform is one of the core measures necessary to rebalance China’s economy and put a stop to the runaway misallocation of credit.

But before we get too excited, it is worth noting that this is only half a story. China’s central bank, operating on the instruction of the State Council, only scrapped the lower limit (or “floor”) for commercial interest rates. That is to say, this change will allow banks to lend at lower rates to their customers.  The effects could be significant, as competition amongst banks for borrowers could now take off. If Bank A doesn’t offer a good rate, a corporate borrower can now go to Bank B to see if they will beat it, and so on. 

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Yet the really important part of interest rate liberalization is yet to come: The reform of the deposit rate. There is currently a ceiling on the rate which penalizes depositors (of whom households make up an important segment) as it prevents banks from offering higher rates in order to attract savers at the expense of borrowers. The ceiling thus limits household income growth and therefore the ever elusive private consumption growth, and gives banks an unnaturally large interest rate margin (the difference between the deposit rate and the lending rate for any segment of funds). This margin allows banks to remain profitable despite making uneconomic lending decisions – such as lending to inefficient state owned enterprises at reduced rates and then rolling over (or otherwise forgiving) the resulting non performing loans.

So although the move is a positive step, it is only really half of the interest rate reform that is necessary, and the lesser half at that. The PBOC itself was quite open about this.

In fact, this change could actually make borrowing cheaper for certain corporations – those with the best credit ratings.  Currently, banks prefer to lend to state owned industries since they see implicit government backing should the loans fall into distress.

Despite these reservations, we shouldn’t be too dismissive. This is yet another sign that Beijing is serious about reforming the financial sector and thus the wider economy. We can anticipate more to come, if Premier Li Keqiang has the political resolve to hold course.

Meanwhile, come market open on Monday morning in China, there may be some interesting movements in bank shares as investors consider what the future holds for them without such a large interest rate margin cushion.

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