This move has been long awaited.
China’s leadership has refused to dismantle its strict control over interest rates until this point, as pressure builds from the shadow banking industry to make banks more profitable and fulfil the individual and institutional search for yield. Interest rate liberalisation will allow interest rates to be guided more closely by the market, and these rates will feed back into the Shanghai Interbank Offered Rate, the interbank lending rate, and the benchmark corporate lending rate. This will pave the way for enhanced use of interest-yielding financial instruments, such as corporate bonds and even interest-rate oriented monetary policy. Savers will finally reap the benefits of saving a large proportion of their income as bank deposits.
There may, however, be some disjoint in bank policy if state owned enterprises (SOEs) continue to receive earmarked funds from the banks. This is a practice that is supposed to decrease, as SOEs become more efficient. But this planned decouping of state capital and production is a process that has been ongoing since reform began, and the state-SOE relationship extends back even further to the Maoist regime. This presents a barrier to true financial reform, and would distort even a liberalised interest rate regime. Aggregate credit quotas may also continue to distort loan markets when the quotas become binding, by reducing the loan supply.
On the whole, the Chinese leadership has been careful to create institutions that will support the nation’s interest rate liberalisation process. The creation of benchmark interest rates has opened the door to a market-guided interest rate regime. The pledge to improve the performance of SOEs will, if carried out, reduce the drain on financial resources brought about through implicitly allotted funds.
Deposit insurance, which will be implemented this year, will allow the central government to take less of a role in backing banks and help transform the way banks deal with deposits. Some banks will strive to obtain more deposits by increasing deposit interest rates, despite rising costs, while other banks will strive to reduce their deposit base by lowering deposit interest rates. The deposit base will therefore change according to the potential competitiveness of each bank.
In 2004, the state lifted the lending rate ceiling. As a result, credit risk was better reflected in lending rates and political influence in setting lending rates was sharply curbed. Loan demand also became more dependent on interest rates.
Like the lending rate ceiling, the deposit rate ceiling is also assumed to be binding since deposit rates have been at or above the maximum official rate. As the banking system is funded mainly by bank deposits, the deposit rate is a key tool for managing the interest rate regime. Once the ceiling is removed, deposit rates are predicted to increase and the financial economy will be guided more by the forces of supply and demand than by government policy.
It is also worth noting that interest rate liberalisation will happen just as the exchange rate is being liberalised and the slow, partial capital account liberalisation takes place. As financial markets become more competitive, exchange rate liberalisation can help financial participants control for risk and ensure price stability, while capital account liberalisation will, over time, allow investors to diversify their assets.
The order and pace of financial liberalisation is crucial to its success, and China’s gradual approach to liberalisation is likely to prevent the financial crises that so many developing countries experienced when they liberalised suddenly, throwing open their banking sectors and their capital accounts at once. Destabilising forces, particularly rapid capital inflows and outflows, are likely to be controlled in China for some time. The actual impact of financial liberalisation will probably be what the authorities are hoping for: that is, financial deepening.
Managing the financial market requires caution. Authorities should closely monitor and control for risk. So far, regulators have been conscientious in attempting to ferret out excess risk, and this is expected to continue. It is hoped that China can liberalise interest rates while sharply reducing the presence of the state in implicitly directing funds from banks to less efficient SOEs. If this complexly choreographed process is carried out properly, then financial markets will metamorphose into more sophisticated structures, and participants will reap the rewards of new market opportunities.
Sarah Hsu is Assistant Professor of Economics at the State University of New York.