Interest Rate Reform
Spills, No Thrills
No matter how “thrilling” pundits may have found the prospect of interest rate liberalization in China’s stagnating economy, the process is unlikely to be fast
If the movie Wall Street taught us anything, it was that “Money Never Sleeps.” In the financial world transformation is often a silent, invisible process, and yet one that can ultimately shake the global economy to its very foundations. Few thought that the financial liberalization that took place under the Reagan, Bush and Clinton administrations would ultimately cause the most catastrophic recession since the Great Depression. But then, few people pay attention to financial policy when things are going right.
On Saturday July 20, the People’s Bank of China (PBoC), China’s central bank, posted an announcement on its web site that the mandatory minimum yuan loan interest rate (previously 70 percent of the PBoC benchmark one-year lending rate), had been permanently removed. With no cap, borrowers and commercial banks were suddenly free to negotiate their own interest rates.
The decision made headlines in financial media worldwide the next Monday morning, providing a shot in the arm for Chinese and international analysts wearied by the implications of the Fed’s move to wean the US economy off stimulus and China’s ongoing economic slowdown.
Loans are generally inaccessible to private and small-scale commercial borrowers in China, and very few loans have been issued below the benchmark rate. Few analysts believe that the new policy will bring down the cost of borrowing. However, the move has left only one on interest rates - the deposit rate cap. If this final hurdle is cleared, China’s banks, the most profitable in the world, will lose their most important safeguard against losses.
As a result, the new policy has triggered investor concerns over shares in China’s main banks shares while also garnering support from financial liberals who have long argued that China is in desperate need of a mature and efficient financial market unburdened by macro-level meddling by the central government. Financial media were awash with speculation as to when the deposit rate cap would be removed.
However, there are signs that such excitement may be premature.
A Thrilling Jump
Before Reform and Opening-up, almost every commercial transaction in China was brokered by the State. From soft drink peddlers to steel concerns – every enterprise was directly or indirectly owned by the government, meaning the State also guaranteed commercial security. China’s economic take-off in the past 35 years was rooted in the easing or lifting of restrictions on manufacturing, marketing and consumption of most industrial products and select services, allowing market forces to determine the future of a sizeable chunk of the national economy. However, rigorous State controls over factors of industrial production, land resources, capital and the labor force have remained rigidly in place. As a result, the full marketization of China remains incomplete, leading to the vastly inefficient use of the country’s economic resources, which has begun to threaten growth.
In China, the groups which possess the largest and cheapest capital resources loaned by State-owned banks are those controlled, backed or intimately connected with the government. This has hurt depositors, private small and medium-sized enterprises (SMEs) and the general health of the national economy.
Reform so far has focused on depriving banks of the protection offered by the dual safeguards of a mandatory deposit rate cap and a bottom line for lending rates. The market competition which is supposed to result from removing these safeguards is intended to force banks to bid up deposit prices and court snubbed borrowers in untapped sectors. Banks will also have to invent more innovative services to diversify revenue. Depositors will enjoy higher returns and thus consume more, private SMEs will get more access to bank loans and the economy will benefit.
In addition, market-determined interest rates are the foundation for the openness of capital accounts, a change crucial for the internationalization of the yuan.
Deposit rates are the fundamental in this system, because the price and size of deposits underpin the entire financial system. Relentless competition may lure banks to overprice deposits, a misstep which led to the collapse of hundreds of smaller banks and the financial market turbulence during interest rate liberalization in the 1980s in the US. To avoid this, deposit rate caps are usually the last to go when liberalizing interest rates – a final leap dubbed the “thrilling jump” by media and analysts.
China’s central bank has a clear road map, and it follows US-set precedents almost to the letter. Market pricing will be applied to holders of large long-term deposit certificates, who are the minority of depositors and are better-protected to stand against risks, before moving down the chain. A deposit insurance system will be established. So far, so orthodox.
With this expectation in mind, some medium-sized Chinese banks recently increased their deposit rates to match the mandatory cap in anticipation of its removal. This further fueled confidence that a fully market-oriented interest rate system is in the pipeline. Some market analysts even trumpeted the “experience” of Chinese banks in pricing interest rates according to market principles through the relatively new raft of wealth management products (which are not subject to the mandatory caps and floors) rolled out in recent years.
Some might argue that it’s time for the central bank to take the final leap of faith.
But, perhaps, they might want to consider – does China have a functioning financial market for banks to set their prices to?
19th century British economist J.R. McCulloch joked that a parrot can be an economist as long as it is trained to speak “supply and demand, supply and demand.” Market prices arouse from the relationship between the two, and the key is to provide ample choice to both.
China’s central bank has struggled to learn this mantra, and thus its commercial underlings are run more like trusts than independent enterprises. Each year the PBoC sets restrictions on how many new loans can be allowed by State banks. With a restricted supply, prices remain stagnant. The central bank also directly imposes benchmark interest rates on commercial banks, which then become the basis of all loan prices along with other financial products – particularly bonds. This means the regulators will continue to directly control pricing in the market, meaning that the market will only grow as much as the PBoC allows it to.
This makes the removal of interest and deposit rate caps seem like a red herring.
With administrative intervention at the core of the system, Professor Wang Guogang, director of Chinese Academy of Social Sciences Institute of Finance and Banking, does not see any substantial progress in building a market-oriented interest rate system.
Wang argues that, in order to create a genuinely efficient banking sector, banks should be able to set prices according to competition in the broader financial market, with the central bank in an indirect role whereby it can only determine its own lending rates to commercial banks. In this process, both pricing and intervention will be determined by the market.
“Is a market that sells pork but no lamb, chicken or beef really a market?” he asked.
For Chinese investors, their “pork” is represented by bank deposits. For enterprises, it is bank loans. Regulators have repeatedly promised to provide other choices, but consistently fail to deliver. Investors are fed up with irregularities and losses on China’s stock market, already written off as a worthless crapshoot by most analysts, and sometimes turned to speculative commodities trading in goods such as tea and orchids.
Bond, a debt instrument which so far is the most developed alternative to deposits and loans, is controlled by different government agencies. In addition, banks use deposits or wealth management products to buy up bonds en masse, turning even this “option” into simply more deposits and loans in disguise. Trusts, insurance and securities have all gone the same way, creating a massive shadow banking sector, according to a recent report by the Chinese Academy of Social Sciences.
In June 2012, the Securities Regulatory Commission launched a trial project allowing private SMEs to issue bonds through non-public offering. Though yields were much higher than bank loans, financial institutions show little interest in such unsecured, uncollateralized products.
Professor Wang urges the issuance of bonds in line with China’s extant Corporate and Securities laws without official administrative approval, and sell directly to “smart individual investors” who are capable of taking relatively higher risks for higher returns.
For the central bank, most of its assets are foreign exchange reserves which are mainly invested in US Treasury Bills. The PBoC simply lacks the assets needed to significantly liberalize its operations.
In Professor Wang’s view, therefore, in China at least, interest rate liberalization is “a process, not a jump.”
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Sep 2011 | Submitted by Brian Snelson
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