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China’s interest-rate liberalisation: the next steps

Interest-rate liberalisation will be crucial to the success of China’s broader financial reform ambitions. Yet, faced with conflicting interests, Beijing needs to proceed with caution.

Interest-rate liberalisation will be crucial to the success of China’s broader financial reform ambitions. Yet, faced with conflicting interests, Beijing needs to proceed with caution.

International experience shows a deposit insurance system to be a prerequisite for deregulating deposit interest rates. Japan and the US set up deposit insurance before deregulating their deposit rates; South Korea and Taiwan did so in parallel with the deregulation process. Beijing has now reached a policy consensus for setting up deposit insurance as a next step forward.

The primary task is for Beijing to gradually allow market forces to determine the deposit rate. To this end, the Chinese government took an initial, albeit small, step by introducing an interbank market for negotiable certificates of deposit (NCDs) in December 2013. However, trading is restricted to inter-bank players for the time being. A natural next step would be to introduce NCDs that are tradable in a public secondary market open to large Chinese firms and ultra-high net worth depositors. Japan is an example of a country which began interest-rate liberalisation by introducing tradable NCDs for its large depositors.

Subsequently, Beijing may consider eliminating the deposit rate caps on large-denomination long-term deposits such as those of five years and longer. This was what the US did before scrapping Regulation Q in 1986. Since long-term deposits account for less than 1% of total bank deposits, their potential systemic effects should be easily manageable.

The benefits are clear

A roadmap for liberalising China’s interest rates is one thing, but the timing and sequencing of implementation is quite another, because Beijing has to balance the interests of the winners and losers in the liberalisation process. The benefits are clear: interest-rate liberalisation, together with other financial reforms, should help improve capital allocation efficiency. It is also a prerequisite for China to be able to deepen its capital markets, enable correct risk-premium pricing and lay a solid foundation for completing capital account and RMB convertibility.

However, interest-rate liberalisation changes the rules of the game by reshuffling the positions of the winners and losers. Small and mid-sized enterprises (SMEs) and households with net savings stand to gain the most as they obtain access to credit and higher returns. But banks and state-owned enterprises (SOEs), the main beneficiaries from financial repression, are likely to be the losers. This could well be a barrier to implementation as the losers would be those with extensive vested and political interests.

A cautious approach would be best

Financial repression has created a minimum 300 basis point spread between the lending and deposit rates of Chinese banks, ensuring them a monopolistic profit to the detriment of households. Scrapping the deposit rate cap will drive up the deposit interest rate as the competition for funds spreads out across different market segments, removing the banks’ monopoly and hitting their profits. The SOEs stand to suffer significantly from much higher financing costs.

Liberalising interest rates too fast could aggravate the risk posed by local government debt, which has markedly deepened China’s public debt burden since 2010. One measure of the long-term viability of public debt is the gap between the nominal interest rate and nominal GDP growth rate. At 53% of GDP, China’s current total public debt load is manageable. But interest-rate liberalisation could threaten this by pushing up the public sector’s debt-to-GDP ratio through a sharply higher interest cost.

Given such challenges, China’s leaders are likely to take a cautious approach to interest-rate liberalisation. Gradual implementation would give the losers time to adapt, while Beijing sustains the momentum on pivotal reforms.

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