Here’s what interest rate liberalisation means for China
The People’s Bank of China has taken some important steps towards embracing market-based pricing for credit, writes BNP Paribas senior economist Chi Lo
The People’s Bank of China scrapped the deposit interest rate ceiling in October, about two years after having scrapped the lending interest rate floor. In principle, the latest move completed the last step of interest rate liberalisation by ending a subsidised credit system that channelled household savings at low cost into state-guided borrowing for investment.
Liberalising interest rates is a policy paradigm shift from a tightly controlled system where the PBOC sets monetary policy based on quantitative targets, such as loan quotas, to a market system where policies are based on market forces setting the price of and, hence, allocating capital. While this final move to liberalise interest rates should help improve pricing in the Chinese credit market, the devil of implementation is always in the details.
Although Chinese banks now have the freedom to set lending and deposit interest rates, there are still hidden interest rate controls. One only needs to ask: with all lending and deposit interest rate restrictions being abolished, why does Beijing still keep the benchmark rates, which have no bearings on market forces and are non-binding constraints to lending and deposits?
On the lending side, the reason is that state-owned enterprises and local governments still borrow at the benchmark rates, and they remain the only entities that have access to these preferential rates. Official data shows that local governments account for 90% of all domestic investment; other data show that SOEs account for over a third of domestic investment. There is no data breakdown to clarify this overlap.
The point is that these entities, with their soft budget constraints, are still driving most domestic investment. Retaining the benchmark lending rates mutes the effects of interest rate liberalisation by keeping cheap credit flows to them and is, thus, representative of hidden interest rate controls.
On the deposit side, scrapping the deposit rate cap should lead to market pricing of interest rates for savers by inducing competition for funds among financial institutions. This would, in turn, break the big state banks’ monopoly of amassing cheap funds as the small banks can now bid for funding by offering higher interest rates.
However, incentive distortions, such as implicit guarantees and cosy relationships between SOEs and big banks that restrict fund flows, are still prevalent. They will prevent effective competition from happening and, thus, erode the effectiveness of market forces on the pricing of capital, despite the abolition of the deposit interest rate cap.
In the short-term, Chinese banks will continue to price their lending and deposit interest rates with reference to the benchmark rates. Before China’s interest rates can be fully market-determined, Beijing will first have to break the structural distortions in the system. De facto interest rate liberalisation will take longer and more effort to achieve.
Nevertheless, the PBOC is preparing to shift towards the new market-driven policy framework as it moves towards the “impossible trinity” eventuality, where capital account convertibility will force it to choose between controlling the exchange rate and the interest rate. Beijing has already chosen to let go exchange rate controls and retain monetary autonomy (i.e. control the interest rate).
During the transition to the new monetary paradigm, the PBOC will have to decide what interest rates to use as the yardsticks for pricing capital. There are a few candidates: the seven-day repo rate and the SLF (Standing Lending Facility) rate may be used to guide short-term interest rate movement, while the MLF (Medium-term Lending Facility) rate and the PSL (Pledged Supplementary Lending) rate may be used to guide medium- and long-term rates.
When the market-driven monetary transmission mechanism is fully established, the PBOC will scrap the lending and deposit benchmark rates. Future interest rate cuts will take the form of a reduction of the PBOC’s target policy rate. This will require it to improve the open market operations to minimise the volatility of short-term money market rates, which act as the conduit for transmitting the policy rate effect to market interest rates. This means further capital market reform is needed.
Under the current monetary framework, interest cuts and liquidity injection are two separate policy moves in China, though in the same direction. The new monetary paradigm should “normalise” China’s monetary policy framework towards the developed market model where interest rate cuts and liquidity injection are one policy move implemented through market forces.
It will also help improve China’s credit-pricing mechanism, as the incentive distortions that have mispriced credit under the current monetary framework will have to be corrected. This means Beijing will have to retreat from the financial sector, especially from the implicit guarantee policy. Appropriate credit-pricing will have to come with some short-term default pain.
Chi Lo is senior economist at BNP Paribas Investment Partners