For China’s banks, pricing in risk hurts
People’s Bank of China is moving the banking industry towards a variation of reference rates but lenders are set for a rough ride as they approach the market
Mainland China banks are getting mixed signals on how to price their loans.
The benchmarks they have used for decades, the one-year lending and deposit rates, are not so much official benchmarks any more. At the same time, the central bank is putting in place a layered channel of rates that banks can watch for a hint on pricing.
Analysts expect them to catch on – within the next few years.
In October, the People’s Bank of China (PBOC) lifted the cap on the rates that banks are allowed to pay depositors. On paper, this looks like full interest rate liberalisation, after the lending floor that stopped banks from competing on lending rates was ditched two years earlier.
However, from a mainland bank’s perspective, the much-anticipated end to the floors and ceilings that obscured the view of true market demand for credit is less of a milestone and more of the start of a long period of adjustment to how the interest rate market really works.
“I think one of the key challenges facing banks is that they need to improve on their price-setting capacity, which allows them to price loans and deposits consistent with their balance sheet situation and the overall macro environment,” said Aidan Yao, senior emerging market economist at AXA Investment Managers in Hong Kong.
For decades, the banks have had most of their work done for them. A wide, government-set spread between deposit and lending rates made the banks some of the most profitable in the world. For the most part, the banks were a government tool used to funnel undervalued deposits to state-owned firms at the lowest price possible.
Few real lending decisions were needed for business between banks and state enterprises. The lenders pushed cash in the direction they were told. If the borrowers could not pay it back, the government might even launch a company to buy up the bad debt.
Much of that has changed in a relatively short period of time. The benchmarks have disappeared. In the span of just two years, China’s four biggest state-owned banks have seen year-on-year profit growth tumble from double digits to under 2 per cent. A few of the lenders have even reported negative profit growth over the past two quarters.
Without the benchmarks and the guaranteed spreads – and without as many state firms to throw loans at – the banks are in the painful process of discovering true market rates. Part of that experiment has manifested in heaps of bad debt from low-cost loans to high-risk firms. Pricing in risk, as the banks are just now discovering, hurts.
But they are not all on their own in a cruel market environment – at least not for a few more years. The PBOC still sets lending and deposit rates as references for the banks. It is also introducing several other rates the banks can use to guide pricing.
“The PBOC benchmarks still serve as benchmarks for the banks but more and more they are incorporating other reference rates,” said Sophie Jiang, a banks analyst at Nomura in Hong Kong. “Our assumption is that within three years banks will fully adapt to interest rate liberalisation.”
The other rates are those on medium and short-term lending facilities the central bank issues to banks. Over the past month, the central bank has cut the rates on those facilities with what analysts say is the intention of creating an interest rate “corridor”, or a range of different rates that will guide pricing.
The lending facility rates will likely serve as the ceiling of the corridor and a rate the central bank pays on excess reserves will act as the floor. Compared to the open market, that leaves a much smaller range in which the banks can price loans.
The PBOC’s touch is not going anywhere quickly. Retaining strong control over interest rates on the mainland is especially important for the central bank as it looks to ease monetary policy to help stimulate economic growth.
“Though this is not primarily a move aimed at loosening policy, we expect the new interest rate corridor to be used to keep market interest rates low for some time to come,” Mark Williams, chief Asia economist at Capital Economics in London, said in a note. “Until there is firm evidence of an economic turnaround, the People’s Bank will retain a bias towards easing.”