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  • Aug 20, 2014
  • Updated: 2:00pm
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PUBLISHED : Thursday, 16 May, 2013, 12:00am
UPDATED : Thursday, 16 May, 2013, 2:47am

Now is the right time for interest rate reforms in China

Hu Shuli says reform of China's money markets needs to take place very soon as a lack of progress has hampered nation's economic system

Now is the right time to loosen state controls on interest and exchange rates, a move that can only serve to boost China's market economy. At a State Council meeting on May 6, nine priorities were mapped out to widen economic reforms. For reform of the financial system, the first two priorities are the gradual introduction of measures to liberalise interest rates and exchange rates.

As early as 1992, the government's intention to eventually adopt such measures was clear and now, after more than 20 years, significant progress has been made.

Reforms have stalled for years, partly because of power struggles among various government departments

With liberalisation of the money market, bond market and financial products, plus deposit and lending rates for domestic and foreign currencies, the central bank now manages only the upper limit on deposit rates and the lower limit for lending rates, while the floating range of deposit and lending rates has been further expanded. China has a managed floating exchange rate regime based on market supply and demand, and pegged to a basket of currencies. Still, the hardest parts of rate reform remain: to further relax and gradually end management of deposit and lending rates; and reduce and eventually end the central bank's role in setting exchange rates.

The lack of progress in these key aspects has hampered efforts to improve China's economic system. Since 2009, to protect itself from the global financial crisis, China has adopted a fairly loose monetary policy. While contributing to an early economic recovery, it has also led to asset price bubbles and overcapacity in some industries. Excessive lending by commercial banks has raised doubts about the viability of many projects. One major problem is that, without constraints on capital costs, banks can still expect stable returns even if they suffer losses on some loans.

Interest and exchange rate reforms have stalled for years, partly because of power struggles among various government departments, as well as fears of change and a preference for the old order.

First, there has been strong concern about the effect of reforms on business. But if we look at the impact of the 2005 exchange rate reforms, the ability of enterprises to adapt to the changes far exceeded government expectations.

Yes, the yuan's appreciation has led to the closure of some low-value-added processing trade enterprises. But many others have become more hi-tech and efficient. High value-added research and development departments of foreign industrial companies are rushing into the China market, creating an important chapter in economic restructuring.

Second, in the past, the government has been quick to roll back longer-term reforms whenever short-term problems and crises emerge. For example, China virtually halted appreciation of the yuan between July 2008 and June 2010, to protect its industries in the wake of the financial crisis.

Over the past 35 years of China's opening up, it is difficult to find a time when reforms were implemented with all the right conditions in place. The key is to weigh the cost and benefits of the changes before acting decisively.

While liberalisation of interest and exchange rates is likely to bear fruit, there are some risks, not least the excessive global liquidity as a result of quantitative easing in developed countries. So one shouldn't rule out the possibility that exchange rate reform may lead to more "hot money" inflows amid expectations of yuan appreciation.

However, with inflation slowing, the situation favours reform. Allowing greater flexibility could exert pressure on commercial banks; interest rates can be adjusted up or down, to avoid short-term market volatility as a result of hostile competition or sudden large withdrawals. And with China's balance of payments improving, external pressure for the yuan to appreciate is easing. Carrying out reform now would be in line with policymakers' core principle of being proactive rather than responding to external pressures.

Of course, such reforms will not be easy; many measures must be taken to achieve the goal. These include establishing a deposit insurance system, which has not been listed as a government priority for the year, as well as allowing private capital to enter the banking sector and implementing ownership reform for state-owned banks.

All this is conducive to a fully competitive market and the creation of favourable conditions for a system of market-oriented interest and exchange rates. Interest rates that are fixed by a handful of large state-owned banks are not genuine market rates.

Policymakers have said they hope to accomplish a measure once a goal has been set. It is not difficult to find reasons to delay reforms, but this will only lead to passiveness, stagnation and a lack of regulation. We should learn lessons from past experiences. Reforms to liberalise interest rates and exchange rates need to press ahead, with a clear road map and a timetable for success.

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