22 January 2019
Households with net savings stand to gain from interest rate liberalization. Photo: Bloomberg
Households with net savings stand to gain from interest rate liberalization. Photo: Bloomberg

Pop goes the Big Bang theory of financial evolution

Some market players have argued that China has entered an era of “big bang” financial reforms, with full capital account and renminbi convertibility just a few short years away.

This optimistic outlook implies that Beijing will soon fully liberalize deposit interest rates, which are capped at 10 percent above the official benchmark rates. The deposit-rate cap is a major element of financial repression in China because it restricts local banks from offering higher deposit interest rates, irrespective of what market forces warrant.

These optimists need to rethink their lines of logic because they have missed the fine balancing act that Beijing has to strike in the course of financial liberalization.

International experience shows that a deposit insurance system is a prerequisite for deregulating deposit interest rates. Japan and the United States set up deposit insurance before deregulating their deposit rates; South Korea and Taiwan did it alongside the deregulation process. Beijing has reached a consensus to establish deposit insurance as a step forward.

The main task is for Beijing to gradually allow market forces to determine the deposit rate. It made an initial, albeit small, step in this direction by introducing an interbank market for negotiable certificates of deposits (NCDs) in December. Trading is restricted to interbank players though.

A natural next step would be to introduce NCDs tradable in a public secondary market open to large Chinese firms and ultra-high-net-worth depositors. Japan began its interest rate liberalization by introducing tradable NCDs for its large depositors.

Next, Beijing could consider scrapping the deposit rate caps for large-denomination, long-term time deposits, such as those of five years and longer. This was what the US did before doing away with Regulation Q in 1986. Since long-term time deposits account for less than 1 percent of total bank deposits, their potential systemic effects should be easy to manage.

A road map for liberalizing China’s interest rates is one thing, but the timing of its rollout is quite another because Beijing has to balance the interests of the winners and losers in the process.

The benefits are clear: Interest rate liberalization, together with other financial reforms, should help improve capital allocation efficiency. It is also a prerequisite for China to deepen its capital markets, enable correct risk-premium pricing, and lay a solid foundation for capital account and RMB convertibility.

But, interest rate liberalization changes the rules of the game by reshuffling the positions of the winners and losers. Small and mid-size enterprises and households with net savings stand to gain the most as they gain access to credit and higher returns. But banks and state-owned enterprises (SOEs), the major beneficiaries of financial repression, should become losers. This is likely to create problems for implementation because the losers would be those with deep vested and political interests in the system.

Financial repression has created a minimum 300-basis-point spread between lending and deposit rates for Chinese banks, thus guaranteeing them a monopolistic profit at the expense of households. Scrapping the deposit rate cap will drive up the deposit interest rate as competition for funds spreads across different market segments and, thus, destroys the banks’ monopolistic profit. The SOEs also stand to suffer from much higher financing costs.

Liberalizing interest rates too fast can aggravate the risk posed by local government debt, which has added significantly to China’s public debt burden since 2010. A key parameter for determining the long-run sustainability of public debt is the gap between the nominal interest rate and nominal GDP growth rate. At 53 percent of GDP, China’s existing total public debt load is manageable. But interest rate liberalization could threaten this sustainability by pushing up the public sector’s debt-to-GDP ratio through sharply higher interest costs.

Given all these challenges, China’s leaders should take a cautious approach to interest rate liberalization. Gradual implementation would enable the losers to adjust their behavior while Beijing can sustain momentum on pivotal reforms.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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