Monday, November 21, 2011

Why Interest Rate Reform is Necessary for China Economy

Many economists believe that it is now the right time for People's Bank of China (PBoC) to consider accelerating marketized interest rate reform to gradually allow domestic commercial banks to set their own lending and deposit rates. This article shall outline the whole background of the story and help you to understand why such a market-based interest rate reform should be necessary for China economy.

Current Interest Rate Operation in China:

It is well-known that in the western countries, like the U.S., commercial banks can basically set their own lending and deposit rates in accordance with the actual funding costs in the monetary market, and the central bank determines only the Federal fund target rate that shall guide the overnight interbank rate. In China, it is totally a different operation: PBoC (People's Bank of China) determines the whole range of policy interest rates, including the benchmark lending and deposit rates of all commercial banks, only subject to the approval of the China State Council. Under the current PBoC operation, lending rates are subject to a floor, while deposit rates are subject to a ceiling.

Using the stated-owned commercial banks as a key instrument of monetary policy, however, has its negative economic side effects. In fact, bank loans that are made in accordance with political rather than commercial initiatives have a larger possibility to turn bad. The key method being used to keep the banks healthy now, even they continue to offer loans that may never been repaid, is basically the net interest rate margin set by the central government. The net interest rate margin is currently at a healthy +3.06% spread between the 6.56% 1-year benchmark lending rate and the 3.5% 1-year benchmark deposit rate. With the support of the central government, the banks can easily borrow low and lend high to earn a very healthy profit margin for covering bad loans they may need to suffer due to political initiatives.

Although it can support bad loans for political initiatives, the method of net interest rate margin still has its own disadvantages, as follows:

(1) For depositors, artificially low banking deposit interest rates have imposed negative investment returns on their savings. Due to the lacking of other investment options, a negative real deposit rate will inevitably pump a huge amount of liquidity from bank savings into the real estate, stock market as well as commodity markets, thus creating asset bubbles in these three speculative markets and also intensifying domestic inflation pressures. Rising inflation (CPI) has then resulted in an even more negative real deposit rate for Chinese depositors.

(2) For bankers, the standardized policy interest rates for all commercial banks has created a banking environment with low competition, thus leading to inefficient and oversized operations. This has undercut motivation of the banks to improve their capability to manage financial risks or to improve their operational competitiveness. Chinese banks therefore trend to lend their money to the state-owned enterprises (SOEs) instead of taking any risk to support private small-and-medium-sized enterprises (SMEs). As a result, most of the monetary resources of the country are lent to all the inefficient stated-owned enterprises (SOEs) at subsidized interest rates. Low lending rates to SOEs eventually generate problems of inefficient fixed asset investment or excessive manufacturing capacity for the national economy.

(3) For the central bank PBoC (People's Bank of China), a market environment with low competition among different banks makes the national interest rate level difficult to response quick enough to reflect the actual funding demand and supply conditions. It can also explain why the PBoC monetary tools sometimes could not generate satisfactory policy results as it expected.

As a brief conclusion, China can make use of market-based interest rate reform to control inflation, to suppress inefficient projects, and to allocate funds more effectively etc. Though the reform itself will not be likely to resolve all the economic problems in China, it can at least make the domestic interest rate market a more mature one. However, due to its complex linkages to the various sections of the existing economy, such kind of reform is something just like dismantling a complicated bomb, and that is why the Chinese authorities have no choice but have to do it gradually step-by-step.

Next article:
Inside the Chinese Interest Rate Reform


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