Inside the Chinese Market-Based Interest Rate Reform

In our previous article, we have explained briefly why the PBoC (People's Bank of China) should expedite its interest rate reform. In this article, we shall go into more details its advantages, implementation approach, and its major drawbacks etc.

Firstly, here is the summary for the main advantages of a market-based interest rate reform:

(1) A market-based interest rate reform allows financial institutions to freely price their services and products on their own, so that they can compete with each other and can reflect the real customer choices in the market. The monetary market can then reflect the risk-taking, risk pricing, and the true demand and supply relationship of financial services and products for different financial institutions. Therefore we can say a market-based interest rate operation can enable proper allocation of market resources and to form a more mature monetary market.

(2) A market-based interest rate reform can also help controlling inflation and help suppressing inefficient projects. Please read: Why Interest Rate Reform is Necessary for China Economy for more details.

(3) In fact, there have actually two kinds of lending rates in China: one is the official lending rate set by the PBoC, while another is the private lending rate determined by the private market. As the central government has started to tighten its monetary policy, bank loans are mostly offered to state-owned enterprises (SOEs) at the official lending rate, and therefore other non-SOEs, or small-and-medium-sized enterprises (SMEs), can only obtain loans at a much higher private lending rate (unofficial rate outside the normal banking system). This is the root cause of the recent SME Credit Crisis in Wenzhou City. It is expected that once a market-based interest rate reform can be carried out, Chinese banks will be able to offer more bank loans to SMEs based on real market needs. Though the banks should still require a higher lending rate to SMEs than SOEs, they should not be allowed to lend at a skyrocketing triple-digit-level rate that had reached in Wenzhou private market.

(4) Now, as interest rate adjustments cannot always produce satisfactory results, PBoC (People's Bank of China) cannot rely too much on this policy tool. With market-based interest rates become available, Chinese central government can then shift the focus of its macroeconomic controls from administrative measures to interest rate adjustments. The main reason is that the market-based interest rate adjustments should normally be more effective than administrative measures for steering the economic growth of a country. In the contrary, the effectiveness of administrative measures relies just too much on the execution of the local government officials who may occasionally not follow exactly what central government wants to do.

(5) As the monetary market becomes more mature and more effective, the central government can then use it to facilitate longer-term economic plan, for example, to reorient investment to develop local demand and to support domestic consumption under the current 12th Five-year plan.

How can a market-based interest rate reform be processed in China?

One implementation approach is to have the central bank to set a target or reference rate, and then to allow different commercial banks to freely set whatever lending and deposit rates they can offer to the market based on commercial considerations. This is just similar to what has been using in most western countries.
Another implementation approach is to have the central bank to manage different commercial banks to offer a more flexible interest rate margin, thus encouraging banks to play a more responsible role in serving not only SOEs but also SMEs.

For timing and sequencing considerations, a market-based interest rate reform should be carried out when the national economy is not at an overheated level and when the opening-up of capital account is not occurred simultaneously.

As the initial stage of implementation, it is estimated that the reform can start with the deposit interest rate, by giving banks a certain degree of flexibility to adjust deposit rate levels on their own to attract customers first. Lending interest rate reform can then be carried out at the later stage.

Main drawbacks of a market-based interest rate reform in China:

(i) Soon after a market-based interest rate reform, it will immediately shrink rate spread of all Chinese banks due to the narrowing of gap between lending and deposit interest rates.

(ii) Overall financial market risk: instability in financial market may occur due to excessive bank competition or excessive lending etc.

The above drawbacks, however, can be resolved by:

(a) Enhance banking regulation and supervision: this can prevent banks from entering into too risky businesses.

(b) Implement strict monetary policy control: this can avoid excessive lending demand of the banks.

(c) Use different policy tools: this can deepen the whole monetary market and avoid financial market instability.

Having considered its advantages and drawbacks, we do support China to continue and speed up the process of market-based interest rate reform. However, the reform has to be carried out extremely carefully in order to avoid any financial instability that could happen in the western world.