Friday, June 15, 2012

Is China Really Cutting Interest Rates? How liberalization Reform Begins

You may be a bit surprised to hear that PBoC (People's Bank of China) suddenly announced on 7 June 2012 to start cutting interest rates by 0.25%. It was the firstrates cut of the central bank since December 2008 when the global financial crisis propagated extensively. This surprise has given a speculative excuse to the financial market that a new round of Chinese monetary easing may be about to begin.

However, it was not the biggest surprise PBoC (People's Bank of China) had delivered to the financial market. PBoC, on the same day, announced to initiate a market-based inertest rate liberalization reform by introducing an unprecedented upper floating-range limit for deposit rates, the first step ever and a milestone in its liberalization reform history. Reference: Liberalization Reform Process. The initial upper floating-range limit, or called deposit-ceiling, is now set at 1.1 times the benchmark deposit interest rates (means maximum 10% more). This gives greater flexibility for bankers to attract their customers by setting their own deposit and lending rates competitively, thus bringing real competition between different commercial banks.

Is PBoC Really Cutting Interest Rates?

This is really a good question, and our answer is obviously NO for Chinese savers. As you should be aware of, devil is always in the details. What is tricky is that PBoC is only cutting benchmark deposit interest rates while allowing a maximum of 10% flexibility for financial institutions. After adding the maximum 10% allowed flexibility, ACTUAL deposit interest rates can even be higher than the previous levels (see below Table) before cutting rates! For Chinese borrowers, however, our answer would be YES. In fact, after applying a lower floating-range limit for loans which is now set at 0.8 times (was 0.9 times) the benchmark lending interest rates (means maximum 20% off), PBoC is actually cutting far more than just 0.25% that can help reducing borrowing costs. Although the net changes (benchmark) appears the same (0.25%) for all time durations (see below Table again), the actual cuts keep rising (net changes are from 0.81% up to 0.905%) as the time duration extends.

Duration PeriodPBoC Rates (Benchmark)Net Change (Benchmark)Maximum Allowed Rates (Actual)Net Change (Actual)
N/A (Saving or Demand deposit)0.40%-0.10%0.440%-0.060%
3-month (Time deposit)2.85%-0.25%3.135%0.035%
6-month (Time deposit)3.05%-0.25%3.355%0.055%
1-year (Time deposit)3.25%-0.25%3.575%0.075%
2-year (Time deposit)4.10%-0.30%4.510%0.110%
3-year (Time deposit)4.65%-0.35%5.115%0.115%
5-year (Time deposit)5.10%-0.40%5.610%0.110%
6-month (Lending)5.85%-0.25%4.680%-0.810%
1-year (Lending)6.31%-0.25%5.048%-0.856%
1-3 years (Lending)6.40%-0.25%5.120%-0.865%
3-5 years (Lending)6.65%-0.25%5.320%-0.890%
Over 5 years (Lending)6.80%-0.25%5.440%-0.905%

Table: Latest Chinese Interest Rates Structure For Different Time Durations - Benchmark vs. Actual. Source: People's Bank of China (PBoC)

By looking at the details of this table, taking 1-year time deposit duration as an example, the latest 1-year benchmark deposit rate is 3.25% after cutting 0.25% (the longer the time duration, the larger the degree of cut). However, it can actually allow to reach 3.575% maximum which is even 0.075% (net change) higher than the previous level (3.5%) prior to liberalization reform. In fact, it is not unique for 1-year duration, the actual net changes are all positive (net changes are from 0.035% up to 0.115%) for all time deposit duration periods (except for saving or demand deposits, which are not time deposits at all).

It already happened the first implementation day of this reform (8 June 2012) that some commercial banks have immediately raised deposit rates to the maximum allowable floating-range level (means 10% more). Large stated-owned commercial banks, although a bit more conservative, have still raised to 1.0769 times the benchmark deposit rates (not making full use of 1.1 times), which is equivalent to 3.5% for 1-year time deposit duration. As a result, 3.5% is now a new standard of minimum 1-year deposit rate in the whole banking market, thus just restoring at least to the same level prior to liberalization reform. It appears as if the benchmark deposit rates cut is only used to compensate the actual deposit rates hike triggered by the liberalization reform.

While many people believe that it can be a start of a new rate-cut cycle and should represent a strong policy signal to stimulate the weakening Chinese economy amid slower growth in exports and weaker lending demands, however, we do not regard it as a turnaround of monetary policy or a signal of monetary easing. In fact, there is no evidence that it can be interpreted as a new round of monetary easing simply because deposit interest rates are not actually lowered. As some commercial banks can no longer follow exactly the PBoC benchmark rates and can even raise up to 10% more on their own, it should encourage savers to put more money into their deposit accounts and can result in a tightening effect on liquidity in the banking system.

We expect, owing to keen banking market competition, most if not all of Chinese commercial banks will soon use the maximum allowed deposit floating-range level (means 10% more) as it goes. This will eventually make actual deposit rates of the overall market surpass the previous levels prior to liberalization reform.

Will this Interest Rates Cut Trigger Inflation Expectation?

There is a long lasting myth that interest rates cut must trigger inflation expectation. However, it is not true for this time as it is processed along with liberalization reform. Deposit interest rates actually increase (not decrease) after factoring all the changes and therefore should not be posting additional risk of inflation expectation at all.

In fact, inflation pressure has already started to ease in recent months. Latest data suggests that CPI (Consumer Price Index) in May is only +3% YoY. It seems a room for more aggressive monetary policy changes is still feasible and is not unlikely to happen.

We do support PBoC (People's Bank of China) to expedite and accelerate its liberalization reform. Reference: Why Liberalization Reform is Useful. However, now commercial banks have only 10%-20% flexibility to adjust on their own according to actual market needs. Policymakers should gradually offer commercial banks greater flexibility, better control and freedom in setting their own lending and deposit rates, so as to give them price-setting ability and to form a more mature monetary market. Chinese central government can then shift the focus of its macroeconomic controls from governmental-administrative measures to market-based interest rate adjustments. According to basic free-market principles, market-based adjustments should normally be more effective than administrative measures for steering the economic growth and controlling inflation expectation of a country. In addition, effectiveness of administrative measures relies mostly on execution of local government officials who may occasionally not follow exactly what central government wants to do. In this case, administrative measures can be highly unreliable and should be avoided in the long term. Relying less on administrative measures should be a more balanced way to give free-market a greater role in policy execution.

Anyway, it is a good news to hear that interest rates liberalization reform now begins in China. Bankers no longer need to follow exactly the benchmark interest rates instructed by PBoC (People's Bank of China) and start to have their own price-setting ability. For ordinary customers like us, we should all celebrate that a new era of Chinese banking sector has already come.


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