As People's Bank of China (PBoC) already announced to start a market-based interest rate liberalization reform on 7 June 2012, we would like to look into more details and discuss about its real outcome in the following paragraphs.
Since the central bank's announcement, there is a sharp cut in lending rates and an actual hike in deposit rates at the same time (Source: How liberalization Reform Starts). These will obviously reduce the interest rate difference (lending-to-deposit), and hence the profit margin, of all Chinese commercial banks. Let us have a closer look at the following table:
| Duration Period | PBoC Rates (Benchmark) | Net Change (Benchmark) | Maximum Allowable Rates (Actual) | Net Change (Actual) |
|---|---|---|---|---|
| 6-month | 2.80% | 0.00% | 1.325% | -0.865% |
| 1-year | 3.06% | 0.00% | 1.473% | -0.931% |
| 2-year | 2.30% | 0.05% | 0.610% | -0.975% |
| 3-year | 2.00% | 0.10% | 0.205% | -1.005% |
| 5-year | 1.70% | 0.15% | -0.170% | -1.015% |
'PBoC rates' refer to benchmark rates set by the Chinese Central Bank.
From this table, the maximum change in actual interest rate difference (lending-to-deposit) can be as high as -1.015%! Actual minimum rate difference is -0.865%, which means Chinese commercial banks at least lose 0.865% of their profit margin and will lose at most 1.015% after the change.
It is also interesting to see that the net change in benchmark interest rate difference (IRD) is no negative from 0% up to +0.15% (showing that IRD expands as time duration extends), which can be really misleading.
Now the maximum interest rate difference (lending-to-deposit) becomes 1.325% (was 3.06%). Rate difference actually decreases and continues to drop from 1.325% as time duration extends and, for example, becomes only 0.205% for 3-year deposits. Surprisingly you will find a negative interest rate difference (-0.17%) as time deposit duration increases to 5 years! This is the first time there is a negative rate difference for Chinese bankers. Possible outcome for Chinese commercial banks is quite obvious: It will unavoidably hurt their expected earnings per share (EPS), thus forecasting a higher forward P/E (Price-to-Earnings Ratio) and a greater pressure on their stock prices.
In financial markets, it is widely expected that the rates cut this time should be regarded as a signal to reduce borrowing costs and to stimulate the Chinese economy amidst European debt crisis. In fact, central banks of many emerging markets, including India, Brazil, Russia etc, have already started lowering interest rates before China to do so.
What seems to be special in China is a side effect for the reduction in interest rates. The sharp cut in official lending rates should suppress the high borrowing costs in private lending markets in cities that heavily relying on SMEs (Small-and-Medium Enterprises) like Wenzhou. This can really reduce debt burdens of lenders in private markets and is therefore a good news to these SMEs.
Who pay the bills for this stimulation? The Chinese commercial banks, of course. They are in fact providing more subsidies to lenders due to the lending interest rates cut. For all Chinese commercial banks, the high-growth era of having large interest rate difference (IRD) and guaranteed profit margin due to monopoly is now over and this is the real outcome of the market-based interest rate reform.
The above table reaffirms our earlier comments that the Chinese commercial banks are the loser of the market-based interest rate reform. Reference: Chinese Banks are Real Losers of the Interest Rate Reform. There is a sharp cut in guaranteed profits out of interest rate difference (IRD) now and bankers should seek additional sources of revenue other than purely IRD as quick as possible. Current IRD-dependent earning model will no longer be feasible soon. Since it will take time for shifting of revenue structure and earning model, we decide that stocks of Chinese commercial banks will not be our picks in 2012.
This is, however, only a short-to-medium term impact on the Chinese banking industry. In the longer run, smaller profit margin of commercial banks should lead to more cautions in their lending activities and better allocation of funds. In fact, there are still too many unnecessary loans available in the Chinese market, and these loans always lead to problems of excessive capacity (supplies more than demands) in various industries. The excessive capacity issue exists traditionally in China for a very long time and a more desirable way to resolve this issue is to make Chinese commercial banks more selective in their lending business. Now this round of market-based interest rate reform should help suppressing low-return projects and reducing unnecessary loans to speculators. It should result in a better non-performing loan (NPL) ratio, and thus a more healthy banking system over the long term. The reform now is similar to dismantling a bomb, and you better do it carefully step-by-step. This will not solve all banking problems overnight in China, but will surely make it a more mature market. Reference: Why Interest Rate Reform is Needed.
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