Last updated: July 19, 2013 6:48 pm

China takes step to financial reform

Building workers unload bricks under a sign that reads 'Beautiful Chinese Dream' in Chinese characters on a street in Shanghai©AFP

Building workers unload bricks under a sign that reads 'Beautiful Chinese Dream' in Chinese characters on a street in Shanghai

China’s central bank has liberalised tightly controlled interest rates in a clear sign of Beijing’s intention to tackle the difficult financial reforms that economists say are needed to keep the Chinese economy on track.

On Friday, the People’s Bank of China said it was scrapping a decades-old floor on the discount that Chinese banks can offer for commercial interest rates – the biggest change to the country’s interest rate regime since caps on lending rates were removed in 2004.

But the highly symbolic move marked something of a bureaucratic defeat for the central bank, which had hoped to liberalise the ceiling on bank deposit rates at the same time, according to people familiar with the matter.

In a statement, the PBOC said the main reason for not removing caps on interest rates for deposits was because the implications of that reform were much greater and the risks of implementing it much higher.

“We must proceed [with this reform] in an orderly manner once all the necessary preconditions are in place,” the bank said.

The main opponents of deposit-rate liberalisation are China’s state-owned banks, which depend on the spread between artificially low deposit rates and lending rates to stay profitable.

In this instance, they were able to convince China’s State Council, or cabinet, to delay the liberalisation that the PBOC was pushing for.

Nevertheless, the move announced on Friday still provides a strong signal that China’s new leaders, who took over in March and are expected to rule the world’s second-largest economy for the next decade, are committed to pushing ahead with financial reforms.

It came only days after the International Monetary Fund took a more cautionary note than it has in the past and warned that it was “increasingly urgent” for Beijing to implement critical economic reforms and that China’s investment-dependent economic model was “not sustainable and is raising vulnerabilities”.

“This is a big deal,” said Mark Williams, chief Asia economist at Capital Economics. “It is the biggest step to date showing the government is willing to allow market forces to play a bigger role in the financial sector.”

As China’s economy slows – from double-digit rates of expansion a couple of years ago to 7.6 per cent annual growth in the first half of this year – financial market reforms are seen as increasingly important.

“From a macro perspective, to some extent, [the latest reform] could be regarded as a ‘stimulus’ to the real economy, as state-owned enterprises will face a lower effective borrowing rate and that would help the economy to pick up somewhat late in the third quarter and in the fourth quarter [of this year],” said Liu Ligang, chief economist for Greater China at ANZ bank.

Reform of the state-owned banking system is seen as especially urgent since easy credit combined with tight restrictions on the formal financial sector have spawned a thriving shadow banking sector in recent years.

A plethora of entities, many of them linked directly or indirectly to state banks, have entered the market selling wealth management products, trust products and other financial instruments that already offer much higher interest rates than tightly regulated traditional bank deposits.

Some analysts argue that this has led to de facto interest rate liberalisation for China’s rich, since poorer people usually cannot afford to invest in these products and are forced to put their savings into deposit accounts offering artificially suppressed interest rates that are barely above the rate of inflation.

Interest rate liberalisation is also regarded as a necessary precondition for eventual full convertibility of the renminbi and for China eventually to loosen its tight restrictions on cross-border capital flows.

Although highly symbolic, the scrapping of the floor on lending rates, previously set at 30 per cent below the benchmark rate, is unlikely to have a significant near-term effect on financial markets and so was seen as a relatively uncontroversial reform to implement.

Only 11 per cent of all loans in China were priced anywhere below the benchmark interest rate in the first quarter of this year and almost none of them was priced at a 30 per cent discount.

“Symbolically, it is a move in the direction of liberalisation, but the actual effect on lending rates will be very small,” said Yu Song, an economist at Goldman Sachs. “This intention is consistent with the recent overall macro policy direction: they want to reduce the financial burden of companies, which is beneficial for economic growth.”

On Friday, the central bank also said it had eliminated the upper limit on lending rates by rural co-operatives and lifted interest-rate controls on the discounting and re-discounting of bankers’ acceptances.

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