On July 19, the PBOC deregulated lending rates by taking away the floor on these rates. Commercial banks in China are now free to fix rates on loans to clients. The floor was earlier set at 30% of the benchmark rate.
The biggest beneficiaries of the deregulation will be the domestic small and medium enterprises (SMEs). These enterprises have been complaining about high interest rates on loans affecting their plans to raise resources. The measure is expected to significantly increase their access to funds.
The floor on lending rates had put SMEs at a distinct disadvantage. Since the interest rate on commercial loans was artificially fixed and not market determined, banks used to extend loans mostly to the state-owned enterprises (SOEs), which could absorb the high-cost loans due to state support. On some occasions, the loans turned bad in bank ledgers as the SOEs were unable to service them due to their own inability to generate profits.
While the new policies will not stop banks from lending to the SOEs, as these are still the high net worth corporate customers, they can spread their lending portfolios wider by including more to SMEs. The SMEs will obviously benefit and Chinas banks will increasingly price their loans based on market principles.
While lending rates have been decontrolled, deposit rates have not. The upper ceiling of 110% of the benchmark rate continues to remain on deposits. Several analysts have expressed surprise at the PBOCs decision to leave the deposit rates untouched. With banks free to determine lending rates, which are higher than the capped deposit rates, profitability of banks remains assured.
One might argue that even if deposit rates had been decontrolled, banks would not have raised them immediately for mobilising credit. Unlike in India, Chinese banks have not been excessively perturbed over liquidity affecting inflation. As a result, they are unlikely to have used the deposit rate as a tool for mobilising cash held by the public.
Moreover, a large number of transactions in China still get carried out in cash. Low deposit rates and lack of enough sophisticated financial instruments yielding high returns have ensured that people hold on to idle cash rather than parking it in banks or other areas.
The PBOCs move though has taken many by surprise. While there have been several opinions expressed in the media and academic circles about China speeding up financial liberalisation, many did not expect the PBOC to decontrol lending rates in one go. Most felt the move would be gradual and calibrated.
It is obvious that the PBOC and Chinas new leadership has been closely monitoring the developments in the international financial markets and the opportunity for China to play a significant role in global financial transactions and movement of financial assets. The strength and size of the Chinese economy and the increasing use of the yuan in international business transactions gives China the head-start in becoming a global financial hub. But this requires Chinas domestic financial markets and institutions to adopt rules that are closer to global financial standards.
Chinas financial sector reforms have lagged much behind its external sector reforms. The gap is reflected in the structure of Chinas balance of payments as well. Huge trade surpluses from the current account have been fuelling foreign exchange reserves. China has not had occasions to worry over current account deficits. Quite unlike India again, for whom capital account surpluses have been essential for managing the current account deficit. While India has not moved to full convertibility in the capital account, its policies on capital inflows and their integration in the domestic debt and equity markets reflect global standards more closely than Chinas. This is understandable since Chinas focus has hardly been on its capital account.
Banking sector and interest rate reforms are fundamental to financial liberalisation and full capital convertibility in China. The earlier regime under President Hu Jintao and Premier Wen Jiabao was more cautious in this respect. The new leadership, however, appears more decisive and keen to change regulations. Deregulating lending rates in one sweep reflects the urgency.
While the interest rate reforms mark the beginning of a new phase of financial liberalisation in China, domestic interest groups opposing decontrol continue to remain active. The PBOCs inability to decontrol deposit rates reflects the resistance of Chinas main state-owned banks to the move. These banks have been profiting from the differential between lending and deposit rates. Freeing deposit rates would have gradually raised the pitch for raising them for curbing excessive liquidity and would have affected profitability.
Clearly, India is not the only example of reforms remaining incomplete due to intervention by domestic groups. China too suffers from such anomalies.
The author is head (Partnership & Programme) and senior research fellow at the Institute of South Asian Studies in the National University of Singapore. Views are personal. He can be reached at email@example.com