Interest rate liberalization in China

Interest rate liberalization in China is long overdue, but steering the banking system of the second large economy in the world to a new direction is not a easy task. That’s why PBOC is hiring new brains to deepen their understanding of how to transform to a central bank more like other central banks, for instance, the Federal Reserve Bank of United States.

Ma Jun, until recently Deutsche Bank ‘s top China economist, was hired as the Chinese central bank’s new chief economist.   At a economic-policy session held by the PBOC and the IMF on March 27 in Beijing, he was proposing a plan to liberalize the country’s financial system within three years,  which he claimed will help the the country‘s economy reformation and sustain economic growth.

Currently, the PBOC targets a measure of bank credit called M2 and instructs China’s giant state-owned banks about their lending practices. For instance, the PBOC has told banks to halt loans to troubled real-estate developers and industries marked by overcapacity. By contrast, other central banks take a less direct role by setting benchmark rates that offer a guidepost to banks as they lend.

Mr. Ma said China should liberalize in steps in approximately three years. First it needs to establish a central bank-blessed interest rate(China’s interbank rate) that would set a benchmark for lenders. That would give China the equivalent of the U.S. federal funds rate. During a first stage of reform, the PBOC should keep its intentions about the interbank market quiet and target a broader measure of money supply, known as M3. If the interbank lending system stabilized, China could shift fully to a monetary policy where the PBOC would set the interbank market rate, and banks would be free to charge what they like for deposits and loans.But for such a plan to carry out, there are several caveats that must be factored in.

First of all, will PBOC be willing to give up control of lending by state-owned banks? Ma Jun must bear in mind the fact that it is much more easy for PBOC officials to send directives than to maneuver in a much more complicated market like Federal Funds Market.

Secondly, the biggest obstacle lies ahead for interest rate liberalization is what is known as the local government debt issue. lots of local governments of China have been facing the risk of default on the colossal debts borrowed from state-owned banks. These debts were used to fund local governments unplanned and outrageous investment in infrastructure in order to boost local GDP growth, which is closely tied to the evaluation of local governors performance.

If the interest rate freed up too quickly, there is fear that the interest rate will be too high and local government will have to borrow more new debts to payback old debts. The huge default risk will put China’s economy in a perilous situation.

Mr. Ma, taking into account the local debt issue, urged China’s local governments to boost the transparency of their operations and make bonds – not borrowing from banks and shadow-banking institutions—their main financial channel. “The advantages of doing so are to boost transparency of local government debt, to let the interest rates better reflect default risks, to solve duration mismatch and to diversify risks over-concentrated in the banking system,” he wrote.

The growing inability of local government to finance their debt is considered one of China’s biggest financial weaknesses. Unless there is a safer way to settle down local debt problem, I am afraid the interest rate liberalization agenda will be postponed.


One thought on “Interest rate liberalization in China

  1. lippmanb

    The inability to pay debt is a huge setback for the Chinese economy. This is made worse by the fact that it is the second largest economy in the world.

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