(Revised) Interest rate liberalization in China

China’s top officials made New Year resolution to bring about economic overhaul. At the Boao Davos Forum, Premier Li Keqiang emphasized that the government won’t panic in the face of slowing growth. Some analyst says that the slowing growth means that difficult reforms will be put off indefinitely. But easier one such as the interest rate reform is unwinding. The People’s Bank of China is in its final stages of winning approval for a bank deposit insurance system.

Interest rate liberalization in China is long overdue. But once it is implemented successfully, it will put money in the pockets of ordinary Chinese savers, make the banks evaluate risks more carefully, and direct lending to privately owned firms that complain of China’s largest banks ignoring them.

Yet steering the banking system of the second large economy in the world to a new direction is not an easy task. 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.

 PBOC is hiring new brains to deepen their understanding of how to transform to a central bank more like other central banks. Ma Jun, until recently Deutsche Bank ‘s top China economist, was hired as the Chinese central bank’s new chief economist. He proposed a plan to liberalize the country’s financial system in steps within 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.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 “(Revised) Interest rate liberalization in China

  1. nickcoll

    I wonder if any foreign government would be willing to step in an help with the debt issue. It seems that many countries want China to reduce their currency manipulation. The reduction in currency manipulation could even increase capital flows into China as investors become less opposed to China.

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