China, the global growth engine, is undergoing a significant transition as the new administration is committed to structural reform in its overall economy. Undoubtedly, financial innovation is on the to-do list, and top officials confirmed an initiative this week: liberalization of the deposit rate.
Specifically, the country’s top central banker reaffirmed their commitment to liberalizing interest rates on bank deposits within two years, an unprecedented move that would force the nation’s lenders to compete for customers by offering the best terms.
What does that mean? Let’s think about this from the standpoint of China’s state-owned banks.
On the borrowing side, they have been soaking up piles of money at a relatively low cost. The Chinese central bank maintains a cap on the rate banks can pay depositors, a system that has left Chinese households poorly compensated, because deposit rates often fall short of the rate of inflation. At present, inflation is running at about 2.5%, while a one-year deposit can pay no more than 3.3%—a level China’s big banks rarely reach. However, most Chinese people still overwhelmingly allocate their assets in savings due to limited investment channels available in the country. As a result, those state-owned banks have no incentive to compete for deposits and make huge profits through the cheap funding.
But with the reform of deposit rate liberalization, they have to improve operations and manage risks more prudently so as to offer the best possible rates in the deposit competition. Who is the winner? Savers! They are highly likely to obtain higher pay on their deposit under the fierce race.
On the lending side, China’s banking sector is well known for the so-called shadow banking system. State-owned banks mainly make loans to state-owned enterprises and many small and medium enterprises (SMEs) are struggling with financing. Furthermore, state-owned banks bypassed the savings restriction by offering wealth management products. The seemingly fancy name of “wealth management” is just another channel of financing. Basically, banks offer higher-than-deposit rates on financial products sold to the general public and then charge even higher rates on lending to government-led investment projects. In this scenario, banks and the government are both winners because they could easily pocket the difference between cost and return, but savers might be the loser since the mismatch of short-term maturity of products and long-term investment projects could trigger serious defaults.
However, I have got a concern here: there is a possibility that those state-owned banks might become even more reluctant to offer loans to SMEs under the pressure of higher borrowing cost. As lenders, what they really care about is borrowers’ credibility, which is usually measured by collateral size, company revenue, track record of investment projects. Consequently, those national lenders might still be skeptical about SMEs’ repayment ability and therefore fund state-owned enterprises, a continuation of what they have been doing for years.
Fortunately, the Chinese government shows its ambition for reform as Beijing advanced a pilot program of private banks at the same time, including two of the country’s Internet giants, Alibaba and Tencent.
For clarification, “Private Bank” here does not refer to the Swiss-style private banking division, which is focused on wealth management business for high-net-worth individuals and families. Instead, it is a new form of banking managed by the private sector, in contrast to those lumbering, state-owned banks.
From my perspective, this initiative would complement the deposit rate liberalization by breaking the state-dominated banking monopoly and addressing the financing problem of SMEs effectively. For instance, let’s think about Alibaba, a selected player in the private-bank trial. The company dominates China’s e-commerce market, which by one measure is now the biggest in the world. Its biggest website, Taobao, is mostly for small merchants and has developed into an online business powerhouse with about 760 million product listings from 7 million sellers. The bond between Alibaba and SMEs has been strengthened through the development of the company’s another affiliate of Small and Micro Lending Group, as well as the enhancement in the so-called Alipay, which is a electronic payment system that protects buyers if sellers don’t deliver. Therefore, the company’s well-developed understanding on SMEs and significant capital advantage tend to prompt financing for SMEs, an action partly motivated by another prospective boom of e-commerce as SMEs progress.
In conclusion, I think the liberalization of deposit rate, as well as the creation of private banks, both call for a stronger regulatory framework, as a significant portion of liquidity in those state banks and in money-market funds offered by Alibaba are flowed into unregulated and untested investments. Therefore, regulators have to develop advanced risk management and consolidation skills to integrate all players into a uniform system for sustainable growth in the financial markets.