Liberal Urge Gaining Support for Bank Policy

Interest Rate Reform is Now a Top Government Priority That Could Spawn a Lot More Financial Initiatives

The orchestra is tuning up for an interest rate liberalization initiative that financial analysts are calling music to their ears.

Recent high-level comments and policy statements heard in Beijing have clearly sounded a central government call for regulators to slowly relax bank lending and deposit rate controls, and thus give financial institutions more room to charge customers according to market conditions.

Premier Li Keqiang’s remarks at a State Council meeting set the tone June 19. He said the government would “push for liberalization of interest rates,” and two weeks later included that theme in the context of government approval for a free-trade zone in Shanghai attached to financial sector reform, including capital account and interest rate liberalization.

Indeed, the State Council’s general office in July issued a policy recommendation for the nation’s financial sector, urging support for a government economic restructuring program that prioritizes interest rate liberalization.

By “steadily” lifting rate controls, the government wants to “let the market play a fundamental role in capital allocation,” according to the document.

A source at the research office of the central bank, the government’s official interest rate setter, told Caixin that in the near-term “it’s likely the fluctuation band for borrowing and lending rates can be loosened further” by the government. China’s benchmark rates as of July 18 were 6 percent for one-year loans and 3 percent for one-year deposits.

But once the music starts, said central bank sources, liberalization would probably proceed step-by-step, starting with the removal of the lending rate floor.

As of mid-July, banks could lend to their best commercial customers at no less than 4.2 percent.

A subsequent move would give rural credit unions more power to fix their highest lending rates. Further steps under study could involve lifting the five-year term bank deposit interest rate, which was 4.75 percent in mid-July. Sources said the government is also looking at letting financial institutions for the first time issue certificates of deposit.

These and other steps could ultimately lead to full liberalization for interest rates.

No timetable has been set for the start or reaching goals for the gradual process, the research office official told Caixin. But what happens next to interest rate controls is sure to set the tone for all sorts of government financial reforms, perhaps including deposit insurance and bankruptcy policies.

Uncharacteristically, interest rate policy was the sole financial reform mentioned by Li in his recent address. Similar speeches by Chinese leaders in the past have taken broad swipes at a range of goals in areas from foreign exchange rates to securities markets.

Li’s focus underscored interest rates as a priority for economic restructuring which “means Beijing intends to make it an important part in the economic reform agenda and let the cost [of capital] play a key role in resource allocation,” said Huang Jinlao, deputy governor of Huaxia Bank.

Although bank loans and capital investment vehicles are today subject to what amounts to de facto, free-floating interest rates, Huang wrote in an op-ed article published on Caixin in April, more than 85 percent of bank deposits are still locked in a rigidly controlled rate regime. That’s changing. 

“There is a silent liberalization taking place among non-bank financial institutions,” he wrote. “This is in line with China’s financial sector development, but the rapid boom is bordering on irrational expansion, which begs for more order.”

Easy Does It

The government wants to ease the financial sector into interest rate liberalization in hopes of avoiding any drastic market reactions. Officials are also keen to plan carefully and wait for the right time to begin the process.

Now is considered a good time for relaxing rate controls because consumer price inflation rates in China are expected to remain low at least through the end of 2013, said a source close to the central bank.

The market is also itching to give banks more incentives to lend to small- and medium-sized enterprises, which have been given the short end of the stick in recent years as lenders concentrate on supporting low-risk, state-owned companies and government-backed projects. Rate controls have prevented banks from considering risky deals that, in a liberal market, offer high returns.

The rate environment has been blamed at least in part for the excess capacity in some of China’s business sectors now riding on the back of too much leverage. The outlook could turn grim in the future if the nation’s economy continues to slow.

Banks have found ways to loosen the chains of rate-setting rules. For example, many have for years used off-the-book wealth management products and other financial strategies to bypass government regulators. Neither have the government’s rate controls shackled private financing, which has been growing rapidly.

Yet pressure to marketize interest rates has been building, especially since summer 2012, when the central bank widened the borrowing and lending rate range. Since then, banks have been allowed to take deposits at rates 10 percent higher than the official benchmark. They’re also allowed to lend at rates as low as 30 percent under the benchmark.

Last year’s move was one of the biggest shifts for Beijing’s interest rate policymakers since 2004, when the central bank decided to stop dictating a fixed floor for deposit rates and a ceiling for lending rates. Banks also then, for the first time, got permission to set lending rates at 10 percent below the benchmark.

The 2012 action on the lending floor has had little impact, though, since most of the nation’s banks have been reluctant to offer rates at a 30 percent discount. A first-quarter 2013 monetary policy report issued by the central bank said under-benchmark rates were set for only 11.4 percent of all bank loans in March, while 64.7 percent of the loans were higher. 

For that reason, said a source close to the central bank, it would make sense for the government to next completely eliminate the rate floor.

It’s been common for China’s banks to raise lending rates since at least 2009, said Zeng Gang, director of the Research Institute on Finance of China Academy of Social Sciences, who advocates eliminating the rate floor as an easy liberalization step.

Other experts have gotten behind the proposal for no-floor rates because they see access to cheap capital as increasingly important for Chinese businesses, said Wu Xiaoling, a deputy director for the Finance and Economic Committee of the National People’s Congress (NPC). And demand for low-rate bank loans can be expected to grow as the economy slows.

It’s even possible that the adjustment could be made before 2014, said Guo Tianyong, director of the Chinese Banking Industry Research Center at the Central University of Finance and Economics in Beijing. “The lending rate floor can be removed this year,” he said.

Credit, Deposit Tweaks

A related, lending-rate adjustment would target rural credit unions, which generally serve farm communities. Authorities are talking about raising the upper limit for credit union loan rates, which currently can be priced at no more than 2.3 times the benchmark. A source at the China Banking Regulatory Commission (CBRC) told Caixin that a higher ceiling is likely to be allowed.

But in fact, said a source at one credit union, raising the ceiling would have only a limited impact. One reason is that a variety of regulations designed to keep a lid on loan rates for agriculture-related purchases, such as a farmer’s seeds, are already in place.

Moreover, small-scale farmers are already reluctant to borrow from credit unions or even banks. One source said higher loan rates could scare away even more farmers.

Lower on the list of possible liberalization steps is a strategy for adjusting deposit rates for savings accounts at banks.

NPC’s Wu said the confusion sown since financial institutions started multiplying wealth management products could point to the risk potential if banks were allowed to set deposit rates.

“The deposit rate ceiling should not be relaxed at all,” she said.

Wealth products circumvent rate restrictions and lure clients with promises of high returns, but they’re also marked by legal issues and lax risk management, Wu said. Furthermore, she said, lifting the rate ceiling would hamper the development of direct financing.

The finance university’s Guo argued that removing the limit would be harmful because it would spur excessive competition among banks. And since policymakers are aware of this risk, he said, “there is little possibility that the ceiling can be removed before 2015.”

“As soon as the rates become free-floating, banks would grab deposits and push up their own interest rates,” said Lu Zhengwei, chief economist at the Industrial Bank.

Another argument against a free-float plan for deposit rates was posed by Lian Ping, chief economist at the Bank of Communications: He said without limits, lending rates could be forced higher to offset a likely increase in capital costs for banks. In turn, companies would find borrowing more difficult, and their worsening financial plight would hurt the economy.

Still, assuming deposit rate ceilings will remain, many experts are advocating changes in the way deposit rates are categorized. Currently, the government sets seven benchmark deposit rates for demand deposit savings accounts covering terms of 3, 6, 12, 24, 36 and 60 months.

Guo wants the central bank to cut some categories and let banks set their own rates within a regulator-determined band. “There are too many categories to give commercial banks flexibility,” he said.

Fu Bingtao, a strategic planning research fellow at Agricultural Bank of China, has suggested trimming the list of deposit rates by initially eliminating fixed rates for long-term, such as five-year, deposits. These account for only a small chunk of banks’ business, he said.

Only 0.2 percent of all deposits by monetary volume were in five-year accounts last year at Industrial and Commercial Bank of China, according to the bank’s annual report. And these comprised only 0.1 percent of the deposits at China Construction Bank.

As an alternative to higher deposit rates, banks might be allowed to start offering customers new ways to save through fixed-rate, certificates of deposit (CDs).

Central bank officials in 2004 raised but quickly shelved the possibility of allowing CD accounts at China’s banks. That was a year of surging liquidity after robust exports sent the nation’s foreign reserves soaring and forced the government to print the currency needed to buy U.S. dollars from exporters and maintain the yuan’s exchange rate. To mop up that liquidity, the central bank issued notes at modest interest rates that would have been unattractive if CDs had been allowed.

The atmosphere changed, and today a CD proposal is back on the agenda.

What’s changed is that the yuan’s exchange rate against the dollar is higher, and a small share of China’s GDP is tied to exports. Thus conditions are ripe for allowing CDs, which are good fund-raising tools for banks, said Ma Jun, managing director and Greater China chief economist at Deutsche Bank.

A bank can set CD interest rates without challenging its traditional deposit savings business, Ma noted. Indeed, if CDs are given a green light, he thinks they would attract 10 percent of the money now held in Chinese bank deposits.

Banks could offer their clients CDs as an alternative to wealth management products, which can pay high interest rates but have been criticized for breeding shadow banking practices.

“Wealth management products hurt a bank’s deposit base,” said Zeng. “But CDs won’t.”

Zeng said that unlike wealth management products, which come with various maturity periods and redemption conditions, CDs carry fixed terms and are tradeable on the secondary market. For banks, therefore, a CD is a safely locked deposit.

But what happens if regulators decide to lift all benchmark interest rates? How then will banks price their products?

A report issued by CBRC’s interest rate liberalization research team this year said that due to the lack of a reliable benchmark yield curve—that is, a curve showing several interest rates with different lengths of maturity but tied to the same contract terms— it’s hard for China’s market players to form effective expectations. This has, in turn, hampered the ability of commercial banks to carry out price discovery.

Experts told Caixin that one possible anchor for interest rates in a future market without government controls could be Shibor, a reference rate based on Shanghai interbank money market lending rates. Shibor’s role could expand to embrace the task of shaping market interest rates without functioning as a benchmark.

In place since January 2007, Shibor reflects the price of lending among Chinese commercial banks with relatively high credit ratings.

But Shibor offers little guidance for long-term bank loans, said Lian of the Bank of Communications. That’s because Shibor can only set yield curves for short-term deals.

And Shibor is not without stability challenges. The industry fretted in late June when Shibor rates suddenly shot up, topping 13.4 percent, in reaction to a cash crunch.

Another possible reference for bank rate-setting, particularly for long-term borrowing and lending, is the central government treasury bond yield, said He Liping, Finance Institute director at Beijing Normal University.

Comments by He reflect a government push to broaden the influence of treasury bonds, which was underscored by a Beijing decision in July to allow the restart of government bond futures trading after a 18-year hiatus. Sources told Caixin futures trading could start as soon as mid-September in Shanghai.