China on path to becoming free market economy

KUWAIT: China took another important step towards liberalization last week by removing the interest rate ceiling for deposits with a maturity of less than one year, having already removed the cap on deposit rates with a maturity of one year and above in August. After months of gradually relaxing its control on interest rates, the Chinese government has finalized its long-promised interest rate liberalization plan. The impact will not be felt in the short-term, but the longer term effect will be substantial.
With deposit rates fully liberalized, commercial lenders and rural cooperatives can offer rates on their deposits that can potentially compete with those in the non-official sector (shadow banking), where rate restrictions did not apply. In the long run, shadow banking products, such as the rapidly growing wealth management products, may begin to lose their appeal. Still, regulators need to step up their fight against shadow banking in order to consolidate bank deposit demand as wealth management products continue to offer returns as high as 20 percent. The liberalization of bank deposit rates may help retrench the shadow banking industry, making the financial sector more transparent and better governed by monetary policy.
The removal of the cap may put further upside pressure on bank deposit rates as they better reflect the market in the long run. In the past, deposits were priced on average below the inflation rate. Given the country’s weak social security structure, Chinese individuals had to save a large portion of their income in order to meet future expenses. The latest deregulation should gradually push rates above inflation, providing Chinese consumers a safe instrument to allocate their income, allowing them to earn more on their savings and spend more. The savings rate is as high as half of GDP in China, compared with less than 20 percent in the US. The latest deregulation could help alleviate that rate as households begin to spend more, accelerating China’s shaky transition from an investment-based economy to a consumer-based economy.
Mid-sized banks will have a greater role in the economy as they finance the credit-hungry small and medium enterprises (SME). In recent years, China’s state-owned enterprises (SOE), the country’s investment engines, enjoyed preferential treatment and an abundance of cheap credit from their big bank counterparts. Large banks’ disregard for yield and risk in their lending activities created an abundance of inefficient and wasteful investments. So far, China’s big five state-owned banks are reluctant to increase deposit rates, fearful of hurting tight margins, especially at a time when credit demand is weak. However, most mid-sized banks have already increased the rate on 1-year deposits to 2 percent, 50 basis points higher than the benchmark rate and 40 basis points higher than inflation. The smaller and probably more productive firms have been struggling to secure bank credit, many resorting to shadow banking financing. The rise in deposit rates could boost mid-sized banks’ funds that could be made available to SMEs, while the tighter net interest margins could spur more prudential lending. Mid-sized banks will gradually attract more SMEs and consumers. In the long run, interest rate liberalization could reduce the role of SOEs and boost the importance of SMEs, a key shift that would help China become more market-based. In fact, this could be seen as one of China’s first steps into SOE reform.
Last week, China’s central bank cut the lending and deposit rates, for the sixth time in less than a year, and the reserve requirement ratio, by a total of 250 basis points this year. Previously, the effect of monetary loosening would exacerbate unbalanced growth through SOEs and the shadow banking industry. The rate deregulation could reduce this effect in the long run, by boosting household consumption and strengthening SMEs. It will take some time before the liberalization of deposit rates makes a significant impact on the economy, while the government still needs to tighten the shadow banking industry and reduce the role of SOEs. But overall, China is on the right path to becoming a more market-based and consumption-led economy.

— Camille Accad is economist at Asiya Investments Company.