Why China's "Interest Rate Liberalization" Is Much Ado About Nothing
One of the catalysts driving the Friday rally in stocks was news from the PBOC that China was pushing forward with liberalization of its "interest rate controls" by removing the lending rate floor. Back then we asked, rhetorically, that "besides optics, because China does not have a market clearing interest rate so this announcement is largely moot, will this announcement have an actual impact on Chinese lending or transmission mechanisms? Hardly." As SocGen lays out today, "Hardly" was indeed the accurate answer: "Although the step is of great significance, the near term impact is likely to be very limited."
The reason being that removing a floor on lending rates is meaningless as no banks were using the already permitted minimum lending rates, and the result is that the PBOC's move is "unlikely to get translated into lower borrowing cost for corporates in the near term." What is far more important to the Chinese credit market (from the demand side) is what the deposit rate is. And it is here that the PBOC is unlikely to do much if anything for the next several years.
The People’s Bank of China is back on the Friday night shift with a pleasant gesture of further interest rate liberalisation. As we anticipated, bank lending rates are fully liberalised. However, this change is unlikely to have much immediate impact on the real economy
The People's Bank of China announced three measures of further interest rate liberalisation, effective on 20 July.
- The floor to lending rates (except mortgage rates) offered by all financial institutions is removed.
- Discount rates are fully liberalised.
- The ceiling on lending rates offered by rural cooperatives is removed.
This announcement and its timing are well in line with our expectation. It is yet another clear indication that the new leadership is genuinely accelerating the pace of financial market reform.
Although the step is of great significance, the near term impact is likely to be very limited. Lending rates were limited to going only as low as 70% of the benchmark lending rates set by the PBoC. We know for a fact that there was barely any loan offered at the lowest permitted levels, as banks see rising cost of funding – rates on deposits, wealth management products as well as interbank borrowing. Hence, the complete removal of the lending floor is unlikely to get translated into lower borrowing cost for corporates in the near term.
Deposit rates, which are still capped at 110% of the PBoC benchmark, are the actual binding constraint for the financial system. Understandably, liberalising deposit rates is much more complicated. The deposit insurance scheme is needed to pave the way, which we think will be initiated in 2013/14. Also, the PBoC has to foster new policy rates before completely giving up controls over its current tool. Besides implementation of the deposit insurance scheme, possible next steps in the near term include 1) further raising the cap on deposit rates, 2) liberalising rates long-dated deposits, and/or 3) liberalising rates on large-amount deposits.
Said otherwise, while optically relevant, Friday's move is irrelevant for the economy and the actual funding constraints in China's market. If and when China finds itself with more interbanking funding lockups as it did when SHIBOR hit all time highs a month ago, it will be forced to resort to traditional easing mechanism such as a rate or RRR cut, or else need to step up once more with targeted bank bailouts as it did, quietly and behind the scenes, in the second half of June when suddenly China found itself on the edge of the bank collapse abyss.
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