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China unlocks lending rates

, August 7, 2013, 1 Comments

While the Reserve Bank of India (RBI) has stubbornly refused to respond to the Indian industry’s repeated pleas for lowering interest rates, its Chinese counterpart, the People’s Bank of China (PBOC) has begun implementing major interest rate reforms.

On 19 July, the PBOC deregulated lending rates by taking away the floor on these rates. Commercial banks in China are now free to fix rates on loans to clients. The floor was earlier set at 30 per cent of the benchmark rate.

The biggest beneficiaries of the deregulation will be the domestic small and medium enterprises (SMEs). These enterprises have been complaining about high interest rates on loans affecting their plans to raise resources.  The measure is expected to significantly increase their access to funds.

The floor on lending rates had put SMEs at a distinct disadvantage. Since the interest rate on commercial loans was artificially fixed and not market determined, banks used to extend loans mostly to the State-owned enterprises (SOEs), which could absorb the high-cost loans due to state support. On some occasions, the loans turned bad debts in bank ledgers as the SOEs were unable to service them due to their own inability to generate profits.

While the new policies will not stop banks from lending to the SOEs, as these are still the high net worth corporate customers, they can spread their lending portfolios wider by including more to SMEs. The SMEs will obviously benefit and China’s banks will increasingly price their loans based on market principles.

While lending rates have been decontrolled, deposit rates have not. The upper ceiling of 110 per cent of the benchmark rate continues to remain on deposits. Several analysts have expressed surprise at the PBOC’s decision to leave the deposit rates untouched. With banks free to determine lending rates, which are higher than the capped deposit rates, profitability of banks remains assured.

One might argue that even if deposit rates had been decontrolled, banks would not have raised them immediately for mobilizing credit. Unlike in India, Chinese banks have not been excessively perturbed over liquidity affecting inflation. As a result, they are unlikely to have used the deposit rate as a tool for mobilizing cash held by the public.

Moreover, a large number of transactions in China still get carried out in cash. Low deposit rates and lack of enough sophisticated financial instruments yielding high returns have ensured that people hold on to idle cash rather than parking it in banks or other areas.

The PBOC’s move though has taken many by surprise. While there have been several opinions expressed in the media and academic circles about China speeding up financial liberalization, many did not expect the PBOC to decontrol lending rates in one go. Most felt the move would be gradual and calibrated.

It is obvious that the PBOC and China’s new leadership has been closely monitoring the developments in the international financial markets and the opportunity for China to play a significant role in global financial transactions and movement of financial assets. The strength and size of the Chinese economy and the increasing use of Yuan in international business transactions gives China the head start in becoming a global financial hub. But this requires China’s domestic financial markets and institutions to adopt rules that are closer to global financial standards.

China’s financial sector reforms have lagged much behind its external sector reforms. The gap is reflected in the structure of China’s balance of payments as well. Huge trade surpluses from the current account have been fueling foreign exchange reserves. China has not had occasions to worry over current account deficits. Quite unlike India again, for whom, capital account surpluses have been essential for managing the current account deficit. While India has not moved to full convertibility in the capital account, its policies on capital inflows and their integration in the domestic debt and equity markets reflect global standards more closely than China’s. This is understandable since China’s focus has hardly been on its capital account.

Banking sector and interest rate reforms are fundamental to financial liberalization and full capital convertibility in China. The earlier regime under President Hu Jintao and Premier Wen Jiabao was more cautious in this respect. The new leadership, however, appears more decisive and keen to change regulations. Deregulating lending rates in one sweep reflects the urgency.

While the interest rate reforms mark the beginning of a new phase of financial liberalization in China, domestic interest groups opposing decontrol continue to remain active. The PBOC’s inability to decontrol deposit rates reflects the resistance of China’s main state-owned banks to the move. These banks have been profiting from the differential between lending and deposit rates. Freeing deposit rates would have gradually raised the pitch for raising them for curbing excessive liquidity and would have affected profitability.

Clearly India is not the only example of reforms remaining incomplete due to intervention by domestic groups. China too suffers from such anomalies.

This article first appeared in the Financial Express

  • P V Rajeev Sebastian

    Will China turn out to be smarter here too ?