China’s decision to abolish its floor on lending rates isn’t regarded as a revolutionary piece of financial reform. It may, however, be the first of a continuing series of steps towards a wider deregulation of financial institutions and markets.
From Saturday, China’s banks have been freed to set their lending rates independently where previously there was a floor under what they could charge which had been set at 70 per cent of China’s benchmark rate. The People's Bank of China’s benchmark rate for one-year lending is currently 6 per cent, so the floor had been 4.2 per cent.
While at face value the move would appear to make cheaper funding available to China’s borrowers within a slowing economy (except for mortgage loans, where the floor remains so that the authorities can keep some control of housing prices) none of the China analysts appear to expect it to have much impact.
That’s because not much lending has been occurring below the benchmark rate, let alone at the floor price.
China’s authorities, trying to get speculative and sub-economic activity within their economy under control, are also more likely to tighten than loosen lending quotas, which would limit their banks’ capacity and appetite for new lower-margin lending, although the larger state-owned enterprises might gain more leverage over the banks to extract cheaper funding as a result of the PBoC’s move.
It is, however, a significant first move away from the regulated rate environment where the PBoC sets a floor price on bank loans and a ceiling (currently 3 per cent) on deposit rates. Deregulating deposit rates would be a far more meaningful, and difficult, step.
Full interest rate deregulation would mean the abolition of the old Chinese model of regulating bank margins by ensuring wide spreads in order to ensure funds flowed to state-owned enterprises and large businesses.
Deregulation of deposit rates would be the obvious next step but is a more difficult one given that competition for deposits could have threatening implications for some of the less well-managed institutions and for non-banks operating within China’s very large "shadow" banking system.
Apart from a long-term commitment to liberalising financial markets and promoting the internationalisation of the renminbi (which ultimately would require financial deregulation) the new Chinese leadership would be acutely aware that the tight regulation of bank lending has promoted the dramatic and destabilising growth in its shadow banking sector.
Whether via the banking system or directly, Chinese savings have been channeled into unregulated lending, much of it of questionable quality, and into high-yielding wealth management schemes that, because of the poor quality of the underlying assets, have sometimes been likened to Ponzi schemes, with the new money funding the interest on existing deposits within that shadow system.
There has been a growing concern that, as the economy slows and the authorities try to reign in speculative activity, those wealth management schemes will collapse and the losses will ultimately flow back to the banks – which would then have to be bailed out by the government.
An apparent attempt to shock the banks into more conservative behaviour and slow the growth of credit in the economy last month misfired when the banks experienced an acute liquidity squeeze. The PBoC initially did nothing to help them – but was then forced to step in.
By creating the potential for bank spreads and profitability to be reduced – at least for larger borrowers – by freeing up lending rates, the PBoC might also reduce the banks’ capacity to funnel funds into the shadow system, although clearly deregulation of deposit rates would have more profound impacts.
Given the unstable and potentially destabilising structures that have emerged within what is supposedly an intensely regulated system, it isn’t surprised that the new leadership is looking for better mechanisms for improving allocations of capital within China’s economy and some liberalisation of rates and markets is an obvious way to bring market disciplines and competitive forces to bear.
The internationalisation of the renminbi is part of that process, although it is also likely to be a driver of deregulation, the development of deep and liquid financial markets and freer capital flows.
For the moment the Chinese authorities are hastening slowly but their direction, at least, appears clear.