Long march to Chinese rates reform

A senior financial policy adviser to China's State Council, the country's main administrative body, wrote an article posted May 22 on a government website saying China may begin reforming its interest rate system by the end of 2012. According to the article, the reforms would give banks more freedom to set their own interest rates, allowing them to compete with each other for customers.

Beijing has long acknowledged that some kind of interest rate reform is necessary to boost consumers' purchasing power and make the allocation of capital to private industry more efficient. These are key elements of Beijing's goal of transitioning to a more sustainable economic model. These sorts of reforms would challenge China's politically connected but often inefficient state-owned enterprises, which receive financial benefits from the current system.

A move to adjust interest rate policy would indicate that the Communist Party of China believes increasing domestic consumption and adjusting the credit disparity between the state and private sector are more pressing needs than protecting inefficient SOEs, at least for the moment. However, like all economic decisions in China, concerns over the political fallout – in this case the consequences of pressing the influential SOEs too hard – will hinder serious reforms.

At present, interest rates are tightly controlled by the central government. State-run banks typically offer very low returns to depositors, who are mainly the 300 million Chinese living along the coasts and who have few other options for investing their capital. Banks then use the money that would normally be paid out to depositors in interest to provide low- or zero-interest loans to borrowers, usually the SOEs.

Financing by China's state-run banking system has always favoured SOEs, a trend exacerbated by the 2008-2009 stimulus plan that funnelled massive amounts of money into the SOEs via credit, leading to huge capital misallocations. The stimulus did succeed in maintaining strong economic growth figures but also led to inflation above government targets from mid-2010 to early 2012, especially on politically sensitive food prices, peaking at 6.5 per cent in July 2011 before declining more recently due to credit-tightening policies.

As a consequence of both the interest rate policy and high inflation, Chinese depositors received effectively negative interest rates, leading to a decline in their disposable income. Some middle-class Chinese have tried to channel personal savings into the real estate sector as a more profitable investment, though the government has also taken steps to curtail this practice because of the systemic risk posed by the threat of a real estate bubble. With less money to pay for staples like food and fuel and little incentive to keep money in banks, Chinese have reduced their bank deposits and thus the amount that banks are able to funnel into SOEs through the preferential loan scheme.

State-owned enterprises' role

While some Chinese SOEs are remarkably efficient, these tend to be in the capital goods industries or firms with operations overseas, such as China's state energy firms. SOEs that are geared toward building domestic infrastructure or manufacturing products for domestic consumption are generally far less efficient. Some of these firms not only fail to be profitable, but barely remain solvent. Low- or zero-interest loans enabled with the money that would otherwise go to depositors have allowed many of these SOEs to continue operating.

SOEs hold this privileged position in part because they are vehicles for implementing a variety of state policies, such as the development of the inland provinces, maintaining employment and developing strategic industries while keeping them under government control. They are also extremely well connected politically. Many heads of SOEs hold ministerial-level rank in the government and exert disproportionate influence over national economic and industrial policymaking – particularly those tied to the central rather than provincial governments.

Any interest rate reform effort by the government will likely be vehemently opposed, if not outright blocked, by those who benefit from the status quo and fear quite reasonably that it will cut off the economic backing SOEs have thus far enjoyed. But with the export-driven model showing signs of weakness, Beijing will be unable to make its transition to a domestic consumption-based model unless returns on deposits are boosted.

Chinese citizens have fairly high levels of savings, but they need these for essentials like health care, education, housing and retirement. After these are paid for, there is little left over for anything beyond food. To boost domestic consumption on non-essentials, Chinese citizens need more disposable income. Higher interest rates would give them the ability to put less in the bank and still feel confident that they have enough for future large expenses and sufficient cash to spend on consumer goods.

China's political worries

The timing for Beijing is particularly difficult as the interest rate reform comes amid an unexpectedly turbulent once-a-decade political transition process. China's leaders are less willing to take risks in policy or make any radical changes at a time when they are seeking stability. In the past, the CPC has exhibited a tendency to deal with problems in a belated and ad hoc manner. This, however, does not necessarily stem from incompetence or corruption, though those issues exist, but from a fault built into the current Chinese political machine: the collective system of decision-making.

Due to the need to address divergent interests while maintaining party control and an image of unity, the political system has an inherent tendency toward political inertia that effectively condemns China to move from crisis to crisis. It is further complicated by the primary intent of keeping the CPC as the sole power in China. This requires that any policy shift be approached cautiously so as not to destabilise the social balance in the country and threaten the party's legitimacy.

There is a recognition within the Chinese government that stopgap measures are no longer sufficient to manage the internal and external pressures on the Chinese economy, and that a fundamental alteration in the system is needed: ease away from export dependency, spur private industry, and in some cases take SOEs off life support and make them more competitive, or force the inefficient ones to close down. However, this could bring about a painful economic 'correction', leading to unemployment and thus the very political instability that the reform effort is intended to forestall.

Consequently, the government will likely move slowly on interest rate adjustments or any other significant economic reforms to avoid a backlash from the SOEs' influential backers and to avoid a socially destabilising economic reaction. And with preservation of the party still the core focus, should this path prove unmanageable, Beijing will reverse it once again, postponing significant economic restructuring even at the risk of simply delaying an unavoidable change.

Stratfor.com Reprinted with permission of STRATFOR.