Move by People's Bank of China Signals Appetite for Reform

The People's Bank of China, the country's central bank, announced that it would remove the longstanding floor on commercial lending rates. Previously, the PBOC had set both a floor for lending rates and ceiling for deposit rates: a happy arrangement for banks guaranteed a fat net interest margin, but not the best way to price credit.

We're heartened by the announcement to the extent that it signals an appetite for reform and could augur further changes aimed at financial liberalization. Because the deposit rate ceiling was left in place, however, the move does little to address the problems of overinvestment and capital misallocation, which threaten a debt crisis if left unchecked.

China's biggest problem isn't capital scarcity; it's capital abundance. We calculate that over the past decade, the official PBOC lending rate floor averaged 1.4% in real terms using the GDP deflator as our inflation gauge. In an economy growing at a double-digit or high-single-digit pace, that's incredibly cheap capital and goes a long way toward explaining the phenomenally high investment share of GDP in China.

Loans were already too cheap for state-owned enterprises and local government borrowers, the main protagonists in China's decade-long investment boom. Making loans cheaper, as this policy change sets out to do, may risk worsening the problem of overinvestment by these entities. Indeed, some might argue that the move will hurt instead of help China's economic transition in the near term.

Furthermore, it's unclear how the reform does anything to stimulate the flow of credit to private enterprises, a stated goal of the government. State-owned enterprises and local governments will remain the preferred recipients of new loans as long as the loans carry the implicit guarantee of Beijing. As such, the announced policy change fails to address the problem of capital misallocation. The dysfunctional risk and return relationship in China's bank lending practices remains in place.

In the context of Beijing's efforts to avoid a debt crisis and rebalance the economy from investment-led growth to more sustainable consumption-led growth, removing the deposit rate ceiling would represent the far more important financial reform. We calculate that the real deposit rate averaged negative 1.8% in the past decade, which constitutes a massive wealth transfer from household savers to banks and state-tied borrowers, which economists have variously estimated at 4%–9% of GDP. Compared with household consumption's 34% share of GDP, that's a large figure.

Chinese Deposit Rates, Real and Nominal

But moving too fast on deposit rate liberalization would be a risky proposition. Local governments and state-owned enterprises have borrowed to fund countless projects that would make little sense under fully liberalized (that is, higher) interest rates. A "big bang" rate liberalization would send countless borrowers into default when they look to roll over hitherto cheap loans, triggering a full-blown financial crisis.

Additionally, higher interest rates would almost certainly mean a drop in new borrowing and therefore sharply lower investment. Given the present massive dependence on investment to drive GDP, the economy would almost surely fall into recession.

Rapid deposit rate liberalization is not a road the newly installed leadership team is eager to take. The PBOC itself noted that deposit rate reform would be the most risky aspect of a financial liberalization program.

That said, public pronouncements from President Xi Jinping and Premier Li Keqiang certainly suggest reformist intent, if not an appetite for a major and immediate overhaul. In all likelihood, financial reform will continue to follow the broader reform pattern set forth under Deng Xiaoping, who counseled the wisdom of "crossing a river by feeling the stones."

With this in mind, we expect deposit rate reform to be a long-term process. In the near term, prospective changes might include the launch of a deposit insurance scheme, an upward adjustment to the deposit rate ceiling, some rate liberalization on longer-term deposits, and the introduction of new consumer saving instruments (such as CDs).

Incrementalism has its merits, but it is not without shortcomings. The longer deposit rates remain artificially low and capital controls limit alternatives for savers, bank loans will remain very cheap in China. As a result, excess capacity and bad debt will continue to build. Crossing the river by feeling the stones is a risky proposition when water levels are rising.