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China Takes a Step Toward Financial Liberalization

Residential housing in Beijing

Photograph by Nelson Ching/Bloomberg

Residential housing in Beijing

China has taken an important, but for now mainly symbolic, step toward reforming its financial sector. The People’s Bank of China announced Friday evening that starting the following morning—or July 20—the floor on lending rates would be abolished. Previously, banks have been barred from offering loans with interest at less than 70 percent below the one-year benchmark—now at six percent. Now that restriction is gone.

Why mainly symbolic? In theory the end to restrictions means that banks can offer much lower rates and compete to win business from particularly desirable borrowers—or those who are most creditworthy. But in fact that is unlikely to happen soon. That’s because the average lending rates have actually been above the benchmark—with only 11 percent of loans in the first quarter priced below the set rate, according to London’s Capital Economics. So banks are unlikely to have to start slashing rates to win new business.

Connections still matter. The move is unlikely to lessen China’s excessive reliance on credit and investment to drive economic growth. “Indeed the problem has been that bank lending rates have been too low,” write Mark Williams and Qinwei Wang, economists at Capital Economics, in a July 19 note. “As a result, loans have been limited by quota and other quantitative means and channeled to the best-connected firms (typically state-owned) rather than those best able to generate returns.”

What about depositors? For now the central bank is not taking the same step to liberalize the deposit rate ceiling (benchmark one-year deposit rates are at 3 percent. Banks are allowed to offer up to 10 percent above the benchmark.) Lifting the deposit cap will be key to China’s drive to rebalance toward a more consumption-driven economy. With inflation, Chinese households now earn close to nothing on bank deposits. “Interest rate policy has limited the ability of households to earn income from their savings,” wrote Andrew Batson and Joyce Poon, analysts at Beijing-based economic consulting firm GK Dragonomics, in a May report.

Stability is at stake. “Removing controls on deposit rates is the most critical and risky step in interest rate liberalization,” the People’s Bank of China said in a statement also released July 19. “The risks mainly concern the impact on banking sector stability. In the past, the spread between deposit and lending rates provided an important buffer for banks laden down with non-performing loans,” writes Capital Economics.

Abolishing the floor on lending rates “is a big step,” wrote Louis Kuijs in a July 19 e-mail to Bloomberg Businessweek. “Not so much because of a major impact on lending, but as a key step in financial and monetary reform.”

Roberts is Bloomberg Businessweek's Asia News Editor and China bureau chief. Follow him on Twitter @dtiffroberts.

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