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Show me the money: Chinese banks retain profits despite interest rate reforms

by | March 4th, 2013 | 01:35 pm
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In 2012, Chinese commercial bank profits grew by 19 percent at the same time regulators increased the flexibility of deposit interest rates. The Peoples Bank of China should take this as an opportunity to continue to gradually liberalize interest rates.

A double digit increase in bank profits in 2012 suggests interest rate liberalization should continue in China. According to the banking performance data released by the CBRC, Chinese commercial bank net profits grew by 19 percent in 2012 reaching Rmb 1.24 trillion.

China maintains strict controls on domestic interest rates at a benchmark rate set by the Peoples Bank of China (PBOC). Until recently deposit rates were capped at the benchmark rate while only lending rates were allowed flexibility – unlimited movement above the benchmark and a floor limiting the discount below the benchmark. The cap on deposit rates coupled with flexibility in lending rates ensured a healthy net interest margin and supported windfall profits for Chinese commercial banks.

However, bank profitability has come at the expense of rebalancing. The controls on deposit rates acts as a tax on savers – mostly households – and thus, hinder efforts to rebalance income toward households. Controls on deposit rates encourage households to invest in real estate rather than keep money in banks, leading to excessive investment in the real estate sector.

Last year, the Peoples Bank of China began to liberalize controls on interest rates for the first time since 2004. In June and July, the Peoples Bank reduced the lending rate floor to 80 percent and 70 percent respectively. In June, the PBC also increased the ceiling on deposit rate flexibility up to 110 percent that of the benchmark rate.

Although small, even this initial move towards interest rate liberalization met criticism. The fears are twofold: first, Chinese banks would struggle to retain profitability with greater competition for interest income and a lower net interest margin. Second, rate liberalization would lead to higher lending rates could undermine the quality of bank assets tied to capital-intensive users – industrial firms and local governments.

The increase in bank profit this year at the same time the PBC began interest rate reforms undermines the first of these concerns. Chinese banks not only experienced a 20 percent gain in net profits in 2012 but they did so mostly in interest income. The ratio of bank non-interest income to total income increased only slightly to 19.83 percent in 2012, up 53 basis points from 2011.  The slight improvement in non-interest income suggests that banks are capable of maintaining growth in interest income even as deposit interest rates are gradually liberalized.

The argument that bank balance sheets are too weak to handle the impact of interest rate liberalization also did not hold true. In 2012, the after-tax return-on-assets of commercial banks remained stable at 1.28 percent compared with 1.3 percent at the end of 2011. The return-on-assets while slightly weaker than last year is still good by international standards. For example, even in the United States all insured commercial banks only had an after-tax return-on-assets of 0.97 percent in 2012.

Yet this is not to say interest rate liberalization will not reduce bank profits or even lead to some bank closures in the future. Interest rate liberalization should drive competition in the banking sector, leading to weaker profitability for non-competitive banks. In particular, smaller regional banks with fewer branches, weaker service offerings, and lower quality assets could find it more difficult to adapt to a more competitive environment. For example, rural commercial banks have the highest non-performing loan ratio at 1.76 percent in 2012, compared with an average of 0.96 percent for all commercial banks.

The performance of the banking sector this year suggests PBOC should look past these concerns and continue gradual reform. Liberalizing interest rates will almost certainly have an impact on those less competitive banks which are overly exposed to capital-intensive users. Yet the cost of maintaining these capital distortions for the economy is too high. The performance of the banking sector last year proves that if implemented gradually, interest rate liberalization need not result in crisis. Gradual reform will send signals to banks to adjust their lending practices and to capital-intensive users to reduce their borrowing. Both adjustments will benefit the economy as a whole, and over-time could lead to more competitive services and more sustainable profits for China’s banking sector.