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Interest Rate Liberalization – A Stepping Stone to Financial Reform in China

by | November 20th, 2013 | 11:40 am
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Full liberalization of interest rates, a critical step for financial reforms, has been highly anticipated by the market. The PBOC’s announcement to remove all restrictions on loan rates on July 19 and the introduction of Loan Primary rate (LPR) opened a new page of rate liberalizations. The next step is to liberalize deposit rates, which should be a gradual process coinciding with the establishment of a deposit insurance system.

Liberalization of loan rates – faster than expected

Inefficient allocation of funds in an over-regulated loan market has led to excess production capacity and inadequate financing support for SMEs with lower credit scores. Liberalization of loan rates is critical to establishing a market-orientated pricing mechanism of funds, and to help allocate funds more efficiently towards productive areas of the economy. Higher risk in a floating rate market also leads to the adoption of stricter and more innovative risk management strategies for both banks and corporations, promoting further opening-up of China’s financial sector.

The PBOC has gradually loosened restrictions on loan rates in the past years, such as removing the cap of loan rates for commercial banks in 2004 and lowering the floor to 70% of the benchmark rate in July 2012.

Loan rate floor removed in July

The PBOC announced the removal of restrictions on loan rates for all banks on July 19, which brought the banking sector in China into a new era of a free loan market. In spite of the remaining regulated mortgage rate, the pace of loan rate liberalization was out of market expectations and showed the PBOC’s determination to accelerate interest rate liberalization.

Loan prime rate introduced in October

The PBOC introduced loan prime rate (LPR) on October 25, publishing it on a daily basis to provide a reference for loans. The 1-year LPR is the average of loan prices offered by 9 banks including the big five state owned banks, Industrial Bank, China Merchants Bank, CITIC Bank, and Shanghai Pudong Development Bank, after deleting the highest and lowest rates. The LPR was announced at 5.71% on the first day, lower than the PBOC’s 1-year benchmark rate of 6%, but higher than the 1-year Shibor rate of 4.4% in the interbank market. The market has seen active responses from financial institutions to the newly published LPR. Several LPR based deals have been closed by ICBC, CCB and BOC, totaling over RMB 1.875 bn. Furthermore, CITIC bank has signed a 2-year LPR-based RMB interest rate swap with Citi Bank with fixed leg of 5.75%; and Standard Charter and HSBC also signed a 1-year LPR-based RMB interest rate swap with fixed leg of 5.76%.

PBOC benchmark rates, LPR and Shibor are expected to co-exist for a while. The benchmark rates as a reference could help prevent large fluctuations of LPRs. And LPRs and Shibors provide reference rates for the loan market and money market respectively, which remains isolated in China.

LPRs with maturities other than 1-year are expected to be published in the future to present a complete term structure of loan rates and increase the pricing transparency of the loan market.

Liberalization of deposit rates – a gradual process

Liberalization of deposit rates is the next step of reform, which will be more gradual and cautious, as it will have wider effects. The PBOC will liberalize deposit rates from two aspects simultaneously – establishing the deposit insurance system and expanding a market orientated pricing mechanism.

The long-awaited deposit insurance system to be established soon

The deposit insurance system, as the core stabilizer of a liberalized deposit market, is considered as a prerequisite to a market-orientated deposit pricing mechanism. It has been discussed for a long time given the systematic importance and dominant role of the banking sector in China, and is likely to be established late this year or early next year. The PBOC signed a MOU with the US Federal Deposit Insurance Corporation (FDIC) on October 24 to strengthen cooperation in establishing China’s deposit insurance system and in preparation for troubled financial institutions.

A market-orientated pricing mechanisms to be expanded

The PBOC introduced several deposit instruments priced by the market previously, but they suffered restricted market access and had limited resell value. More market oriented products are expected to be introduced step-by-step.

Negotiable Certificate of Deposits to be re-launched soon

Negotiable Certificate of Deposits (NCD) is likely to be re-launched by the end of November. NCD was firstly introduced in 1986 by the Bank of Communications but was suspended in 1997 by the PBOC due to technical issues. Proposals of re-launching NCD have been filed to the PBOC by five major state-owned banks including Bank of China, Industrial and Commercial Bank of China, China Construction Bank, Bank of Communications and Agricultural Bank of China. The NCD will be introduced to the interbank market first, covering 10 pilot banks including China Development Bank, Industrial Bank, China Merchants Bank, CITIC Bank, Shanghai Pudong Development Bank and five major banks. The pilot phase of NCD will be very similar to the existing interbank borrowing business, and is expected to bring limited impact to the interbank market while improving the transparency of transactions.

Corporate Certificates of Deposit and Certificates of Deposit for householders are expected to be launched after the NCD pilot program. Cash management products, as an alternative to term deposits, are currently being favored by householders in China due to higher return and short maturities. But the nature of those products are collateralized debt obligations backed by bonds in the money market, implying an unsecured and volatile rate of return. Introduction of Certificates of Deposit will present householders with a financial instrument with similar levels of return but much lower risk.

Deposit rate liberalization to start from less sensitive long term rates

Specifically, 5-years deposits only account for 0.5% of total deposits, so these could be liberalized first. Then the liberalization process could expand to other terms to minimize the impact on the banking sector and achieve a smoother transition from a regulated market to a liberalized market.

The consequences of full interest rate liberalization

Full liberalization of interest rates generally brings large fluctuations in the market. The banking sector is to encounter complex post-liberalization market dynamics including narrowing interest spread, more severe competition, and rising risk amid a more challenging liquidity scenario.

1. The interest rate spread will narrow significantly

High interest rate spreads that delivers stable profit streams will begin to disappear upon liberalization of interest rates. Widely adopted liability management strategies drive banks to actively manage the size of their liabilities to match the funding needs of their assets. Actively narrowing down interest rate spread to attract clients and depositors would become a norm in the banking sector as it allows rapid expansion of the balance sheet and leverage. Take the US, Taiwan and Korea as examples. The 1-year interest rate spread in the US dropped significantly to almost zero in 1984 from 5% in 1980 after interest rates were liberalized. It rebounded to around 3% and stabilized at that level. Interest rate spread in Taiwan narrowed to below 2% after liberalization started in the late 1980s.

2. Competitive pressures will increase

Interest rate liberalization also intensifies competition. The easiest method for banks to differentiate themselves in a fully liberalized market is by offering more competitive rates to clients. During the interest rate liberalization in Taiwan, banks with smaller asset sizes started an “interest rate war” against large banks, trying to pump up their balance sheets at the expense of higher funding costs. Large banks, at the same time, adopted a follow up strategy and sought advantages from economies of scale and larger networks of branches. Over-competition on rates eventually led to a number of bankruptcies of banks and deposit taking institutions in Taiwan.

3. Banking risks will grow

Risk management will become the priority for banks as a result of shrinking profit margin/core capital after rate liberalization. Banks with aggressive strategies on maturity mismatches or risk management are likely to benefit from rapid expansion of their balance sheets in the short run. But climbing non-performing loan ratios during the period of economic fluctuations would eventually put a burden on their share prices.

The self-correction mechanism would penalize risky banks as well as amplify the overall risk. The deposit insurance program is designed to eliminate the probability of a government bailout in the event of bank insolvencies. Risky banks are more likely to encounter banks runs in the event of cyclical fluctuation, delivering systematic shock to the whole banking sector.

The banking sector in the US experienced a wave of bankruptcies and M&As after interest rates were liberalized. Liberalization of rates in the US started in the 1970s, when the NCD was invented to get around the Regulation Q that imposed interest rate ceilings on various types of bank deposits. The number of bankrupted banks hit double digits in 1980 and reached a historical high of 531 in 1989.

Conclusion

Liberalization of interest rates is expected to raise the efficiency of the banking sector in China through introduction of a market orientated pricing mechanism of funding, and accelerate further opening-up of the financial sector by promoting more prudent and innovative risk management strategies. On the other hand, challenges will arise along with the complex post-liberalization market dynamics, presenting the necessity of being well-prepared for banks in China.