China further deregulates interest rates

The marketization of interest rates helps transmission mechanism of monetary policies and facilitates efficient capital allocation in the real economy.

The People's Bank of China (PBOC) announced July 19 that China will fully liberalize the financial institutions lending rate control.

The measure is scheduled to take effect the following day, and is a key step in China's interest rate marketization reform.

The removal of lending rate control is PBOC's most significant move since June 2012 when the government allowed an uplift of up to 10 percent in deposit interest rates, and at the same time a maximum 20 percent discount in the lending interest rate.

Currently, the PBOC only regulates the deposit rate ceiling and loan rate floor. China's currency market, bond market interest rates and foreign currencies deposit rate within China have all been fully liberalized.

According to statistics from the PBOC, only 0.2 percent of financial institutions have their actual lending rates touch the loan rates floor. As a result, in the short term, removing the lending rate control will hardly affect financial organs' credit behavior, but rather serve as a pledge to reform.

However, the measure has opened up new opportunities for future extended risk adjustment of the banking industry.

Easing control over the minimum loan interest rate means that the next step of substantive reforms would involve the deposit rate cap. It signals a warning for banks to be ready to cope with deepening reforms in the future.

It is the market's consensus that a "golden age" of high growth, big profits and low non-performing assets for commercial banks in China has ended, and a "silver age" of modest growth, complicated business environment and gradually exposed risk is coming.

With the easing of financial control, more diversified financial institutions like privately owned banks would be entering the market, making it unsustainable for banks to keep relying on policy protection and interest margin to survive. Banks with more pricing power will prevail.

According to statistics from the China Banking Regulatory Commission, if interest rates could be fully liberalized within the next 10 years, the interest rate differential would drop 60 to 80 basis points. Banks' profits would be cut in half, their capacity to resist risks would be lowered, and the pressure for capital supplement would be increased. This would pose enormous challenges for banks that are used to surviving on interest rate differentials.

At the same time, the risk in interest rates, markets, liquidities and operations would drastically increase. The correlation between different types of risk would also increase.

The marketization of interest rates is the biggest step of the market-oriented reforms of essential productive factors. It makes financial products more market-driven and diversified and grants more freedom in two-way choices of supply and demand. The marketization of interest rates also helps transmission mechanism of monetary policies and facilitates efficient capital allocation in the real economy.

However, the reform can only take effect when restrictions on financial product innovations are lifted, and financial institutions are encouraged to expand their capital pricing power.

In the long term, proper exit mechanisms for financial institutions should be established to further promote market-oriented reforms of interest rates. Strengthened regulations and self-discipline of institutions are both needed to prevent "bad banks" from attracting deposits via high interest rates in the face of a crisis. Only in this manner could a favorable financial ecological environment be secured to promote the healthy development of China's real economy.