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August 12, 2013

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Home » Business » Finance Special

Lending rates break chains, but it’s only one step on long road

China in July took another step toward interest rate deregulation by removing the floor on lending rates. Banks are now allowed to set loan rates lower than a previous maximum of 30 percent off benchmark rates.

The move, though expected for several years, is considered a landmark in China’s financial reforms. The interest rate system has hitherto long been under the control of state-owned banks that focus their lending on large state-owned companies and major government-run projects.

But for many economists, the latest move seems to have created more questions than it answered.

Analysts have been quick to note that the move will not have much immediate impact, given that only about 10 percent of total lending is now below the benchmark rate, according to central bank data.

Even state-owned companies aren’t likely to benefit much in an environment of relatively tight monetary policy. Smaller and private companies may hardly see any benefit at all.

“Canceling the floor for the lending rate is a milestone in liberalizing interest rates,” said Lu Zhengwei, chief economist at Industrial Bank. “But for sound reform, there are many measures that need to be implemented.”

Economists are focused on three future steps deemed important in the reform process: deregulation of deposit rates, establishment of the next-generation benchmark rate and reform of the whole economic system.

China, which has been talking about interest rate reform since 1990s, has been slowly driving the process by developing the interbank fund market and by establishing a floating range for lending and deposit rates.

The prosperous “shadow banking” sector that offers wealth management products to the public at higher rates has also contributed to changes in the official rate-setting system.

Deposit rates

Many analysts said a change to deposit rates is next on tap. Such a change is expected to have a noticeable impact on the public and on banks’ bottom lines. The move is more “demanding,” the central bank said, and thus will take more coordination among various government departments.

At present, banks are allowed to offer deposit rates no higher than 1.1 times the official benchmark rates.

“The deposit rate should be liberalized before financial institutions can really set the loan rate freely,” said Lu. “But at the moment, there is no mechanism to prevent a price war among banks as they strive for deposits.”

He said China should ease the rigid controls on the amount of lending banks can offer, now based on deposits, to ease the thirst for money, and a deposit insurance system should be set up to protect the interests of depositors.

A Standard Chartered Bank report said that other funding channels should be opened for banks to lessen the impact of the central bank’s benchmark deposit rates on the overall cost of funding.

Besides a deposit insurance program, China should also set up legal framework covering financial institution failures, the report said.

“Much more needs to be done before China’s deposit rates can be fully liberalized, so the process is unlikely to be completed in the next 12 months,” it said.

While the deposit rate is not to be liberalized anytime soon, the central bank has formulated a schedule for rate reform that will start with deregulating long-term deposit rates, Caijing magazine reported, citing sources from the State Council.

According to the plan, the central bank will simplify policy rates, set up a quote system for interest rates and allow banks to issue certificates of deposit that can be traded on the market.

So far, some city commercial banks have raised 5-year deposit rates to 5.225 percent, the highest allowed by the central bank.

Still, according to the central bank, deposits in five-year accounts comprise only about 0.3 percent of total savings.

If policy rates for lending and deposits are to be gradually phased out, the need for new benchmark rates to guide the market will likely be necessary.

Ideal candidates

Economists said the Shanghai interbank offered rate (Shibor) or the yield on Chinese government bonds would be ideal candidates as benchmark lending rates.

Shibor is modeled on the London interbank offered rate (Libor). It is the daily reference rate based on the interest rates banks offer to lend unsecured funds to other banks in the Shanghai wholesale money market.

There are eight Shibor rates, with maturities ranging from overnight to a year. They are calculated from rates quoted by 16 banks, by eliminating the two highest and the two lowest rates, and then averaging the rest.

For many, the Shibor now is a bit unreliable because of its volatility and arbitrariness.

“While the overnight or seven-day Shibor is a potential new benchmark, its swings during a record cash squeeze show the need for better controls by the central bank,” JP Morgan Chase & Co said.

The seven-day Shibor shot up to 12 percent on June 20 during a quarter-end credit crunch, when the central bank refrained from an immediate injection of cash and its actions were interpreted as a rebuke to the risky lending behavior of banks.

Market watchers still prefer to use the seven-day repurchase rate, a fund-raising method through exchange of bonds, when measuring short-term borrowing costs among banks.

The repo rate usually goes up and down in line with Shibor, but researchers found the latter is more prone to the arbitrary reporting of banks.

The Standard Chartered Bank suggested that the central bank’s open market operation rates, now used to adjust liquidity in financial institutions, are plausible policy rates that could be used to set short-term rates and guide long-term interest rates in the banking system.

“We believe the PBOC will strive to make Shibor more reflective of banks’ cost of funding, possibly via open market operations,” StanChart said. “Banks will then have the incentive to price more loans based on the Shibor.”

According to the central bank plan, a “prime rate” system will be adopted, under which banks will be required to report the loan rate for their best quality clients and the central bank will compile a guiding rate based on the quotes.

The system is similar to that used in the US, where banks set the rate with reference to the interbank borrowing cost.

To many economists, such a system leaves loopholes in China, where the most difficult part of reform lies not within the financial system but in government interference in the economy.

Without such changes, any “prime rate” proposed by the central bank will still be controlled by state-owned banks and state-owned enterprises.

“To complete interest rate reform without negative impact, China will have to further reduce the dominance of state-owned companies and regulate local government budgets,” said Lu at Industrial Bank.

Xiang Weida, chief strategist of Great Wall Fund Management Co, said the essence of interest rate reform is to enhance the independent pricing flexibility of banks, and the reform will end up in a deadlock if neither banks nor borrowers care about the rate.

“State-owned companies and local governments now control a lot financial resources, and they can always get cheap money backed by government guarantees,” he said. “Private firms won’t benefit from interest rate reform if those financial controls continue.”

Carrying out financial reform without economic reform will only lead to more unfair competition, he added.



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