China just moved to drop its control of lending rates. allowing banks to lend at whatever rate they like. So what, exactly, does that mean?
It may not immediately help China with its economic growth slowdown, and it doesn’t go as far as many economists would like. But it’s a strong indicator that China is serious about shaking up a financial system that is in need of reform.
As it does in so many other areas ranging from entertainment to the Internet. China keeps a firm grip on its financial system. In Beijing’s view, that helps it push and pull the levers of the economy as needed, channeling lending to priority projects and opening the lending valves to support growth when needed.
That includes interest rates. Its central bank, the People’s Bank of China, sets a benchmark for deposit rates and for lending rates as well. Then it caps how high and how low banks can go above or below those rates. Currently, lending rates are limited to going only as low as 70% of the lending benchmark, while deposits are capped at 110% of the deposit guideline rate. How does that translate in the real world?
Currently the PBOC sets the one year benchmark rate for deposits at 3%, while the one-year benchmark rate for loans is 6%. So the highest rate you can get on a traditional one-year bank deposit in China is 3.3%, while the cheapest one-year traditional bank loan you can get is 4.2%.
If you’re a Chinese bank, that’s a pretty sweet deal. You’re basically assured a fat margin between what you charge on your loans and the payout you give to those pesky depositors. And that’s before taking into account the substantial amount of deposits in accounts earning close to zero interest, and the fact that most loans are priced above the benchmark.
That’s one reason why Chinese bank profit growth, though declining, has been stellar. According to official data, Chinese banking sector
profits rose 39% in 2011 and 21% last year.
The downside: That profit comes as a cost elsewhere in the Chinese economy. For China’s households, low returns on deposits – with bank rates often below the rate of inflation – crimp income. That dents their ability to spend at the shops – with low consumption a key concern for China’s policy makers.
Low bank rates also force savers to find ingenious ways to beat inflation by putting their money elsewhere. That goes a long way to explain China’s runaway real estate prices, and bubbles that appear in everything from art to garlic bulbs and caterpillar fungus .
The big winners from the existing system are state-owned enterprises and local governments that get to borrow at bargain basement rates. But for the economy as a whole the consequence of that is wasteful investment – sparking overcapacity in industry, bridges to nowhere and ghost towns of unsold property.
In addition, the high cost of financial intermediation — economist talk for excess profits at the banks — is bad for the economy, and makes the banks unpopular among China’s chattering classes.
Economists both inside and outside the country don’t think that set-up works. They want market-set interest rates to reward household savers more and make firms pay a more realistic price for their borrowing.
China on Friday didn’t go that far. It left deposit rates alone and instead dropped the restrictions on lending rates. China’s leaders appear to hope that the move will keep the economy moving by reducing costs for servicing debt, as well as encourage more competition between the banks – pushing them to do more to support the real economy.
But perhaps most important, it shows China’s leaders might be willing to undertake even deeper reforms – like liberalizing deposit rates – to shore up a financial system widely considered creaky.
–Carlos Tejada and Tom Orlik
Sign up for CRT’s daily newsletter to get the latest headlines by email.