China’s successful transformation from a middle-income country to a modern, high-income country will depend largely on the reforms that the government undertakes over the next decade. Financial reforms should top the agenda, beginning with interest-rate liberalisation. But, liberalising interest rates carries both risks and rewards, and will create both winners and losers. Thus, policymakers must be prudent in their approach.
In 2012, the People’s Bank of China (PBoC) allowed commercial banks to float interest rates on deposits upward by 10pc from the benchmark, and on bank loans downward by 20pc. So, if the PBoC sets the interest rate on one-year deposits at three percent, commercial banks can offer depositors a rate as high as 3.3pc. Many analysts viewed this policy, which introduced a small degree of previously non-existent competition among commercial banks, as a sign that China would soon liberalise interest rates further.
But, any further move towards interest-rate liberalisation must account for all potential costs and benefits. Chinese policymakers should begin with a careful examination of the effects of current financial repression (the practice of keeping interest rates below the market equilibrium level).
The degree of financial repression in a country can be estimated by calculating the gap between the average nominal gross domestic product (GDP) growth rate and the average long-term interest rate – with a larger gap indicating more severe repression. In the last 20 years, this gap has been eight percentage points for China, compared to roughly four percentage points, on average, for emerging economies and nearly zero for most developed economies – where interest rates are fully liberalised.
Developing-country Central Banks keep interest rates artificially low to ensure sufficient low-cost financing for the public sector, while avoiding large fiscal deficits and high inflation. But, in the long run, such low interest rates may also discourage households from saving, lead to insufficient private-sector investment and, eventually, result in economy-wide underinvestment, as occurred in many Latin American countries in the past.
In many ways, China is breaking the mould. Despite severe financial repression, it has experienced extremely high savings and investment, owing mainly to Chinese households’ strong propensity to save and massive government-driven investment, particularly by local governments.
The adverse effects of financial repression in China are reflected primarily in its economic imbalances. Low interest rates on deposits encourage savers, especially households, to invest in fixed assets, rather than keep their money in banks. This leads to overcapacity in some sectors – reflected in China’s growing real-estate bubble, for example – and underinvestment in others.
More importantly, financial repression is contributing to a widening disparity between state-owned enterprises (SOEs) and small and medium-size enterprises (SMEs), with the former enjoying artificially low interest rates from commercial banks and the latter forced to pay extremely high interest rates in the shadow-banking system (or unable to access external financing at all).
Interest-rate liberalisation – together with other financial reforms – would help to improve the efficiency of capital allocation and to optimise the economic structure. It might also be a prerequisite for China to deepen its financial markets, particularly the bond market, laying a solid foundation for floating the Renminbi’s exchange rate and opening China’s capital and financial accounts further – a precondition for the Renminbi’s eventual adoption as an international reserve currency.
SMEs and households with net savings stand to gain the most from interest-rate liberalisation. But, financial repression’s “winners” – commercial banks and SOEs – will face new challenges.
Under the current system, the fixed differentials between interest rates on deposits and those on loans translate into monopolistic profits for commercial banks. The three percentage-point differentials that Chinese banks have enjoyed are roughly on par with those of their developed-country counterparts. By creating more competition for interest income and reducing net interest-rate differentials, liberalised interest rates could reduce banks’ profitability, while SOEs will likely suffer the most, owing to much higher financing costs.
Another major risk of interest-rate liberalisation in China stems from rising public debt – particularly local-government debt – which has grown significantly in the wake of the global financial crisis. A key parameter for determining the long-run sustainability of public debt is the gap between interest rates and the nominal GDP growth rate. In China, total public debt currently amounts to roughly 60pc to 70pc of GDP – a manageable burden. But, after interest rates are liberalised, the public sector’s debt-to-GDP ratio is expected to increase substantially.
Given these challenges, China’s leaders must take a cautious approach to interest-rate liberalisation. Its gradual implementation would enable the losers to adjust their behaviour before it is too late, while sustaining momentum on pivotal reforms, which should be the policymakers’ top priority. After all, as Premier Li Keqiang has put it, “reforms will pay the biggest dividend for China.”
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