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THE People’s Bank of China（PBC） scrapped controls over interest rates on loans offered by financial institutions on July 19. The floor on lending rates， which was 70 percent of benchmark lending rates， has been removed. Financial institutions will now independently determine the interest rates on a client-specific basis， depending on market forces.
The move is considered one of the Chinese government’s most significant financial market reforms in recent years， and a major step toward comprehensive interest rate liberalization.
China’s financial reforms have been advancing at an accelerated pace in re- cent years. PBC had already loosened its control over interest rates in the currency market， bond market and on foreign currency deposits and loans before this move， only maintaining regulation on the borrowing and lending rates of commercial banks. Now， interest rate liberalization has one last step to make： the removal of controls on deposit interest rates.
Progressive， Market-oriented Reform
Market-oriented reform of interest rates has come a long way in China. Controls on the China Interbank Offered Rate （CHIBOR） were abolished starting from June 1996. Since then， interest rate liberalization has generally advanced at a gradual pace.
Recently， this pace has been cranked up a notch. On June 8， 2012， PBC raised the upper limit on the floating range for deposit interest rates to 1.1 times the benchmark interest rate and reduced the lower limit of the floating range for loan interest rates to 0.8 times the benchmark interest rate. The floor was further lowered to 0.7 times the benchmark interest rate just a month later on July 6. These adjustments embodied both the practical need for interest rate liberalization and the solid determination of the Chinese leadership to push reform forward.
According to PBC， the recent reform will enable the market to better play a positive role in efficient resource allocation. It will enhance the importance of finance in supporting the real economy and promote economic restructuring and upgrading.
While the floor on loan interest rates has been scrapped， the floating range of mortgage interest rates remains unchanged in an attempt to support the regulation of the property market， curb speculation and promote healthy development， according to PBC.
PBC Governor Zhou Xiaochuan said that financial market fundamentals should be determined primarily by the market， but since interest rate liberalization was influenced by multiple factors， it would be a gradual process. Brighter Financing Prospects for Small and Micro Businesses
Small and medium-sized businesses in China have long faced high financing costs and limited access to loans. As a result， there has been much debate as to whether this round of deregulation can improve the financing environment of such businesses.
The vital issue here is the supply and demand of credit， and the current credit shortage means bargaining power lies with banks. From the perspective of financial institutions， small and mediumsized businesses are by no means desirable clients due to the higher probability of bad debts and default. Hence， in order to increase profits and ameliorate risk， banks tend to implement stricter standards when lending to small and medium-sized enterprises. Commercial banks in particular heavily favor lending to large state-owned enterprises.
Lending practices reveal a disconnect with the real economy. Statistics show that small and medium-sized enterprises account for 90 percent of all businesses in the country. They contribute to over 60 percent of GDP， more than 50 percent of tax revenue and 80 percent of urban employment. The Chinese leadership has repeatedly highlighted the importance of their development to the well-being of the overall economy， and introduced substantial policy support. Since 2011， a series of preferential tax and fee policies for small and medium-sized businesses， and small and micro ones in particular， have been put into practice. Just several weeks ago， the General Office of the State Council proposed two principles regarding financial services for small and micro businesses. Firstly， while maintaining risks within controllable levels， the growth rate of loans offered to small and micro businesses should be no lower than the average overall loans growth rate. Secondly， the increase in loan volume should be no less than that of the same period last year.
“The vital issue in providing credit to small and medium-sized enterprises is not the interest rate， but whether to offer the loans at all，” said Jia Kang， a renowned expert on the economy and president of the Research Institute for Fiscal Science at the Ministry of Finance in an interview. He added that in the context of interest rate liberalization， the possibility of banks charging higher interest rates to small and medium businesses will prove an incentive to lend， and offers a path to greater profit than high-volume， low-margin loans to large enterprises. This is also precisely what the central bank aims to achieve by liberalizing interest rates. “Small and medium-sized enterprises that have been qualified through credit investigations will accept bank loans without a second thought， since even a rate 30 percent higher than benchmark lending rates still means lower costs than private financing，” said a credit department employee at a major bank.
The best-outcome scenario of interest rate liberalization is the breaking of the monopoly on lending currently enjoyed by state-owned banks. Following that， some small and medium-sized financial institutions would likely join the market to provide customized services at lower interest rates to small and medium enterprises. If all goes to plan， the oncedisadvantaged businesses will gain more bargaining power and better financial support when trying to get loans.
Promoting a Better Banking Industry
The most direct impact of this round of interest rate liberalization will be felt by the banking industry itself. Banks have historically enjoyed huge interest rate spreads on deposits and loans. Now， as other financial institutes are empowered with pricing rights and heat up industry competition， banks must figure out how to deal with lower profit margins.
Banks have reacted to the deregulation move in different ways. The four largest state-owned banks， namely the Industrial and Commercial Bank of China， the Agricultural Bank of China， the Bank of China and China Construction Bank， have reacted rather prudently， while private banks and joint-stock banks have been more aggressive. China Minsheng Bank issued bold plans for micro finance and community finance initiatives， as well as finance for industrial chain and supply chain management based on regional features. Retail businesses are also set to become a strategic focus for the bank. Ping’an Bank is on record as saying that banks may encounter considerable pressure in the future and must promote their competitiveness by restructuring their business models and diversifying their revenue base.
Foreign banks have welcomed the liberalization. Standard Chartered said it was a “huge improvement.” “HSBC will take an active part in the process of China’s interest rate liberalization and serve the real economy by satisfying the financial needs of various customers，”said an HSBC representative.
The varying attitudes held by banks toward the new policies reflect their respective competitive positions in the industry， according to Jia Kang’s analysis. The Big Four have the greatest volume of capital at hand， so they are taking relatively slow yet prudent steps. As a pioneer of financial innovation， Minsheng Bank hopes to seize the opportunity to expand. Small and medium-sized joint-stock commercial banks are highly flexible， and though they are faced with many disadvantageous conditions， they will likely attempt to gain market share through aggressive pricing. As for foreign banks， many decades of experience with market-based interests should serve them well in China. It is worth mentioning that even if foreign banks are restricted by China’s capital account rules， their businesses should still have ample room for expansion on the mainland as more areas of the financial sector are being opened up for them. Just recently， the China Securities Regulatory Commission （CSRC） allowed eight foreign banks， including HSBC， Citibank， BEA and Hang Seng Bank to commence mutual fund distributions in China.
Wealth management is just one link in foreign banks’ traditional business chains on the mainland. Releases from the U.S.-China Strategic Economic Dialogue show that China will soon allow qualified foreign banks to trade in government-bond futures. The latest raising of QFII investment quotas has also opened up more space for foreign banks.
“The accelerated interest rate liberalization is pushing Chinese banks onto a level playing field， and in the long run， open market competition will exert a profound influence on the banking industry，” said Jia Kang.
Uncharted Waters
What many industry experts care most about has been left out of this round of deregulation： financial institutions’ deposit interest rate ceiling.
“Removal of the deposit interest rate ceiling is the most critical and riskiest step of the whole process，” said Jia Kang.“The fact that the central bank has left it untouched this time is not surprising given the PBC’s reputation for prudence. The process of interest rate liberalization in China will continue for some time yet， and will draw on best practices of other countries as it progresses. Only in this way will the reform targets be achieved， and will the price of capital be fully determined by the market.”
Interest rate liberalization， which is now entering uncharted waters， is just the first step in China’s grand financial reform plans. Successive steps， such as marketization of the exchange rate and realization of capital account convertibility， will be tough yet vital battles to fight.
Just as an article on the Chinese edition of Wall Street Journal noted， “China’s transition towards a more stable and balanced economic model will be uneven， but its new leadership wants to show the world that they have the capacity to handle the challenge.”
The move is considered one of the Chinese government’s most significant financial market reforms in recent years， and a major step toward comprehensive interest rate liberalization.
China’s financial reforms have been advancing at an accelerated pace in re- cent years. PBC had already loosened its control over interest rates in the currency market， bond market and on foreign currency deposits and loans before this move， only maintaining regulation on the borrowing and lending rates of commercial banks. Now， interest rate liberalization has one last step to make： the removal of controls on deposit interest rates.
Progressive， Market-oriented Reform
Market-oriented reform of interest rates has come a long way in China. Controls on the China Interbank Offered Rate （CHIBOR） were abolished starting from June 1996. Since then， interest rate liberalization has generally advanced at a gradual pace.
Recently， this pace has been cranked up a notch. On June 8， 2012， PBC raised the upper limit on the floating range for deposit interest rates to 1.1 times the benchmark interest rate and reduced the lower limit of the floating range for loan interest rates to 0.8 times the benchmark interest rate. The floor was further lowered to 0.7 times the benchmark interest rate just a month later on July 6. These adjustments embodied both the practical need for interest rate liberalization and the solid determination of the Chinese leadership to push reform forward.
According to PBC， the recent reform will enable the market to better play a positive role in efficient resource allocation. It will enhance the importance of finance in supporting the real economy and promote economic restructuring and upgrading.
While the floor on loan interest rates has been scrapped， the floating range of mortgage interest rates remains unchanged in an attempt to support the regulation of the property market， curb speculation and promote healthy development， according to PBC.
PBC Governor Zhou Xiaochuan said that financial market fundamentals should be determined primarily by the market， but since interest rate liberalization was influenced by multiple factors， it would be a gradual process. Brighter Financing Prospects for Small and Micro Businesses
Small and medium-sized businesses in China have long faced high financing costs and limited access to loans. As a result， there has been much debate as to whether this round of deregulation can improve the financing environment of such businesses.
The vital issue here is the supply and demand of credit， and the current credit shortage means bargaining power lies with banks. From the perspective of financial institutions， small and mediumsized businesses are by no means desirable clients due to the higher probability of bad debts and default. Hence， in order to increase profits and ameliorate risk， banks tend to implement stricter standards when lending to small and medium-sized enterprises. Commercial banks in particular heavily favor lending to large state-owned enterprises.
Lending practices reveal a disconnect with the real economy. Statistics show that small and medium-sized enterprises account for 90 percent of all businesses in the country. They contribute to over 60 percent of GDP， more than 50 percent of tax revenue and 80 percent of urban employment. The Chinese leadership has repeatedly highlighted the importance of their development to the well-being of the overall economy， and introduced substantial policy support. Since 2011， a series of preferential tax and fee policies for small and medium-sized businesses， and small and micro ones in particular， have been put into practice. Just several weeks ago， the General Office of the State Council proposed two principles regarding financial services for small and micro businesses. Firstly， while maintaining risks within controllable levels， the growth rate of loans offered to small and micro businesses should be no lower than the average overall loans growth rate. Secondly， the increase in loan volume should be no less than that of the same period last year.
“The vital issue in providing credit to small and medium-sized enterprises is not the interest rate， but whether to offer the loans at all，” said Jia Kang， a renowned expert on the economy and president of the Research Institute for Fiscal Science at the Ministry of Finance in an interview. He added that in the context of interest rate liberalization， the possibility of banks charging higher interest rates to small and medium businesses will prove an incentive to lend， and offers a path to greater profit than high-volume， low-margin loans to large enterprises. This is also precisely what the central bank aims to achieve by liberalizing interest rates. “Small and medium-sized enterprises that have been qualified through credit investigations will accept bank loans without a second thought， since even a rate 30 percent higher than benchmark lending rates still means lower costs than private financing，” said a credit department employee at a major bank.
The best-outcome scenario of interest rate liberalization is the breaking of the monopoly on lending currently enjoyed by state-owned banks. Following that， some small and medium-sized financial institutions would likely join the market to provide customized services at lower interest rates to small and medium enterprises. If all goes to plan， the oncedisadvantaged businesses will gain more bargaining power and better financial support when trying to get loans.
Promoting a Better Banking Industry
The most direct impact of this round of interest rate liberalization will be felt by the banking industry itself. Banks have historically enjoyed huge interest rate spreads on deposits and loans. Now， as other financial institutes are empowered with pricing rights and heat up industry competition， banks must figure out how to deal with lower profit margins.
Banks have reacted to the deregulation move in different ways. The four largest state-owned banks， namely the Industrial and Commercial Bank of China， the Agricultural Bank of China， the Bank of China and China Construction Bank， have reacted rather prudently， while private banks and joint-stock banks have been more aggressive. China Minsheng Bank issued bold plans for micro finance and community finance initiatives， as well as finance for industrial chain and supply chain management based on regional features. Retail businesses are also set to become a strategic focus for the bank. Ping’an Bank is on record as saying that banks may encounter considerable pressure in the future and must promote their competitiveness by restructuring their business models and diversifying their revenue base.
Foreign banks have welcomed the liberalization. Standard Chartered said it was a “huge improvement.” “HSBC will take an active part in the process of China’s interest rate liberalization and serve the real economy by satisfying the financial needs of various customers，”said an HSBC representative.
The varying attitudes held by banks toward the new policies reflect their respective competitive positions in the industry， according to Jia Kang’s analysis. The Big Four have the greatest volume of capital at hand， so they are taking relatively slow yet prudent steps. As a pioneer of financial innovation， Minsheng Bank hopes to seize the opportunity to expand. Small and medium-sized joint-stock commercial banks are highly flexible， and though they are faced with many disadvantageous conditions， they will likely attempt to gain market share through aggressive pricing. As for foreign banks， many decades of experience with market-based interests should serve them well in China. It is worth mentioning that even if foreign banks are restricted by China’s capital account rules， their businesses should still have ample room for expansion on the mainland as more areas of the financial sector are being opened up for them. Just recently， the China Securities Regulatory Commission （CSRC） allowed eight foreign banks， including HSBC， Citibank， BEA and Hang Seng Bank to commence mutual fund distributions in China.
Wealth management is just one link in foreign banks’ traditional business chains on the mainland. Releases from the U.S.-China Strategic Economic Dialogue show that China will soon allow qualified foreign banks to trade in government-bond futures. The latest raising of QFII investment quotas has also opened up more space for foreign banks.
“The accelerated interest rate liberalization is pushing Chinese banks onto a level playing field， and in the long run， open market competition will exert a profound influence on the banking industry，” said Jia Kang.
Uncharted Waters
What many industry experts care most about has been left out of this round of deregulation： financial institutions’ deposit interest rate ceiling.
“Removal of the deposit interest rate ceiling is the most critical and riskiest step of the whole process，” said Jia Kang.“The fact that the central bank has left it untouched this time is not surprising given the PBC’s reputation for prudence. The process of interest rate liberalization in China will continue for some time yet， and will draw on best practices of other countries as it progresses. Only in this way will the reform targets be achieved， and will the price of capital be fully determined by the market.”
Interest rate liberalization， which is now entering uncharted waters， is just the first step in China’s grand financial reform plans. Successive steps， such as marketization of the exchange rate and realization of capital account convertibility， will be tough yet vital battles to fight.
Just as an article on the Chinese edition of Wall Street Journal noted， “China’s transition towards a more stable and balanced economic model will be uneven， but its new leadership wants to show the world that they have the capacity to handle the challenge.”