China’s Interest-Rate Liberalization Takes A Sideways Step

IS THE PAST prologue when it comes to China’s interest rates? For two years, the answer was no. Late last week, that answer changed with the central bank’s surprise cut in its benchmark one-year lending rate by 40 basis points (bps) to 5.6% and the matching deposit rate by 25 bps to 2.75%, its first cuts since July 2012. More to come is the question now.

An across-the-board measure is at odds with the targeted approach to managing the economy’s slowdown hitherto pursued by the People’s Bank of China. In September, it had injected 500 billion yuan ($81 billion) of liquidity into the five big banks to support credit and growth. Earlier in the year, it had cut reserve requirements for rural commercial banks and credit cooperatives.

Nonetheless, the central bank says that its rate move does not represent a change in monetary policy. In as much as the benchmark lending rate is largely symbolic, that may be true in a perverse way. The bank also lifted the maximum permitted deposit rate to 1.2 times the benchmark from 1.1 times. That is another incremental step in the direction of interest-rate liberalization. However, it will also largely negate the effect of the newly announced rate cut on the economy.

If anything the asymmetric cut will amplify the narrowing of the gap between lending and borrowing rates that has been going on for some time. That, we think, is more likely to cool the home-building market, as it will make home-buying loans even less profitable for banks than they are now, than to stimulate it.

If the economic mood music does not seem to presage further cuts, this Bystander suspects that factional infighting is underway, with the State Council leaning on the central bank to cut corporate borrowing costs. That mostly benefits the politically well connected large state-owned enterprises, who do not particularly need to borrow money, but will be happy enough to see their profit margins expanded through lower financing costs. As we have noted before, there are still vested interests providing considerable obstacles to the drive for economic reform.

The language of the central bank’s explanation of its rate move is telling. It is casting the cut in terms of financing costs, especially for small businesses, rather than a need to stimulate a slowing economy. However, if it is serious in what it says about guiding market rates lower, it would be best served by advancing the cause of interest-rate liberalization.

In its statement explaining the cut, it says:

Market-oriented interest rate reform is a systematic task, and calls for coordination with other reforms. Therefore we need to strengthen the coordination of various reform measures, unite those together as a force, and in the end finish building the mechanism and system to fully allow for the market’s decisive role in resource allocation and better allow the government to function.

The central bank has been a leading proponent of financial reform. Those measured words sound like it is on the back foot at the moment in the broader political debate.

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