Saturday, August 30, 2014
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China’s Interest-Rate Challenge

NEW YORK – 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 liberalization. But liberalizing interest rates carries both risks and rewards, and will create both winners and losers, so policymakers must be prudent in their approach.

In 2012, the People’s Bank of China allowed commercial banks to float interest rates on deposits upward by 10% from the benchmark, and on bank loans downward by 20%. So, if the PBOC sets the interest rate on one-year deposits at 3%, commercial banks can offer depositors a rate as high as 3.3%. 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 liberalize interest rates further.

But any further move toward interest-rate liberalization 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 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 liberalized.

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 mold. 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 important, 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 liberalization – together with other financial reforms – would help to improve the efficiency of capital allocation and to optimize 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 liberalization. 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, liberalized 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 liberalization 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 60-70% of GDP – a manageable burden. But, after interest rates are liberalized, the public sector’s debt/GDP ratio is expected to increase substantially.

Given these challenges, China’s leaders must take a cautious approach to interest-rate liberalization. Gradual implementation would enable the losers to adjust their behavior before it is too late, while sustaining momentum on pivotal reforms, which should be policymakers’ top priority. After all, as Premier Li Keqiang has put it, “reforms will pay the biggest dividend for China.”

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  1. CommentedJonathan Lam

    Gamesmith94134: China’s Interest-Rate Challenge
    The present china government must take the interest rate liberalization seriously to take charge of the pivotal reforms for its future. They must contemplate on both of the currency valuation and sustainability for the small and medium size business; since the moderate economical growth is the reality on the next years. 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). In term of the calculation on the failing EU and the emerging market nations, the China’s capital market runs on an inequality mode that balance of payment on the foreign investment that left with a large gap for crediting market since its M2 have grew faster than its development. It all has given a fair warning on the stagflation on its horizon; that the equity market with its bubbles in Hong Kong and metro too, soon as the QE is off.
    Why should China follow to repeat? I think the BRICS were short-sighted with price and valuation that the developed nations attempted to use financial repression (the practice of keeping interest rates below the market equilibrium level) to balance its fiscal deficits and high inflation. Currently, they avoided the developed nations using the interest differential and currency exchange advantage that they neglected the intrinsic valuation of its own equitable to adjust its speed on growth. Many have fallen into the entrapment of liquidity. They burn them out with inflation and inequality with profitability since their social stratum development is less flexible with their income compared to capital equity growth even though the pricing is moderately depressed with the financial crisis.
    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). In China, total public debt currently amounts to roughly 60-70% of GDP – a manageable burden. But, after interest rates are liberalized, the public sector’s debt/GDP ratio is expected to increase substantially. In the hindsight, currency exchange rate might escalate if the RMB is substantively strengthened with the liberalized interest rate, then, china would lose its competitiveness and cut its growth if the domestic market is not catching on with inflation (3-5%).
    Perhaps, it is time for the Chinese economists to contemplate the advantages and disadvantages to liberalize its interest rate and inflation; and how china would place itself in the due course of the QE cliff and the fallout of the EU. It would be a gamble if China would raise its interest rate to stop the bleeding on outflow on the foreigner’s investment or cash; but, stability is the key issue to keep equity market from the free fall mode. Besides, there are a vacuum where the retirement fund would hold in the next ten years; raising interest rate would assure to stay. Eventually, I hope these economists can convinced the politicians that repeating the tracking on stimulation would get the same result for irrational exuberance since the process of QE is only extending inequality as income is depressed by unemployment.
    Mr. Bannake may think QE could work for unemployment. Liberalized interest rate may not stop invasion of hot cash or stop them from leaving China; but it is the basis of leverage on the RMB that sustain in the international currency reserves. A real economist think of inflation plus 4% risk factor was a yard stick for the real interest rate set for business mode in the short term, what is the long term rate? Negative for politics, for economics, Who know?
    May the Buddha bless you?

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