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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.”