The Next Phase of China’s Financial Deepening

Financial deepening in China is not simply a matter of reducing financial repression. In order to enable the corporate sector to manage the transition to a modern knowledge-based economy, China must also rebalance the financial system by carrying out a shift from bank and short-term funding toward equity and long-term bonds.

HONG KONG – The People’s Bank of China (PBOC) has reduced official interest rates for the first time in more than two years, cutting the one-year lending rate by 0.4 percentage points, to 5.6%, and the one-year deposit rate by 0.25 percentage points, to 2.75%. The net interest margin – the spread between what banks pay for deposits and what they charge for loans – has thus narrowed by 0.15 percentage points, to 2.85%. The decision, taken after more modest attempts at monetary easing failed to increase bank lending and private-sector borrowing, reflects a renewed focus on boosting economic growth.

The PBOC’s move also highlights declining inflationary pressures. China’s producer price index has been falling for 32 months, reflecting excess capacity and weak external demand, while the consumer price index has declined from 3.2% to 1.6% over the last 12 months. Moreover, the housing price index for 70 major Chinese cities has dropped from 9.6% in January to -2.6% last month. With the price of oil and commodities also dropping, the risks of deflation and a growth slowdown far outweigh the threat of inflation.

Policymakers and financial regulators lately have been seeking to reduce funding costs for businesses, which have been piling on risky debt in recent years, as insufficient access to official loans has pushed them to the shadow banking system. In this sense, the interest-rate cut provides welcome relief.

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