Freeing interest rates is more than a financial test for China. Lifting strict controls on the official cost of money is necessary for the development for the world’s second-largest economy. The question is whether China can avoid the financial problems that other liberalising countries suffered, and relax its grip on banks, companies, and citizens.
China’s central bank caps the amount that banks can pay for deposits, and sets a minimum charge for loans. This leads to three kinds of economic distortions. First, it guarantees banks a positive spread on every loan of around three percent, according to the World Bank, giving them little incentive to distinguish between good and bad risks, or compete for business.
Second, the state has for decades held deposit rates at or below the level of inflation. This has allowed borrowers to engage in wasteful spending, while forcing consumers to seek riskier investments like property to protect the real value of their savings. Crude lending quotas distort the system still further. Large state-owned enterprises and officially sanctioned projects gobble up available credit, leaving smaller private businesses to seek other, more expensive sources of finance.
It goes without saying that China would be better off without these oddities. The central bank would be able to make greater use of interest rates to control the overall economy. And cross-border capital controls could be eased with less risk of sudden outflows.
China’s rulers appear to agree: in May, the country’s ruling State Council identified interest rate reform as one of its key economic priorities for 2013. The recent spike in Chinese interbank rates may be a sign officials are testing how banks cope when markets are allowed to set the price of money.
History advises caution. In the last 40 years, Argentina, Sweden, Korea and the United States all granted some banks the liberty to set their own deposit and lending rates, only to suffer damaging booms and busts.
Imagine what would happen if China loosened interest rate controls today. Banks would quickly raise savings rates in an attempt to attract new deposits. All else being equal, if deposit rates rose by just one percentage point, banks’ interest income would fall by as much as a third. To make things worse, large companies would probably demand cheaper loans, since the lending floor had been eliminated.
Banks rely on strong earnings to absorb future bad debts. So they might slash costs just when they should be beefing up their risk management. Even now, few have the equivalent of a chief operating officer.
And to protect margins, they might offer loans to riskier borrowers at higher rates, leading to an expansion in overall credit. China already faces the consequences of a large and poorly controlled lending splurge. If liberalisation left some borrowers paying higher interest rates, many would face a severe cash crunch.
Assume that China manages these challenges, and joins the small group of countries - including Canada and Australia - that liberalised interest rates without unleashing turmoil. Even then, true reform could be undone if state retains its grip on the economy. Most countries liberalised interest rates as part of an embrace of free markets. If money is to be priced by supply and demand, overextended borrowers must be allowed to default, and reckless lenders must suffer the consequences of their mistakes.
China’s unique brand of capitalism is far from this ideal: the state controls most of the banking system, and many of the country’s largest corporations. Any institution at risk of bankruptcy would expect the government to bail it out. China’s domestic bond market has yet to experience a single default.
This may explain why, even though China has been talking about liberalising interest rates since the mid-1980s, it has made little progress. Unlike other changes, rate reform can’t be embraced gradually, or tested in a few remote provinces. China has tended to “cross the river by feeling the stones”; in this case, it would simply have to take the plunge.
The country’s new leaders may deliver on their promise. But if they successfully embrace genuine interest rate reform it will signal a more profound shift for China than for any other country that has trodden this path before.