Beginning of a new era in lending

Interest rate reforms will continue, but more needs to be done to mitigate financial woes

The People's Bank of China's decision to scrap the floor on lending rates from July 19 has effectively ended the lending rate controls for commercial lenders, after the central bank abolished the ceiling in 2004.

Though the limits have been abolished, the central bank will still have a benchmark lending rate for commercial lenders. The benchmark will be a reference for the lenders and also a guide for judicial institutions to detect loan-shark cases. Loans that are offered at rates of more than four times the benchmark rate are often considered in that category.

Using the benchmark, commercial lenders can freely determine what rate they should lend. Theoretically, if they wish, they can even lend at zero rate.

The freedom definitely gives more leeway to banks. They can lend at deep discount to credit-worthy clients and thus ensure long-term, stable returns. Banks can also use the lower rates to compete with peers for important clients. What's more, the cancellation of the floor rate also makes it possible for banks to design attractive product packages. For example, they can offer a small amount of low-rate or zero-rate loans to a company in return for other business opportunities such as bond issuance.

In practice, the abolition of the floor will not make a big splash in monetary and banking markets because very few banks will lend at a rate lower than the floor.

Before the deregulation, the floor for the one-year lending rate stood at 4.2 percent, that is, 70 percent of the benchmark rate of 6 percent.

According to a central bank report, only 11 percent of loans were with rates lower than the benchmark from January to March. The report didn't say how many of these below-benchmark loans were at the floor rate of 4.2 percent, but a survey of 16 loan managers at nine banks indicates that the amount of floor-rate loans were so small that they can be ignored.

After the abolition of the floor, banks will now decide the lowest lending rate in accordance with market conditions.

Yield rates of corporate and government bonds will be an important yardstick in this matter. This is because, generally speaking, if a lending rate is even lower than the bond's yield rate, there is no logic for the bank to extend the loan. In that case, the bank can simply invest in the bond market, which is generally risk-proof, instead of making loans.

The other reference banks will look at is the interbank rate. As a major financing channel, the interbank market is where banks often borrow from each other. If a bank lends at a rate lower than the interbank rate, it means it is lending at a rate below market costs. In most cases, banks won't do that.

Currently bonds with one-year maturity have yields of around 4.5 percent, while the average one-year interbank rate is around 4.4 percent.

Clearly, the room for banks to lend below the floor rate of 4.2 percent is very limited. In this sense, the cancellation of the floor is not going to make a significant change in the financial market.

But the liberalization still deserves attention as it has both short-term and long-term significance.

In the short term, this offers a chance for companies to reduce their financing costs, and will effectively help revive business confidence.

The abolition of the lending limit also increases the bargaining chip of some companies that are likely to get preferential loans, at a very low rate, from banks.

These companies include large state-owned companies and enterprises that boast long-term and stable development prospects. These companies are always in a good position to get preferential loans from banks. The cancellation of lending rate control will enhance their advantages in that regard, and chances for this to happen are increased, especially with large banks that sit on large amounts of deposits and are looking for stable investment options.

More importantly, the move shows that the government has been paying attention to the financing difficulties plaguing the real-economy sectors.

Scrapping the floor rate may not immediately boost money supplies to manufacturing and services sectors, but the decision is clearly a signal that central authorities will continue their efforts to address the financing woes of businesses.

It is expected that quantitative measures and structural reforms of the loan market will follow to ensure China's ample liquidity be channeled to support the real economy.

In the long run, putting lending rate controls to an end is a beginning of a package of financial reforms that will lead to the complete abolition of curbs over interest rates and foreign exchange rates.

The message behind the government decision to announce the lending rate reform just a week after the release of second-quarter economic data is loud and clear. That is, Likonomics, Premier Li Keqiang's economic-policy philosophy that emphasizes reforms more than high economic growth, will definitely continue.

There were doubts that the premier might pull back from his reformist measures, after the Chinese economy grew 7.5 percent and after Li said a certain level of economic growth must be maintained.

Local governments and global economies were expecting the central government to roll out some, if not massive, stimulus measures to support economic growth. Speculation of a brake on reforms was circulating, as many believed central authorities would have to put more efforts into maintaining growth.

But the lending rate reform, along with the earlier announcement that foreign exchange rate controls will be totally lifted in the free trade area in Shanghai, serves as a clear signal that China's financial reform will not stop simply because of a deeper economic slowdown.

This display is of vital importance, as China has not made any major breakthroughs in financial reforms since 2006. It cannot afford to lose any more time.

That said, the next move in interest rate reform would be the removal of the ceiling on deposit rates.

Because of the ceiling on deposit rates, China's real interest rate, measured by the difference between the deposit rate and the consumer price index, is very low and often in negative territory. This dampens household wealth and is one of the major factors hindering the economic rebalance from investment toward consumption.

So, axing the deposit rate ceiling is needed to let the interest rate reflect the money market's demand-supply relationship.

But the task remains a tough one, because authorities fear that if the limit is axed, banks will compete to attract depositors by excessively increasing the deposit rates. Smaller banks, thirsty for funds, will be very likely to do so. That will increase risks for these banks, which are less good at fending off risks when compared with their bigger counterparts.

This fear, although well founded, should not be exaggerated.

Actually many city commercial banks have already bypassed the deposit rate ceiling by offering extra interest gains to depositors. This reflects the call of the market.

The good thing is that the government is working in that direction. Its recent efforts to prepare for the establishment of a deposit insurance system are apparently a prelude to lifting all deposit rate controls.

It is expected that the government will adopt a gradual approach to phase out the curbs.

Very likely, China will first widen the floating range for deposit rates. At the same time, the central bank may allow banks to issue negotiable certificates of deposits with free rates in large denominations. It will then allow banks to set rates for long-term deposits before a full deregulation on all types of deposits is made.

Although a timetable of this reform is not certain, the spirit is there, and a total liberalization of interest rates is just a matter of time.

While China is pressing ahead with the rate liberalization, which addresses the question of how banks lend, two other questions must be answered as the country reforms its financial system.

The first question is to whom should the banks lend.

Currently most of the bank loans are flowing to local governments, leaving many cash-strapped companies high and dry.

This must be rectified to avoid a systematic default and an undue reliance on local investment. To achieve the goal, it is important for the government to check local spending, revise the GDP growth-centered performance appraisal system and curb banks' collaboration with shadow banking agencies.

The other question is who can lend. State-owned banks are dominant players in the market, with a small number of private lenders recently allowed to operate under restrictions. The absence of due competition has led to state-owned banks' reluctance to innovate, upgrade and improve efficiency. The situation also hampers capital resources from going to real economies and small companies.

Only by addressing these two questions can potential dividends of the liberalization of interest rates be brought into a full play.

The author is a financial analyst in Shanghai. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 07/26/2013 page11)