Completing China's Interest Rate Liberalization

• Published date: 01 March 2016
• Author: Yuyan Tan,Yiping Huang,Yang Ji
• Date: 01 March 2016
• DOI: http://doi.org/10.1111/cwe.12148

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China & World Economy / 1–22, Vol. 24, No. 2, 2016

©2016 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Completing China’s Interest Rate Liberalization

Yuyan Tan, Yang Ji, Yiping Huang*

Abstract

China’s recent removal of the last ceiling restriction on deposit rates in October 2015 is a

milestone in interest rate liberalization, but not the end of it. International experience suggests

that, without structural and quantitative reforms, simply freeing interest rates can result in

major financial stress. Before China’s central bank can completely relinquish implicit or

explicit guidance for commercial banks’ interest rate determination, it needs to accomplish

two tasks: improvement of commercial banks’ pricing capability as well as the monetary

policy transmission mechanism. Both tasks require significant reform measures to be initiated,

such as enforcing market discipline, forming a new monetary policy framework, developing

money and capital markets, abandoning quantitative restrictions on credit and reforming

the financial regulatory system.

Key words: dual-track financial system, interest rate liberalization, quantity and structural

reforms

JEL codes: E26, E44, G18

I. Introduction

Recently, the People’s Bank of China (PBOC) undertook major steps to liberalize the interest

rate. In July 2013, it lifted restrictions on banks’ lending rates. From November 2014, it

increased floating ranges for deposit rates three times, before eliminating the final ceiling

for deposit rates in October 2015. However, whether this represents the end of China ’s

interest rate liberalization is questionable.

*Yuyan Tan (corresponding author), PhD candidate, National School of Development, Peking University,

Beijing, China. Email: yuyan.tan11@gmail.com; Yang Ji, PhD candidate, National School of Development,

Peking University, Beijing, China. Email: jiyangpku@163.com; Yiping Huang, Professor, National School

of Development, Peking University, Beijing, China. Email: yhuang@nsd.pku.edu.cn . The authors would

like to thank Guofeng Sun, Bin Li, Ge Wu, Guoqing Song, Honglin Wang and Jun Ma for sharing insightful

comments on this subject and Amelia Huang for editorial assistance.

2Yuyan Tan et al. / 1–22, Vol. 24, No. 2, 2016

©2016 Institute of World Economics and Politics, Chinese Academy of Social Sciences

When China started its economic reform, it only had one major financial institution, the

PBOC, which served both as the central bank and as a commercial bank. Over the following

three decades, China developed a virtually complete institutional framework and also amassed

sizeable financial assets. However, the authorities maintained relatively tight controls over

commercial banks’ lending and deposit rates. Such regulation resulted in a dual-track financial

system. In the formal sector (e.g. commercial banks), interest rates were generally repressed,

and the authorities had to introduce credit rationing, which was in favor of the state-owned

enterprises (SOEs). In contrast, in the informal sector (e.g. the curb markets), from which

most private enterprises raise funds, interest rates are often excessively high.

There are a number of consequences of interest rate regulation. First, because interest rates

are quite low in the formal sector, there is excessive demand for credit. Credit rationing and non-

market credit allocation become inevitable. Second, commercial banks effectively serve as a tax

scheme, redistributing income from households (depositors) to enterprises (borrowers). Third,

because most private enterprises are crowded into the informal financial sector, interest rate

regulation effectively discriminates against the private enterprises in favor of the SOEs.

It is suggested in The Economist that, following China ’s removal of the last formal

restriction, full interest rate liberalization should change the face of its financial system. 1

However, the de jure completion of interest rate liberalization has generated little impact on

the Chinese financial system. First, commercial banks still stick to the official benchmark

rates set by the PBOC, although they are not required to do so anymore, at least in theory.

Both deposit rates and loan rates have stayed nearly the same as those before reform.

Without any real change in the pattern of financial institutions ’ behavior, the recent reforms

have not yet put an end to financial repression. Second, the financing cost in the informal

market is still nearly 20 percent, much higher than the official benchmark rate, and keeps

rising even when the PBOC lowers both the benchmark interest rate and the required

reserve ratio (RRR). Because SOEs still have better access to credit while more efficient

private enterprises have to incur much higher funding costs, there is no sign of diminishing

distortion of capital allocation.

The PBOC’s chief economist Jun Ma has stated that there is still more to do before

completing the interest rate liberalization, including improving the price-setting ability of

financial institutions and enhancing the monetary policy transmission channels. 2 Those

are the two main preconditions if the PBOC is to shift its monetary policy operation from

monetary aggregates targeting to interest rate targeting. Clearly, removal of price (interest

1“China liberalises interest rates at last,” The Economist , 31 October 2015. See http://www.economist.

com/news/finance-and-economics/21677238-china-liberalises-interest-rates-last-letting-go.

2See http://finance.sina.com.cn/money/bank/bank_hydt/20151026/081623576920.shtml .