Do Interest Rate Liberalization and Fintech Mix? Impact on Shadow Deposits in China

• Date: 01 January 2020
• DOI: http://doi.org/10.1111/cwe.12304
• Published date: 01 January 2020

©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 4–22, Vol. 28, No. 1, 2020

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*Stephanie Chan, Assistant Professor, Department of Finance, School of Economics and WISE, Xiamen

University. Email: stephaniechan@xmu.edu.cn; Yang Ji (corresponding author), Assistant Professor,

Department of Finance, School of Economics and Gregory and Paula Chow Center for Economics Research,

Xiamen University. Email: jiyang@xmu.edu.cn. The authors would like to thank Yan Zeng, Qiang Gong, and

Yiping Huang for helpful advice and comments. Stephanie Chan acknowledges support from Central University

Startup Fund Grant (No. 20720181045). Yang Ji acknowledges the support from the National Natural Science

Foundation of China (No.71803163) and Central University Startup Fund Grant (No. 20720181039).

Do Interest Rate Liberalization and Fintech Mix?

Impact on Shadow Deposits in China

Stephanie Chan, Yang Ji*

Abstract

In this paper we attempt to characterize the stability of shadow deposits in China with

interest rate liberalization and ntech developments. We emphasize that shadow banks

provide higher but riskier returns and such characteristics affect the stability of shadow

deposits. In our setting, the stability of shadow deposits is inuenced by two offsetting

effects, namely: the patience effect, which makes investors more willing to wait because

of the potentially higher returns; and the uncertainty effect, which makes investors

more likely to withdraw as a result of higher risk. Under liberalized interest rates, the

patience effect will erode and the uncertainty effect will be heightened because the

post-liberalization higher return of traditional banks undermines the importance of

the extra return of shadow deposits to depositors, while preserving the importance of

the risk aspect. Fintech development is modeled as a reduction in the withdrawal cost

that facilitates runs. This affects the stability of shadow deposits because of their wider

fintech reliance. Regulators should be cautious in pushing interest rate liberalization

and ntech application alongside building a safety net for shadow banking.

Key words: bank run, ntech, interest rate liberalization, shadow banking

JEL codes: E26, E422, G18

I. Introduction

The rapid development of wealth management products (WMPs) in recent years has

led to shadow banking deposits becoming the most important part of Chinese shadow

banking (Ehlers et al., 2018). Maturity transformation of shadow banking deposits,

©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Interest Rate Liberalization and Fintech 5

much like traditional bank deposits, occurs when banks take funds from individuals and

businesses and provide credit to borrowers. However, shadow deposits provide higher

rates of return compared to traditional bank deposits, leading to their popularity.1

Because shadow deposits are demand deposits, they are fragile as a result of

possible bank runs. By the end of 2016, shadow deposits accounted for approximately

77.1 percent of GDP (Ehlers et al., 2018), creating a potential source of financial

instability in the Chinese economy. The rapid growth of shadow deposits is a form of

regulatory arbitrage aimed at circumventing China’s longstanding policy of low interest

rates on deposits. The People’s Bank of China (PBOC) sets a ceiling on the interest

rate that can be paid on savings deposits.2 This policy grew out of the historical need

to maintain a relatively low nancing cost for state-owned enterprises and to prevent

vicious competition among banks. However, this interest rate policy is detrimental to

depositors. For most of the past decade, the deposit rate has been below the ination

rate, giving savers a negative real rate on their deposits. Unsurprisingly, Chinese savers

have sought alternatives with higher returns. Shadow deposits, such as WMPs, give

investors both liquidity and a sense of security as their money is placed in a deposit-like

investment.

Another driving force behind the growth of shadow deposits is nancial innovation,

specically, the rapid growth of nancial technology or “ntech.” An important segment

of growth in shadow deposits is fintech-backed WMPs offered online. This includes

well-known products by ntech giants such as Alipay and WeChat, as well as WMPs

offered by traditional banks. Yu’E Bao, a popular WMP provided by Alipay that invests

the surplus money of Alipay users into money market mutual funds, is one signicant

example of how ntech has led to the buildup of short-term pools of funding (Borst,

2013; Xu, 2017). Yu’E Bao not only offers higher returns than bank deposits, but daily

returns are also convenient to track because Yu’E Bao is linked to Alipay’s mobile phone

application. As a result, mobile phone users have quickly adapted to Yu’E Bao, leading

to its rapid spreading across the country. As of 2019, more than 600 million users have

joined Yu’E Bao, nearly half of the Chinese population, while the total amount invested

in Yu’E Bao reached RMB1.13tn last year.3 However, while most users treat Yu’E

Bao as an alternative saving instrument, the product itself is outside of the connes of

deposit protection.

Considering the popularity of fintech companies and the large scale of shadow

deposits that circumvent regulation, Ehlers et al. (2018) reported that by the end of

1We use the term “shadow deposits” to refer to shadow banking deposits.

2As of 10 July 2019, the benchmark rate for one-year deposits is 1.50 percent.

3http://www.chinairn.com/hyzx/20190109/102055746.shtml (online; cited 19 November 2019).