Blog Post

China’s financial liberalisation: interest rate deregulation or currency flexibility first?

Part I discusses three institutional factors favouring a strategy of greater currency flexibility ahead of fuller domestic interest rate liberalisation. Part II (coming later this week) explores three cyclical factors that would tend to favour the same strategy.

By: Date: October 16, 2014 Topic: Finance & Financial Regulation

Part I discusses three institutional factors favouring a strategy of greater currency flexibility ahead of fuller domestic interest rate liberalisation. Part II (coming later this week) explores three cyclical factors that would tend to favour the same strategy.

PBC is currently negotiating a tricky transition away from a convoluted monetary regime

China’s central bank, the People’s Bank of China (PBC), is currently negotiating a tricky transition away from a convoluted monetary regime that features a managed currency, a controlled capital account and a regulated domestic interest rate. Chinese policymakers have so far pursued a financial liberalisation strategy involving simultaneous and small steps on all three fronts: incremental opening up of the capital account, deregulating most of the domestic interest rates except the official ceilings on benchmark bank deposit rates, and instilling some two-way FX volatility into the renminbi (RMB). The global financial system and economy has a big stake in the fate of Chinese financial liberalisation, which is promising but risky. 

But should domestic interest rate liberalisation or currency flexibility lead, in particular in the context of the Chinese communist party’s reform announcements late last year? While there are no black-and-white answers to this question, the current state of the Chinese financial system and the eventual financial reform end game might help identify which strategy is currently preferable.  

It would be useful to first put the Chinese monetary system in perspective. Before the “unconventional era”, most OECD economies had a monetary regime characterised by a free floating exchange rate, a benchmark overnight interest rate set by the inflation-targeting central bank, and a yield curve mostly shaped by domestic and global market forces, which would in turn influence bank rates for retail consumers and small firms. Private agents would then respond to such price signals in their decision making. End of the story.

The Chinese monetary system, however, differs from this simple paradigm in at least three important aspects. First, the RMB exchange rate is heavily managed, initially against the US dollar and after 2005 in part with reference to a undisclosed basket of currencies (Ma and McCauley, 2011).

Second, the Chinese government still sets the ceiling on key term benchmark bank deposit rates, but many other interest rates, including bond yields, money market rates and bank lending rates are mostly determined by market forces. So the yield curve is still under heavy government influence in China.

Third, state banks, state-owned enterprises (SOEs) and local governments are still big players on both the demand and supply sides of the Chinese credit market (Ma, 2007). The state banks maintain two thirds of the Chinese deposit market share, and two thirds of Chinese bank loans still go to SOEs and local government investment vehicles.

These important factors may help shape the likely path of China’s financial liberalisation

These important structural and institutional factors may help shape the likely path of China’s financial liberalisation, in three main ways.

First, as SOEs, local governments and their investment vehicles remain big borrowers in the Chinese credit market, but still face “soft budget constraints”, they therefore tend to be less sensitive and less responsive to market interest rates, partially nullifying the potential benefits of allocating capital more efficiently via market-based interest rates. Hence additional economic reforms on other fronts would ideally be needed to support fuller interest rate liberalisation.

Worse, the presence of implicit government guarantees might initially aggravate moral hazard risks in the wake of loan interest rate deregulation, because state banks might take excessive risks, and because of implicit government guarantees to the SOEs, the credit spread of private firms over SOEs demanded by banks and bond investors has actually widened, as interest rates became more market-based (Zhang and Huang, 2014). This perverse outcome would further distort the credit market and punish the private sector, which has been the main source of productivity growth in the Chinese economy.

Thus more needs to be done to wean the SOEs off government support and to strengthen the financial discipline of SOEs, state banks and local government, before market-based interest rates can meaningfully improve the allocation of capital in China.

Second, a functioning deposit insurance scheme should be in place ahead of full interest rate deregulation. Chinese policymakers appear ready to roll out the first ever deposit insurance scheme in China. This is much needed, because price competition among banks is expected to intensify, likely squeezing interest margins and possibly leading to bank failures. However, it might take time for the new deposit insurance scheme to function properly, because banks, depositors, market participants and regulators all need to gain experience and adapt to the new regime.

Third, the PBC may also need more time to ready itself for a new monetary policy regime. With fuller domestic interest rate deregulation, the PBC will have to be responsible for anchoring the short end of a more market-based yield curve. Presumably in this new world, the PBC would also like to shift toward an OECD-like monetary policy regime featuring a policy rate or some benchmark short-term interest rate as its key operating target. At the moment, however, the PBC still targets money supply using a mix of administrative, quantitative and price instruments, such as reserve requirements, open market operations and administered deposit rate (Ma, Yan and Liu, 2011). So it remains to be seen whether the PBC is ready to play its role in a new era of fully liberalised interest rates.

Since 2013, the PBC has been actively introducing more new policy tools such as the short-term liquidity operations (SLO), and considering a wider set of eligible collateral, in addition to its more traditional open market operations. Nevertheless, new tools to help it hit the policy rate target should ideally be tested and refined first.

Over the years, the PBC has also painstakingly nurtured local benchmark interbank rates such as the overnight and 7-day SHIBOR (Shanghai Interbank Offered Rate) rates, which form the base for the short end of the yield curve and serve to price off many interest rate derivative contracts and negotiable certificates of deposits.

These benchmark short rates, however, suffered sharp swings in June 2013, raising questions about their usefulness and reliability (Graph 1). While some claim that this “controlled experiment” with the SHIBOR rollercoaster was a warning to misbehaving banks, others are simply baffled why one should abuse these bellwether interbank rates in order to curb shadow banking that often caters to the financing needs of Chinese local governments, which are less interest-rate sensitive in the first place.

Graph 1: Daily Shanghai interbank offered rates (%)

In any case, one may ask whether the recent rising and positive real interest rates in China represent a move to an equilibrium level, or are a reflection of the underlying distortions in the unmistakably weakening Chinese economy. The Chinese economy currently needs a more flexible currency that could help absorb shocks, rather than a more volatile interest rate that could inflict damage on the economy. In another article tomorrow, I will make this same point on the basis of three cyclical considerations. Hence one can argue that for China currently, exchange rate flexibility should go ahead first before fuller interest rate liberalisation.  Stay tuned.

***

References

Ma, G (2007): “Who pays China’s bank restructuring bill?”, Asian Economic Papers, 6 (1), pp 46-71, MIT Press.

Ma, G and R McCauley (2011): “The evolving renminbi regime and implications for Asian currency stability”, Journal of the Japanese and International Economies, March, No 25, pp 23-38.

Ma, G, X Yan and X Liu (2012): “China’s reserve requirements: practices, effects and implications”, in China Economic Policy Review, Vol 1, No 2 pp 1-34.

Zhang, Z and H Huang (2014): “Stress testing China’s bond market”, HSBC.

Assistance by Simon Ganem is gratefully acknowledge

Read more on China

China seeking to cash in on Europe’s crises

Review: The China slowdown effect

Financial openness of China and India: Implications for capital account liberalisation

Developing an underlying inflation gauge for China

Are financial conditions in China too lax or too stringent?

How tight is China’s monetary policy?

The Dragon awakes: Is Chinese competition policy a cause for concern?

How loose is China’s monetary policy?

China gingerly taking the capital account liberalisation path


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event More on this topic

Upcoming Event

Nov
7
13:45

Russian economy at the crossroads: how to boost long-term growth?

Russia’s convergence to advanced economy income levels has stalled. Long-term growth prospects are still obstructed by sluggish productivity growth, low capital accumulation and shrinking labour inputs. The new government has articulated a set of ambitious policy objectives for the next six years. But are additional reforms necessary to further boost productivity and investments in line with government targets?

Speakers: Marek Dabrowski, Markus Ederer, Elena Flores, Niclas Frederic Poitiers and Dmitry Polevoy Topic: Global Economics & Governance Location: Kadashevskaya Naberezhnaya, 14, Moscow, Russia, 115035
Read article More on this topic

Blog Post

Implications of the Japan – United States Mini Trade Agreement

Details of the US-Japan mini-trade deal are lacking but the agreements’ direct impact on the US and Japanese economies is likely to be minuscule. The deal seems to have been made to compensate American farmers – a crucial electoral base of the President – for their losses from the trade war with China.

By: Sybrand Brekelmans and Uri Dadush Topic: Global Economics & Governance Date: October 11, 2019
Read article More on this topic More by this author

Opinion

The Case for Intelligent Industrial Policy

Although national industrial policies have a bad reputation, there is a strong case for government support to sectors that will increasingly rely on artificial intelligence. In this regard, the German government’s plan to promote production of electric-car batteries may accelerate an industrial renaissance in Europe.

By: Dalia Marin Topic: European Macroeconomics & Governance Date: October 7, 2019
Read article

Opinion

Southbound flows rescuing Hong Kong equity market

China seems to be coming to the rescue as social unrest affects the city’s financial market, but it’s probably only for arbitrage reasons

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 2, 2019
Read article More by this author

Blog Post

Questions to the High Representative and Vice-President-designate Josep Borrell

Josep Borrell, the incoming High Representative and Vice-President-designate must explain how von der Leyen’s ‘geopolitical Commission’ intends to adapt to a global landscape dominated by an intensifying rivalry between Washington and Bejing.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 30, 2019
Read about event More on this topic

Upcoming Event

Nov
28-29
09:00

EU-Asia trade and investment connectivity

The Asia Europe Economic Forum (AEEF) was established in 2006 as a high level forum for in-depth research-based exchanges on global issues between Asian and European policy makers and experts. This year, the AEEF will be hosted by Bertelsmann Stiftung on 28-29 November, 2019 in Berlin, Germany, and it will focus on “EU-Asia trade and investment connectivity”.

Speakers: Aart de Geus, Guntram B. Wolff, He Fan, Alessia Amighini, John Beirne, Nicolaus Heinen, Jae-Young Lee, Cora Jungbluth, Alicia García-Herrero, Xin Yuan, Andreas Esche, Ken Wu, Sébastien Jean and Amb. Karsten Warnecke Topic: Global Economics & Governance Location: Bertelsmann Representative Office, Unter den Linden 1, 10117 Berlin
Read article Download PDF

External Publication

European Parliament

Challenges ahead for the European Central Bank: Navigating in the dark?

Since the second half of 2018, signs of a slowdown have been piling up in the euro area. The ECB will face major challenges in this potentially difficult period: its main tools are nearly exhausted, the monetary union in which it operates is still incomplete, and it lacks the understanding of what the ‘new normal’ looks like. The authors, therefore, urge the ECB to review its strategy and framework to be able to face these challenges.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 25, 2019
Read article

Blog Post

The EU is in the US trade war crosshairs. It should further raise its game

The incoming European Commission faces a dilemma on the transatlantic trade relationship, because of the unpredictable policies of the Trump administration. The EU must rally its citizens; the greater the divides between member states and EU institutions, the lesser the chances are of forging effective policies toward the United States and China.

By: Anabel González and Nicolas Véron Topic: European Macroeconomics & Governance, Global Economics & Governance Date: September 19, 2019
Read article Download PDF More on this topic

Working Paper

EU trade policy amid the China-US clash: caught in the crossfire?

What risks face the EU with regard to China’s strategic aims in trade policy and how can the EU respond? The US effort to isolate China poses particular risks for Europe. How can the EU counter such efforts with the aim of forging its own distinct trade policy? How should the EU move forward with reform of the World Trade Organization (WTO) in light of differing demands and aims of trading blocs like China and the US?

By: Anabel González and Nicolas Véron Topic: Global Economics & Governance Date: September 17, 2019
Read article More on this topic

Opinion

China's dual banking system: consolidation as the final solution for weak small banks

There are fundamental solvency and liquidity issues for some small Chinese banks, widely influencing both the bond market as well as the broader financial sector. Given the difficulties in creating a level playing field between small and large banks, there is an expectation that small banks will continue to under-perform.

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation Date: September 16, 2019
Read about event

Past Event

Past Event

Climate change and the role of central banks

What connections exist between central banks and climate change, and what are the resulting implications?

Speakers: Emanuele Campiglio, Paul Hiebert, Pierre Monnin, Kjell G. Nyborg, Luiz Awazu Pereira da Silva, Mario Quagliariello, Mattia Romani, Paweł Samecki and Dirk Schoenmaker Topic: Energy & Climate, European Macroeconomics & Governance Location: Narodowy Bank Polski, Świętokrzyska 11/21, 00-919 Warsaw Date: September 16, 2019
Read article More on this topic More by this author

Blog Post

Argentina, plus ça change…

Recent primary elections in Argentina saw the defeat by a wide margin of President Macri. This fueled market volatility given expectations of a reversal of reforms after national elections in October; the recent re-introduction of capital controls attests to the extent of the economic fallout. With Macri’s end in sight, this post will review the evolution of the Argentinian economy during his term.

By: Marta Domínguez-Jiménez Topic: Global Economics & Governance Date: September 9, 2019
Load more posts