China’s recent interest rate cut could ease corporate debt financing pressure. But at the same time, by expanding the floating range of interest rates on bank deposits, China could move towards more financial market liberalization.
On 21 November 2014, People’s Bank of China (PBOC), China’s central bank, surprised the market by cutting the one-year lending rate by 0.4 percentage points, to 5.6%, and the one-year deposit rate by 0.25 percentage points, to 2.75%. This was the first benchmark interest rate cut in more than two years. PBOC told the press that its intention was to “alleviate high financing costs for corporations,” especially for small and medium-sized enterprises (SMEs), and further liberalize the financial market.
The market experienced an adrenaline rush. The Chinese, Asian, Australian, and U.S. stock markets rose after the new policy announcement. With dropping inflation and the economy slowing down, analysts have been calling for a rate cut for months. The announcement of lowered borrowing costs also boosted real estate developers’ sales performances in many Chinese cities. On November 22, for example, thousands of people queued up to buy 1,500 new apartments in Shenzhen.
Nevertheless, a closer look at the rate cuts challenges the rationality of such upbeat emotions. Packed into the announcement was a further step toward interest rate liberalization, allowing banks to set their maximum deposit rate at as high as 1.2 times the benchmark, compared with 1.1 times previously. That leaves the de facto upper limit of banks’ deposit rate unchanged.
Meanwhile, the floor on the lending rate is not binding for banks in China, buffering the real impact of the lending rate cut. If banks ignore PBOC’s lending rate guidance, which they have every right to do, the central bank’s plan to reduce financing costs for enterprises becomes nonsense.
The good news is that banks’ interest partly aligns with PBOC regarding cutting lending rates. Non-performing loans from China’s banks surged 10% in the third quarter this year; cutting the lending rates would help the banks’ existing clients service their debts, and reduce banking risks. Indeed, the one-year loan prime rate, a weighted average of nine major banks’ lending rates, had dropped from 5.76% to 5.51% between 22 November and 3 December 2014. That means PBOC’s new guidance has already lowered the financing costs as planned.
According to PBOC’s latest report, banks’ balance sheets have expanded rapidly since the announcement of the rate cuts. However, the rate cuts have made financing easier for China’s large state-owned companies (SOEs) rather than SMEs. Banks prefer government-backed projects to risky SME loans. The government-backed banking sector has a mandate to support the SOEs with easy access to loans, making them indispensable clients to banks.
It makes sense to ease SOEs’ debt pressure before they fail to refinance their loans and bring down the entire banking sector. Meanwhile, the evermore risk-averse banking sector is becoming more reluctant to make relatively high-risk SME loans, leaving SMEs no choice but to stick with costly shadow banking.
Thus, easier credit, as has been already observed, may not do much to support China’s cash strapped SMEs and turn around China’s over-reliance on inefficient industries. Moral hazard is likely to prevail. Moreover, as the Yuan depreciates against the dollar after the rate cuts (see chart below), opening up the capital account and promoting Yuan in the international market becomes risky business. These cases do not make the rate cuts as reformist as advocated by PBOC.
On the bright side, with a stimulus in place and new ones ready to take effect, China may not need to worry about its GDP figures – for now.
