Chapter 10: Interest rate reform: full or partial liberalization?
The PBOC has put China on course to free up interest rates on bank deposits in the past several years. The impact is multifaceted. First, this would force commercial lenders to compete for customers by offering the best terms. As commercial lenders are under pressure to more carefully evaluate risks, they are likely to lend more to privately owned firms. Second, this may offer more protection to depositors. The risk is also clear. The removal of interest rate restrictions may lead to the sharp growth and then collapse of a number of savings-and-loan firms. This took place in the US, which eased the rules on interest rates in the 1980s followed by many savings-and-loan firms’ collapse. The main reason for this side effect is due to the fact that banks compete for funds, pushing up their costs and leading them to make risky loans that end up badly. Third, interest rate liberalization is the key to solving the problem of financing small businesses. On the other hand, a surge in interest rates could put further pressure on local governments, real-estate developers and other companies already struggling to repay debt. Banks’ inability to offer higher deposit rates has fueled the growth of less regulated informal lenders that are willing to pay more. This chapter looks into China’s recent path of reforming its interest rate formation mechanism. Section 1 briefly outlines the current interest rate formation mechanism, followed by Section 2 which unveils the connection between this formation mechanism and commercial lenders’ high profitability. Imposing restrictions on interest rates is a key aspect showing that the nature of China’s financial system is a repressed one. Section 3 explains this perspective in detail. Section 4 moves to China’s efforts to liberalize its interest rate formation regime while Section 5 focuses on China’s latest reform approaches and limitations. A conclusion follows in Section 6.
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