2014-03-11

Political Reform in China: Interest Rates

When interest rates are allowed to float, power will shift away from the party controlled state-owned companies towards the private economy. The PBOC was thwarted in its reform efforts back in 2005 by party insiders, who turned power over to the Ministry of Finance. Had reform taken place in 2006-2008, the ensuing crisis could have been blamed on the U.S. The leadership would have gotten a free pass for destabilizing reform. Now these policies are coming a decade late, after a huge explosion in debt.

China Expects to Liberalize Interest Rates Within 2 Years
Beijing is hoping the changes will put money into the pockets of ordinary Chinese savers, make the banks assess risks more carefully, and direct more lending to privately owned firms who complain that China's largest banks ignore them. But the transition is risky and other countries have foundered, including the U.S., whose savings-and-loan crisis in the 1980s followed deposit-rate liberalization.

Currently, the People's Bank of China maintains a cap on the rate banks can pay depositors, a system that has left Chinese households poorly compensated because deposit rates rarely top the rate of inflation. At present, a one-year deposit pays no more than 3.3%, while inflation is running at about 2.5%.

......Under Mr. Zhou, the central bank has pressed to remake the Chinese economy so it is based more on domestic consumer demand rather than exports abroad or capital-intensive industries at home. To that end, having banks compete on deposit rates should give ordinary people more money to spend. By boosting the cost of funding for banks, analysts say, the move could also require banks to better analyze risks and allocate more lending to private firms that would be willing to pay higher rates.

"Funding is a serious problem for small businesses right now," said Zhou Dewen, head of the Wenzhou Small- and Medium-Sized Enterprises Promotion Association, a trade group. "Interest-rate liberalization is key to solving the problem."

At the same news conference Tuesday, China's top banking regulator, Shang Fulin, said the government will allow privately owned banks to be set up in the wealthier regions of Tianjin, Shanghai, Zhejiang and Guangdong to provide financing for cash-strapped small and private businesses. China's technology giants Alibaba Group Holding Ltd. and Tencent Holdings Ltd. are among the companies that have won regulatory approval to take part in the pilot program, according to the China Banking Regulatory Commission.

But bank deposit liberalization has sometimes led to financial crises as banks compete for funds, pushing up their costs, and make risky loans that end up badly. In the U.S. in the 1980s, for instance, savings and loan institutions freed to compete for deposits made bad bets on real-estate projects, which couldn't repay their loans. More than 1,600 banks were closed at a cost of $160 billion, according to a study by the U.S. Federal Deposit Insurance Corp.
A few thoughts. Reform is always destabilizing for the status quo. Banks are already worried about fighting for deposits at the end of every quarter (the cash crunches). They are also upset at Alibaba and other online money market firms that are already liberalizing interest rates via the market and have complained about it. To that point, Zhou Xiaochuan has said the money market funds are not a problem. Maybe this the slow rollout of reform will help the banks adjust; maybe not.

As for the politics. The big banks and SOEs are controlled by party insiders who use them to get rich. This group was weakened by the ousting of Bo Xilai somewhat because the conservatives (in China to be conservative is to conserve Mao thought and communism) were anti-reform. The reform camp is headed by Prime Minister Li, with the PBOC a reform-oriented institution that pursues market solutions. Interest rate reform directly hurts one faction of the Communist Party and benefits another. The Party clearly does not want a crisis, but if it sometimes seems like they are taking steps that could lead to a crisis, it is good to remember that the party is not monolithic. The Party will bailout the big four banks no matter what, but if they get into trouble due to some reforms such as interest rate liberalization, that can be a feature, not a bug, to some factions in the party.

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