Editor’s Note: The reduction of interest rates and reserve requirement ratio announced by the People’s Bank of China on October 23 is an important measure adopted in response to the current macro-economic situation, as well as a pre-emptive, fine-tuning adjustment based on the price movements and liquidity situation. In addition, the central bank has announced to remove the deposit interest rate ceiling for commercial banks and rural credit cooperatives. As a result, interest rate controls have been basically lifted and the market-based interest rate reform has entered a new stage. Despite the recent difficulties such as stock market turbulence and the worrying signs in capital flows and foreign exchange, the State Council decided to take the most decisive step in liberalizing interest rates. This reflects the determination of the Chinese Government to press ahead with reforms. In this sense, the removal of the deposit interest rate ceiling has far reaching significance that warrants deeper and closer examination. Deputy Governor Yi Gang recently had a discussion on this issue with academic experts. Below is a summary of the Deputy Governor’s key points.
1. A brief history of market-based interest rate reform. The market-based interest rate reform started more than two decades ago. In 1992, the Chinese Communist Party in its 14th National Congress proposed, for the first time, market-based resource allocation, i.e. to have the market play a fundamental role in resource allocation. Since then, our understanding of resource allocation has gradually shifted from focusing on market allocation of products to market allocation of factors of production. Seen from this perspective, the market-based interest rate reform has come a long way. At the operational level, with the lifting of controls over the inter-bank lending interest rates in 1996 as a start, the PBC has, since then, been advancing the market-based interest rate reform progressively. In 2003-2004, major steps were adopted to further liberalize the control over interest rates, with the ceiling of deposit interest rates raised and the floor of loan interest rates lowered. After this, due to the rapid buildup of foreign exchange reserves and the subsequent excessive liquidity supply, the focus of macro-economic management was shifted to sterilization of excess liquidity through quantitative tools and the pace of market-based interest rate reform slowed down somewhat. Since 2012-2013, the reform pace accelerated, leading to the removal of interest rate controls nowadays. Interest rate liberalization is an integral part of China’s economic reform and an important step toward achieving market-based resource allocation. It is also a long and gradual process in which one step is taken after another following careful preparations.
2. Improving the pricing of factors of production is key to enhancing the efficiency of resource allocation. Allocation of financial resources or capital is closely related to the efficiency of resource allocation. In a traditional planned economy, consideration is usually given to where resources are to be allocated, for example to urbanization, to real estate sector, to infrastructure building, or to other areas. Ultimately, how resources are allocated is about efficiency. If efficiency is low, a lot will be wasted and the effects in terms of supporting economic growth, increasing income, and building a well-off society will be poor. The core of enhancing allocation efficiency lies in getting the factor prices right. In economic theory, this is very clear. The general public may think otherwise since they are mainly concerned with where resources are allocated. But in fact, allowing the price mechanism to allocate capital to more efficient sectors of the economy will be the most beneficial to China’s economic development and people’s livelihood.
3. The market-based interest rate reform is an important way to diversify financial products. With economic development, there are more diversified demands for the allocation of financial resources. There are all kinds of enterprises, large-scale, small- and medium-sized, and micro businesses; there are state-owned, private, and foreign-invested enterprises. Their demands are different. As far as individuals’ demands are concerned, people save for varying purposes, such as old-age support, children’s wedding, and contingent uses, etc. Therefore, having interest rates determined by market supply and demand will provide a basis for more diversified financial products and differentiated interest rates to meet the varying demands of market participants.
When price is controlled, products supplied are all alike. In a planned economy, products are not diversified. The subsequent weak demands further contributes lack of variety of products supplied. In the 1980s, those Chinese visiting Russia found big department stores near the Red Square, and a street full of shops selling products from the central and eastern European countries that were members of the Council for Mutual Economic Assistance (CMEA). They favored those shops selling products from Yugoslavia and Poland, because market-based reforms started earlier in these countries and their products were more diversified. However, shops selling products from the CMEA members with a strongly planned economy only offered one kind of product with poor quality, although those shops were very large. Therefore, lack of product diversity is associated with the old days of a planned economy. The same applies to financial products. If prices of financial products are tightly controlled, products would lack variety, and as a result supply and demand would not be able to meet the needs of economic development and social progress. It is fair to say that interest rate liberalization is the main channel to meet the increasingly diversified financial demands and promote economic development.
4. Interest rate liberalization creates basic conditions for the transformation of monetary policy framework. There were very few types of financial products and no real monetary policy in the planned economy era. At the beginning of the transition period, the conduct of monetary policy inevitably relied more on quantitative instruments, and many called for acceleration of the transformation of the monetary policy framework. With the reform this time, we also talked about the transformation of monetary policy framework and improving the transmission mechanism. Path dependence might happen in this process. The existence of administrative controls will lead to dependence on such controls and the perception that the removal of controls will create chaos. Such a perception usually hinders reforms. Similar perceptions existed in 1980s when people were skeptic about the price reform.
In fact, progress of market-based interest rate reform provides basic conditions for transforming the monetary policy framework. Such progress also provides microeconomic foundations for the transmission of monetary policy, facilitating the transition towards price-based instruments. Looking at the microeconomic level, if interest rates are always controlled and determined by the central bank, commercial banks tend to rely on the rates set by the central bank. At the initial stage of interest rate liberalization, commercial banks still preferred to rely on the rates decided by the central bank due to their limited pricing capabilities and inadequate analysis of pricing mechanism. Even if you ask them to price their own interest rates, they would simply follow their peers. But it has been more than a decade since the interest rate reform in 2004, and substantial progress has been made. Commercial banks are relatively well-prepared now.
Nevertheless, there are still signs that commercial banks rely on administrative controls. For instance, if you go to a commercial bank branch for a mortgage loan, its sales person would show you the bank's preferential policies, and elaborate on how competitive these policies are compared with those of other commercial banks. But if you ask for a lower interest rate, the sales person would say no and explain that the interest rates are set by the central bank. This is quite interesting. Once commercial banks feel that something is difficult to explain, they will refer to the central bank, which demonstrates their reliance. If the administrative controls over interest rates are lifted, commercial banks will have to handle their competitive pressures in a more independent and market-based way.
5. Partial liberalization creates a dual-track price system and distorts the market. The price within the controlled track is usually lower and that outside the track is higher in such a system. When we first launched the market-based price reform in 1980s, steel was very costly in the market but the price within the controlled system was quite cheap. This caused speculation and arbitrage.
When commercial banks were first allowed to sell wealth management products, the interest rates on these products were very high, and savings products within the controlled track had relatively low interest rates. The price difference has narrowed as more products are offered outside the controlled track. Of course, during this process, there might be growing concerns that interest rate liberalization will push all interest rates higher towards the level of those on wealth management products. Actually this concern is unfounded because it is inconsistent with the supply and demand relationship of capital.
6. The substantial decline in the cost of information processing should also be flexibly reflected in interest rates. The pricing of deposit products and some credit products rely heavily on data processing cost. Information technology including computer system, network, internet, and cloud computing has had a huge impact on financial business, especially the cost of data processing. Therefore it’s natural that such impact should be reflected in interest rates. Otherwise, it may be reflected in the other track of the dual-track system, which would cause many problems.
In terms of deposits, experiences of mature market economies such as the United States, United Kingdom, and Australia show that demand deposits or checking accounts involve a huge amount of information processing, which is very costly for the banking sector. Since customers may withdraw such deposits at any time, the banking sector did not pay interests on this category of deposits at first. A very important clause in Regulation Q of the United States banned interest payments on demand deposits by member banks of the Federal Reserve System. With the enhanced efficiency in information processing and the abolishment of Regulation Q in the late 1980’s, banks began to pay small interests on demand deposits. In the United States, however, interest on demand deposits is very low. The interest rate on demand deposits in China is currently 0.35%, which is much higher than that in the United States.
The substantial fall of information processing cost is mainly a result of advances in electronic processing thanks to the development of computer science and networks. With the decline in information processing cost and competition from financial innovation initiated by internet companies such as third-party payment companies, some customers expect a higher return on deposits. Of course, in their early days such businesses offered products linked to money market funds and took advantage of the dual-track system. It can be expected that the evolution of competition in the future will be closely related to technological progress and changes in costs.
7. The market-based interest rate reform is not about leaving everything to the market. There will still be monetary policy adjustments and macro-prudential regulation. Interest rates are the outcome of resource allocation, determined by market supply and demand. At the same time, interest rates are also an important element of monetary policy and macro-economic management, as emphasized by the State Council on many occasions. From a micro perspective, the liberalization of interest rates can optimize resource allocation. From a macro perspective, the reform is not about leaving everything to the market. There will be monetary policy adjustment in line with counter-cyclical needs to make interest rates consistent with the direction of macro-economic management. More specifically, interest rates should be adjusted at different stages of national development and reflect the inflation cycle. As a result, more efforts should be paid to the improvement of the central bank’s monetary policy framework and the improvement of transmission mechanism in the process of interest rate liberalization.
Meanwhile, regulation and self-regulation are also necessary for macro-prudential management. Some “teeth” are required to address certain abnormal market phenomenon. At the beginning of the global financial crisis, the U.S. Federal Reserve cut its policy rate to around zero and launched the first round of quantitative easing. The monetary condition became very accommodative. At that time, some banks on the verge of bankruptcy such as Washington Mutual and Wachovia offered deposit rates of 7%-8% or even above 10% to attract deposits. This reflected their desperation to attract new deposits to cover their deteriorating conditions. From the perspective of macro-prudential management and financial stability, this kind of behavior was destructive. So some “teeth” were needed to address these issues. Similar situation existed in China. During the Asian financial crisis, some insolvent small trust companies, securities companies, and credit cooperatives issued OTC debts with high interest rates to delay their closure. In fact, this kind of practices caused more troubles and became more difficult to handle.
For this reason, liberalization of interest rate both emphasizes the concept of market and resource allocation and requires macro-economic management. This involves knowledge of economic theory, which may create confusion in the general public. We hope that academic circles can spread knowledge of basic economics and help the general public understand this reform better. This way, some misunderstanding of the reform or incorrect opinions can be avoided. Of course, we will always keep an open mind when listening to all kinds of opinions. To sum up, it’s not easy to make up the mind to push ahead with the market-based interest rate reform, and to achieve final success is no easy job either. I hope we can make joint efforts to support and help the financial sector in this process.
The growing Chinese economy calls for commensurate financial markets and products. Country experiences have shown that real economy can benefit from more developed financial markets and more efficient resource allocation that meet diversified demands. In today’s interconnected global economy, an efficient and sound financial market is crucial, and letting market forces to determine interest rates is an unavoidable path toward that goal. As such, we have to strengthen the guidance and management of interest rates, remain vigilant on potential risks, and press ahead with the market-based interest rate reform steadfastly.
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