Efficiency of banking sector will increase through market-oriented pricing mechanism

Full liberalization of China's interest rates, a critical step for financial reforms, is highly anticipated by the market. The central bank's July announcement that it would remove all restrictions on loan rates, and introduce loan primary rate, or LPR, opened a new page in rate liberalization. The next step is to liberalize deposit rates, which should be a gradual process with the establishment of a deposit insurance system.

Inefficient allocation of funds in an over-regulated loan market has led to excess production capacity and inadequate financing support for SMEs with lower credit ratings. Liberalization of loan rates is critical to establishing a market-oriented pricing mechanism for funds, and to help funds be allocated toward where there is more efficient use. Higher risk in a floating rate market also leads to the adoption of stricter and more innovative risk management strategies for both banks and corporations, promoting further opening-up of the financial sector.

The People's Bank of China has gradually loosened restrictions on loan rates, such as removing the cap on loan rates for commercial banks in 2004 and lowering the floor to 70 percent of the benchmark rate in July 2012.

The PBOC announced the removal of restrictions on loan rates for all banks on July 19 last year, bringing the banking sector in China into a new era. In spite of the regulated mortgage rate which remains in place, the pace of loan rate liberalization was beyond market expectations and reflected the PBOC's determination to accelerate interest rate liberalization.

The PBOC introduced LPR on Oct 25 last year, publishing it on a daily basis to provide a reference for loans. The one-year LPR is the average of loan prices offered by nine banks: the big five state-owned banks, Industrial Bank, China Merchants Bank, CITIC Bank and Shanghai Pudong Development Bank. The LPR was announced at 5.71 percent on the first day, lower than the PBOC's one-year benchmark rate of 6 percent, but higher than the one-year Shibor rate of 4.4 percent in the interbank market.

The market has seen active responses from financial institutions to the newly published LPR. Several LPR-based deals have been closed by Industrial and Commercial Bank of China, China Construction Bank and Bank of China, totaling more than 1.875 billion yuan ($309 million; 266 million euros). Furthermore, CITIC Bank has signed a two-year LPR-based renminbi interest rate swap with Citi Bank with a fixed leg of 5.75 percent; and Standard Chartered and HSBC also signed a one-year LPR-based yuan interest rate swap with a fixed leg of 5.76 percent.

PBOC benchmark rates, LPRs and Shibors are expected to coexist for a while. The benchmark rates as a reference could help prevent large fluctuations of LPRs. And LPRs and Shibor provide reference rates for the loan market and the money market, which remain isolated in China.

LPRs with maturities other than one-year are expected to be published in the future to present a complete term structure of loan rates and increase the pricing transparency of the loan market.

Liberalization of deposit rates is the next step in reform. It will be more gradual and cautious, as it will have wider effect. The PBOC will liberalize deposit rates in two aspects simultaneously - establishing the deposit insurance system and expanding a market-orientated pricing mechanism.

The deposit insurance system, as the core stabilizer of a liberalized deposit market, is considered a prerequisite to a market-oriented deposit pricing mechanism. It has been discussed for a long time given the systemic importance and dominant role of the banking sector in China, and is likely to be established late this year or early next year. The PBOC signed a memorandum of understanding with the US Federal Deposit Insurance Corporation on Oct 24 last year to strengthen collaboration in establishing China's deposit insurance system and in preparation to deal with troubled financial institutions.

The PBOC introduced several deposit instruments priced by the market previously, which have restricted market access and limited resell value. More market-oriented products are expected to be introduced step by step.

Negotiable certificates of deposits are likely to be relaunched by the end of November. NCD were first introduced in 1986 by the Bank of Communications but were suspended in 1997 by the PBOC due to technical issues. Proposals for relaunching NCD have been filed to the PBOC by five major state-owned banks: BOC, ICBC, CCB, BOCOM and Agricultural Bank of China. The NCD will be introduced to the interbank market first, covering 10 pilot banks: China Development Bank, Industrial Bank, China Merchants Bank, CITIC Bank, Shanghai Pudong Development Bank and other major state-owned banks. The pilot phase of NCD will be very similar to the existing interbank borrowing business, and is expected to have limited impact on the interbank market while improving the transparency of transactions.

Corporate certificates of deposit and certificates of deposit for households are expected to be launched after the NCD pilot program. Cash management products, as an alternative to term deposits, are currently favored by households in China due to higher returns and short maturities. But the nature of those products is collateralized debt obligation backed by bonds in the money market, implying an unsecured and volatile rate of return. The introduction of certificates of deposit will present households with a financial instrument with similar levels of return but much lower risk.

Specifically, five-years deposits only account for 0.5 percent of total deposits, so these could be liberalized first. Then the liberalization process could expand to other terms to minimize the impact on the banking sector and achieve a smoother transition from a regulated market to a liberalized market.

Full liberalization of interest rates generally brings large fluctuations in the market. The banking sector will encounter complex post-liberalization market dynamics, including narrowing interest spreads, more competition and rising risks amid a more challenging liquidity scenario.

High interest rate spreads that deliver stable profit streams will be phased out upon liberalization of interest rates. Widely adopted liability management strategies drive banks to actively manage the size of their liabilities to match the funding needs of their assets. Actively narrowing down interest rate spreads to attract clients and depositors would become a norm in the banking sector as it allows rapid expansion of the balance sheet and leverage as has been the case in developed economies such as the US, Taiwan and South Korea.

Interest rate liberalization also intensifies competition. The easiest method for banks to differentiate themselves in a fully liberalized market is by offering more competitive rates to clients.

Risk management will become the priority for banks as a result of shrinking profit margin and core capital after rate liberalization. Banks with aggressive strategies on maturity mismatches or risk management are likely to benefit from rapid expansion of their balance sheets in the short run. But climbing non-performing loan ratios during the period of economic fluctuations would eventually put a burden on their share prices.

The self-correction mechanism would penalize risky banks as well as amplify the overall risk. The deposit insurance program is designed to eliminate the probability of a government bailout in the event of bank insolvencies. Risky banks are more likely to encounter bank runs in the event of cyclical fluctuation, delivering systematic shock to the whole banking sector.

Liberalization of interest rates is expected to raise the efficiency of the banking sector in China through the introduction of a market-oriented pricing mechanism of funding, and accelerate further opening-up of the financial sector by promoting more prudent and innovative risk management strategies. On the other hand, challenges will arise along with the complex post-liberalization market dynamics, forcing banks to be well prepared.

The author is chief economist of Haitong International based in Hong Kong. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 02/14/2014 page12)