Market-Based Interest Rate Reform in China

China Finance 40 Forum Research Group

• Editorial: Routledge
• Año: 2018
• ISBN:
  9780429889998
• Edición: 1
• Categoría: Negocios y empresa
• Categoría: Negocios en general

The market-based interest rate reform remains a core part of China's financial reforms, and an important topic of both theoretical and policy studies. This book presents a comprehensive analysis of the process and logic of China's interest rate reform from a historical perspective. It is structured along three lines, i.e. loosening interest rate controls, establishing market-based interest rates, and building an effective interest rate adjustment mechanism, and systematically reviews the characteristics and evolvement of the reform process. The book further explores the lessons and challenges of the reform by examining China's development stage and auxiliary reforms needed, and offers policy recommendations on how to further push forward the reform.

1
Interest rate deregulation

China’s path

Relaxing interest rate controls is a key part and an important goal of interest rate liberalization in both the Chinese and global context. Different countries have different approaches to interest rate liberalization; some liberalize the interest rate quickly, while others do it gradually after taking certain steps. China has adopted a measured approach. After removing controls on its money market rates, bond market rates, and foreign currency deposit and loan rates, it relaxed control of lending rates in July 2013 and lifted the cap on deposit rates in October 2015. Therefore, China has basically removed regulation on interest rates, marking an important milestone in the process of market-based interest rate reform. This chapter provides a comprehensive and systematic review of China’s practice in relaxing interest rate controls to provide an understanding of the principles, approach, sequence, and pace of the reform measures.

I Path selection of interest rate deregulation: theoretical basis and international experiences

A Theoretical analysis: regulation and liberalization of interest rates

Judging from a historical perspective, most countries have undergone “free–controlled–free” stages in their interest rate systems. This process is a reflection of the development of economic theory. Before the 1930s, the “laissez-faire” theory played a dominant role and most nations did not regulate interest rates. For instance, the US embraced a free banking system before the establishment of the Federal Reserve System in 1913. And from then until the Great Depression, the US government and the Federal Reserve did not intervene strongly in the financial market, and interest rates were decided by supply and demand. The Great Depression from 1929 to 1933 weakened the dominance of the free market theory and Keynesianism became the mainstream. Many countries began to emphasize the importance of the government’s role in economic activities, and interest rate regulation became a crucial part of government intervention. The US passed Regulation Q in 1933, which prohibited banks from paying interest on demand deposits and imposed maximum interest rates on savings and fixed deposit. Germany started to regulate interest rates in 1932 and continued to do so long after the Second World War; France imposed regulations on deposit and lending rates during the war and strengthened credit regulation afterward to boost economic growth, with the State Credit Commission setting the maximum interest rates of bank deposit and loans and keeping the rates at a low level; Japan in 1947 imposed regulation on deposit rates, short-term lending rates, long-term loan preferential interest rates, and bond issuance interest rates. However, many western countries experienced stagflation in the 1970s, and Keynesianism began to be challenged. Liberal thinking represented by neoclassical economics became popular, and some major nations started to relax control on the economy with liberalizing interest rates as the main focus.

From the perspective of financial theory, the term financial deepening, coined by Ronald McKinnon and Edward Shaw, laid the foundation for interest rate liberalization. McKinnon and Shaw felt that interest rate and credit regulation were restraining financial development in developing countries. The low interest rate was leading to low savings, and the government was forced to conduct credit allocation due to strong investment demand. This reduced accumulation of capital led to misal-location of financial resources and affected the channeling of savings to investment, hindered economic growth, and eventually resulted in a vicious cycle of financial repression and economic distress. In developing countries, money and physical capital are to a large extent complementary rather than substitutional as suggested by traditional theory, and the real interest rate is to a degree in positive correlation with savings and investment. Therefore, developing countries should reduce intervention in the financial system and remove regulation of the interest rate to let it reflect the real supply and demand of capital in the market, increase the interest rate to an equilibrium level, and allow the financial system to be the intermediator, thus achieving a virtuous cycle between the financial system and economic development. The theory of financial deepening caught widespread attention in academic and policy circles; empirical research on developing countries had confirmed its conclusions. The policy recommendation was adopted by most developing nations.

However, financial liberalization with interest rate reform as the prime focus has caused some countries severe economic and financial problems. The theory of financial restraint brought forward by Thomas Hellmann, Kevin Murdock, and Joseph Stiglitz (1997) argues about issues such as moral hazard and adverse selection in the context of information asymmetry. According to them, laissez-faire financial policies often lead to market failure or economic crisis if there’s not enough prudential regulation. Therefore, for developing countries with weak market infrastructure, financial repression, a monopolistic financial institutional arrangement set by the government, works better than financial liberalization and a competitive institutional arrangement in terms of financial deepening and economic growth. By implementing financial repression policies, the government can, on the one hand, maintain a positive but lower than equilibrium deposit rate and reduce the financing cost for banks; on the other hand, the government can put a cap on the lending rate to minimize default risks for borrowers and financing costs for companies and help boost economic growth.

Though Hellmann, Murdock, and Stiglitz (1997) believe that financial restraint is good for developing countries, they do not reject the possibility of liberalization. They further point out that financial restraint is not a static financial instrument. Rather, it should be adjusted as the economy matures. So, the policy options provided by this theory are not a static comparison between laissez-faire and financial restraint, but a dynamic process following financial market development. The arguments set forth in this paper are not designed to claim that there exists a single optimal level of financial restraint that should be implemented by all governments identically, regardless of the state of financial development. Rather, financial restraint should be a dynamic policy regime, adjusting as the economy develops, and moving in the general direction of freer and more competitive financial markets. The policy trade-off is not a static one between laissez-faire and government intervention; the relevant question is over the proper order of financial market development.

The comparison of the two theories shows that financial deepening theory points out the necessity of financial liberalization but fails to take into account the conditions of developing countries and the risks involved in the process, whereas financial restraint provides a thorough analysis of the conditions and approaches for liberalization and is more in line with the reality of developing nations. In fact, Ronald McKinnon (1991) also proposed the sequence of financial liberalization for developing countries in his book The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy.

For reasons such as financial information asymmetry and the particularity of financial conduct, it’s debatable if complete financial liberalization is even good for developed countries. Some economists have reflected on the direction of interest rate reform after the recent financial crisis; Professor Amar Bhide, among others, pointed out that it’s necessary to put a cap on demand deposit interest rates to reduce excess competition among financial institutions and ensure financial stability. And Stiglitz argued that a well-functioning market economy is in itself neither stable nor effective. He further said that the only time in modern capitalism that did not see reoccurring financial crises was the short period when strong financial regulation was exercised after the Great Depression, and it was also a period when the fruit of economic growth was widely shared. Of course, there are those who argue against Stiglitz.

In short, the various theories on interest rate liberalization reflect different views on the role of market and government in financial resource allocation. The relation between the government and the market is an abiding theme in economic and financial research. With the development of the economy and financial sector, people’s understanding is also evolving and deepening, and the views of experts vary. But one thing is certain: The allocation of resources should not be completely handed over to the market, nor be completely dependent on the government, and the boundary between the market and the government often relies on a lot of factors. Relaxing interest rate controls is inevitable, but there’s no absolute truth as to how to do it and how much liberalization should be allowed.

B International experience: radical or incremental

Countries all over the world usually choose one of two paths for interest rate liberalization: Complete liberalization carried out over a short period or incremental reform.

a Deregulate interest rates entirely over a short time

Of all the developing countries, Latin American nations are the best examples of this model of liberalization. Argentina in 1975 totally deregulated all interest rates except for the upper limit for the deposit rate and lifted the cap on the deposit rate in June 1977. Chile started to liberalize interest rates in May 1974 and lifted restrictions on deposit rates by November the same year, and all regulations by April the next year. However, since these nations had less developed financial systems, poor corporate governance, and insufficient supervision, this led to moral hazard in the banking sector. The nominal interest rate and inflation rose, real interest rate began experiencing volatility, and bad loans increased. The governments were forced to intervene. Argentina set the upper limit back for the deposit rate and Chile halted liberalization by releasing guiding rates.

The former Soviet Union and Eastern European countries adopted the same model under the shock therapy prescribed by the west. Russia initiated reform on interest rates in 1993 and finished it in 1995. The process improved the interest rate transmission mechanism, but it was so radical that the other aspects of the system couldn’t keep up. The stability of the financial system was adversely affected.

Developed countries such as the UK, Germany, and other European nations also deregulated their interest rates over a short time. The Federal Republic of Germany removed restrictions on interest rates of fixed deposits longer than two and a half years in March 1965, and restrictions on interest rates of large deposits of more than one million Deutsche Marks and longer than three and a half months in July 1966. The government rolled out a liberalization plan in February 1967 and completely let go of control of interest rates in April the same year. But the government kept its guidance on the deposit and lending rates of financial institutions until October 1973.

The Bank of England abolished the regulation on interbank deposit and lending rates in one go in September 1971, allowing financial institutions to decide their own interest rates. But due to the pressure of high inflation, economic recession, and a weak currency, the central bank forbade banks to pay an interest rate above 9.5 percent on deposits of less than 10,000 pounds in September 1973, which lasted until February 1975. To control short-term interest rates, it announced the lowest loans rate every week. The UK did not achieve full liberalization of interest rates until August 1981.

b Incremental liberalization

Among developed economies, the US, Japan, France, and Australia adopted the model of incremental liberalization. The US liberalized interest rates on long-term, large-amount loans and deposits, and then moved to liberalize rates for short-term, small-amount loans and deposits. Since 1970, the US has gradually relaxed regulations on large-denomination negotiable certificates of deposit and fixed deposits. The Depository Institutions Liberalization and Monetary Control Act in 1980 marked the official beginning of interest rate liberalization, and by 1986 the US had basically achieved full liberalization.

Japan’s reform followed the sequence of “Treasury bonds first and other categories later, interbank business first and bank customers later, long-term large deposits first and short-term small deposits later”. Japan liberalized the issuing rate and trading rate of government bonds from 1975 to 1978. The central bank allowed some flexibility to the interbank offered rate in April 1978 and liberalized the interbank note rate that June. Meanwhile, it lowered the threshold for fixed deposit interest control and increased the variety and term structure of liberalized fixed deposits. By April 1991, Japan had basically liberalized fixed deposit rates and by October 1994 demand deposit rates. The liberalization of lending rates went hand in hand with deposit rates.

France lifted the cap on the rates of fixed deposit longer than six years in April 1965 and deregulated rates on deposits over 250,000 francs and with a two-year term in July 1976. The French central bank revised its regulation on deposit rates three times, in 1969, 1976, and 1979, and by then all deposit rates had been deregulated except for fixed deposits of less than six months and of less than one year but not over 500,000 francs. According to the 1984 Banking Act, demand deposits were not interest-bearing, and banks were allowed to issue certificates of deposit with independent pricing.

Australia was more cautious about the liberalization of interest rates, but the reformer...