China has historically maintained a low interest rate policy so that consumers received a negative return on their savings. Many have argued that such a policy, often referred to as financial repression, is the crux of China’s various economic ills, from misallocating capital to sustaining large trade surpluses. The antidote, policymakers inside and outside China have argued, is to liberalize interest rates so that Chinese savers will enjoy reasonable returns on their savings.
These arguments have gained traction with decision makers in Beijing, and nearly five year ago, China embarked on a process of interest-rate reforms. Today, on paper at least, restrictions have been fully lifted on how much banks can charge for a loan or pay on deposits—effectively liberalizing interest rates.
But some cautionary notes are in order. For one, deposits protected by insurance are effectively risk-free, and that risk-free rate is always controlled by central banks, at least in the short run. Since banks generally can issue senior bonds at close to the risk-free rate, they will not pay savers an interest rate that is higher than the interest on the bond. As such, there remains a de facto ceiling on how much banks are willing to pay on deposits, even when interest rates are technically liberalized.
A real-world example is the low interest paid to American depositors in recent years. Despite the fact that the United States has had fully market-based interest rates for more than three decades, American savers have nonetheless earned negative real returns on their savings for almost a decade.
Figure 1. Deposit Rate and Inflation in the United States
Sources: Federal Deposit Insurance Corporation, U.S. Bureau of Labor Statistics
This applies equally in China—banks will not pay savers interest that is higher than the prevailing risk-free rate. In other words, despite liberalizing interest rates, the People’s Bank of China (PBOC), the Chinese central bank, still has considerable influence over deposit rates and can set it at whatever level it likes.
However, what is different in China is that PBOC controls multiple benchmark interests. Since the completion of interest rate reform, the PBOC has continued to publish benchmark deposit and loan rates while also fine-tuning the economy through adjusting the liquidity condition in the inter-bank market. And these benchmark interest rates do not move in tandem. The one-year deposit rate has been significantly lower than the one year borrowing cost in the inter-bank market, and this gap has widened lately. Since late 2016, in an effort to discipline banks from taking excessive risks, the PBOC has gradually raised the borrowing cost in the inter-bank market. Yet no change has been made regarding deposit rate.
In addition, the PBOC asks Chinese banks to form “self-discipline” committees to stop them from competing with each other in an effort to attract deposits by offering higher interest rates. In most cases, banks are not allowed to offer a deposit rate that is 40% higher than the benchmark. Thus, the maximum deposit rate a Chinese bank can offer is still significantly lower than the one-year Shanghai Interbank Offered Rate (Shibor).
Figure 2. One Year Shibor and One Year Deposit Rate
Source: PBOC and Shibor.
The existence of two benchmark interest rates has many consequences. The most notable and certain are (1) that saving behavior has moved to money market funds and (2) that this has provided big banks an edge over smaller banks.
Wealth management products (WMP), which are China’s most common type of money market fund, can lend to a bank at the wholesale funding rate and invest in other risky (and high return) financial products. So, WMP offers Chinese savers a much higher rate than bank deposits. The relative unattractiveness of bank deposits diverts savings away from banks to WMPs. As figure 3 shows, the share of personal deposits in bank liabilities has been declining in China over the past decade.
Although both deposits and WMPs are runnable—in other words, people can easily withdraw these funds once they perceive the bank to be unsound—WMPs are usually short term and even more unstable as a source of funding than are deposits. Therefore, the movement of savings from deposit accounts to WMPs has very likely made the Chinese banking system more fragile.
Figure 3. The Declining Share of Personal Deposits in Bank Liabilities
Although deposits have been diverted away by WMPs, larger Chinese banks fare better than smaller ones. As a result of the abovementioned “self-discipline” mechanism, the deposit interest rate offered by smaller banks in China is not significantly higher than the rate offered by big banks. The average interest on deposit offered by the Bank of Beijing and the Industrial and Commercial Bank of China (ICBC) are almost the same, despite the fact that the latter is more than 10 times as big. And at both banks, deposits are the cheapest form of liabilities, compared to borrowing from other financial institutions or bonds. Still, deposits comprise more than 80% of ICBC’s liabilities, while the Bank of Beijing only has deposit equivalent to about 60% of its liabilities and needs to finance the rest with more expansive means of debt instruments.
Previously, many analysts expected that interest rate liberalization in China would help smaller banks to attract funding and better compete with large banks. But so far, this seems not to have happened, in large part due to the fact that smaller banks are not allowed to really compete for deposits.
Neither has interest rate liberalization slowed down the growth of WMPs, as was the experience of United States. On the contrary, WMPs in China have enjoyed above 20% growth in the past two years as they continue to offer significantly higher return than deposit.
Since deposit interest rate liberalization commenced less than two years ago, it was to be expected that the PBOC would continue fine-tuning the way it uses its monetary policy toolkits, in particular how it adjusts Shibor and the deposit rate. But eventually, the PBOC will likely only keep one of these as its monetary policy tool and leave the other to the marketplace.