Interest Rate Liberalization and the International Role of the RMB. Nicholas Lardy. Senior Fellow Peterson Institute for International Economics
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1 Interest Rate Liberalization and the International Role of the RMB Nicholas Lardy Senior Fellow Peterson Institute for International Economics April 2012 Summary: Since the beginning of 2003 China s financial system has become significantly repressed, as reflected in a real one year deposit rate averaging -0.5 percent as compared with 3.0 percent in Unwinding financial repression by gradually liberalizing deposit rates is essential if China is to be successful in internationalizing the role of the renminbi and moving toward significant further capital account liberalization. First, interest rate controls create a cossetted environment for banks, undermining the incentive to develop the risk assessment skills that are essential for the development of a fully commercialized banking system. Interest rate controls are also detrimental to broader financial market development. Finally, it will be difficult to ease restrictions on international flows of portfolio capital if interest rates in China are not largely market determined. Broadly speaking there are three key conditions that China must fulfill to move successfully toward significant further capital account liberalization, a key goal of the campaign to internationalize the role of the renminbi: a strong domestic banking system, relatively developed domestic financial markets, and a mechanism for sustaining an exchange rate close to equilibrium (Lardy and Douglass 2011; Prasad and Ye, 2012). This paper explores how interest rate liberalization is an important prerequisite for achieving these key conditions. Figure 1 suggests that China s interest rate policy changed fundamentally after From 1997 through 2003 the real return on a one-year bank deposit was persistently positive and averaged 3.0 percent. Since the beginning of 2004 the real return on a one-year deposit has been in negative territory about half the time and has averaged -0.5 percent. Since the central bank sets nominal benchmark deposit rates and thus can achieve any desired real deposit rate, the obvious question is what caused such a dramatic change in the government s interest rate policy starting in 2004? 1
2 A key thesis of Sustaining Economic Growth in China after the Global Financial Crisis (Lardy 2012) is that the change in China s interest rate policy can be attributed to the emergence of a large external surplus position starting in 2003 and the government s policy of maintaining a fixed nominal exchange rate vis a vis the US dollar. To maintain this currency peg the People s Bank of China intervened massively in the foreign exchange market starting in 2003, when official reserves rose by $117 billion, a sharp jump compared to an annual average increase of only $30.2 billion in Even after the government depegged the renminbi from the dollar in mid-2005 and allowed the currency to appreciate gradually, China s current account continued to grow and the central bank continued large scale intervention in the foreign exchange market to moderate the pace of renminbi appreciation. Thus additions to official foreign exchange reserves averaged of almost 10 percent of GDP per year culminating with official reserves by year-end 2011 that reached the unprecedented level of $3.2 trillion. To maintain price stability the central bank engaged in increasingly large sterilization operations, carried out by raising the required reserve ratio and, beginning in 2003, by the issuance of central bank bills. The central bank by 2011 had raised the required reserve ratio to 21.5 percent (19.5 percent for small and medium size banks) and the volume of central bank bills peaked at about RMB5 trillion in The magnitude of what might be conceptualized as sterilization liabilities, the sum of bank deposits placed at the central bank and central bank bills held by banks, is shown in figure 2. These liabilities averaged 17.5 percent of GDP in but soared to an average of 38.4 percent of GDP in and stood at 40.7 percent at the end of The large balance of payments surplus in 2003 was due primarily to a large surplus on the capital and financial account rather than the current account. But in subsequent years China s large surplus was overwhelmingly due to the current account rather than the capital account. For example, from 2005 through 2009 the current account contributed three-quarters of the overall balance of payments surplus. State Administration of Foreign Exchange International Balance of Payments Small Group, Report on China s 2011 International Balance of Payments (March 31, 2012). Available at (accessed on April 4, 2012). 2
3 It appears that the central bank adopted a low interest rate policy in 2004 to reduce the cost of financing its sterilization liabilities. Even with the benefit of the low interest rate policy the costs of sterilization rose dramatically over time from an estimated RMB40 billion in 2004 to RMB231 billion in 2010 (Xu Yisheng 2011). Even with financial repression holding down interest rates, on one estimate the central bank actually was losing money on its foreign exchange operations in If market forces played a greater role in the determination of interest rates the costs of sterilization and thus central bank losses would have been substantially higher. The central bank s policy of using financial repression to hold down the costs of sterilization had several elements. First, by several measures the interest rate the central bank pays on three-month and one-year central bank bills is extremely low. These rates have consistently been below the three-month and one-year Shanghai Interbank Offered Rate (SHIBOR), the most market-driven interest rates in China (Ming Zhang 2012). The difference between the bill rates and the SHIBOR rates represents an opportunity cost incurred when banks are required to purchase central bank bills. On several occasions the gap between the two rates has been so large that auctions of central bank bills have failed to attract bidders, leading to the placement of these bills via direct administrative pressure. Another measure of the low interest rate banks earn on central bank bills is reflected in the gap between rate the central bank paid on one-year central bank bills and the central bank s benchmark one-year lending rate. This differential was even larger than the gap with one-year SHIBOR. As shown in figure 3, from mid-year 2008 through the end of 2011 this difference has ranged between 3 and 4 2 Joseph Gagnon, Nicholas R. Lardy, and Nicholas Borst, The Internal Cost of China s Currency Policy, China Economic Watch, September 30, Available at They estimated that the total losses on the People s Bank of China foreign exchange operations in 2011 was $240 billion of which $66 billion is the excess of interest paid on sterilization liabilities over earnings on foreign exchange reserves and $172 billion was expected capital losses due to the appreciation of the renminbi. 3
4 percentage points. Comparing the one-year bill rate with the actual weighted average lending rate across all loan tenors further increases the gap beginning in A second element of the central bank s low interest rate policy after 2003 is the extremely low interest rate the central bank pays on required reserves. From 1997 through 2003 banks earned a rate of interest on required reserves that was well above the rate of inflation, whereas beginning in 2004 the pace of inflation has outstripped the rate paid on reserves in most years and the average real return has been well into negative territory. The gap between the rate the central bank pays on required reserves and the central bank s benchmark one-year lending rate is also large, much larger than the gap between the rate on one-year central bank bills and the one-year benchmark lending rate. Requiring banks to place a large share of their deposits at the central bank and to purchase large quantities of central bank bills, both of which have returns far below alternatives available to banks, constitutes a high implicit tax on banks. By the end of 2011 almost one-fifth of all bank assets were lowyielding central bank sterilization liabilities. 3 Nonetheless, China s banks have been quite profitable. Despite the slowing of China s GDP growth last year, net profits of China s banks soared by 36 percent to exceed RMB1 trillion. Bank profitability as measured by return on assets was 1.3 percent in Q4 last year, far and away the highest of any national banking system. These high profits are largely the direct result of financial repression, as reflected in the negative deposit rates received by savers in China s banking system. The government has set a ceiling on deposit rates and a floor on lending rates that assures very high margins on banks normal lending and deposit taking activities. Yang Kaisheng s recent assertion that the interest rate spread for Chinese banks is actually low compared to banks in economies with market determined interest rates is fundamentally 3 Sterilization liabilities were RMB19.2 trillion while assets were RMB113.8 trillion. 4
5 misleading. 4 The overall spreads of Chinese banks may be slightly below spreads in market economies, but the spread banks earn is an average of the extremely low spreads the banks earn on central bank sterilization assets and much higher spreads they earn on their loan and deposit taking activity. For example, in 2010 the Industrial and Commercial Bank of China reported a net interest spread of 2.35 percentage points. But the bank earned an average yield of 4.99 percent on its loans to customers while paying an average interest rate on customer deposits of only 1.35 percent, making the net interest rate spread 3.64 percentage points or 129 basis points above its average spread. But the bank earned only 1.56 percent on its deposits with the central bank, while the cost of these funds, which came from deposits from customers, also was 1.35 percent. Thus the spread on deposits placed at the central bank was only 21 basis points or 214 basis points below its average spread. 5 Thus the third element of the central bank s low interest rate policy was to set the ceiling on rates banks could pay on deposits and the floor that they could charge on loans in a manner that guaranteed that the banks earned very high profits. In effect the three elements of central bank interest rate policy shifted the cost of sterilization away from the central bank, onto the commercial banks, and then ultimately largely to the household sector. Unwinding financial repression is essential if China is to be successful in internationalizing the role of the renminbi and moving toward significant further capital account liberalization. First, interest rate controls create a cossetted environment for banks, undermining the incentive to develop the risk assessment skills that are essential for the development of a fully commercialized banking system. Interest rate controls are also detrimental to broader financial market development, another important condition for the internationalization of the renminbi (Prasad and Ye 2012, 19). Finally, it will be difficult to ease controls on flows of portfolio capital if interest rates in China are not largely market determined. Market-oriented interest rate reform was a key plank in the 11 th Five-Year Plan ( ) and Premier Wen Jiabao in his speech to the National People s Congress in 2009 called for the implementation of market-oriented interest rate reform. 6 But a combination of opposition from vested interests and technical challenges has stalled this reform initiative. Unless this situation changes significant further capital account liberalization will be difficult. 4 Kelvin Soh and Koh Gui Qing, Under fire, Chinese banks back status quo on rates, Reuters, March 14, Available at (accessed April 4, 2012). 5 Industrial and Commercial Bank of China, 2010 Annual Report, pp Wen Jiabao, Report on Work of the Government (March 5). Available at 5
6 References Lardy, Nicholas R Sustaining Economic Growth in China after the Global Financial Crisis. Washington: Peterson Institute for International Economics. Lardy, Nicholas R. and Patrick Douglass Capital Account Liberalization and the Role of the RMB. Working Paper 11-6 (February). Washington: Peterson Institute for International Economics. Ming Zhang Chinese Stylized Sterilization: The Cost-sharing Mechanism and Financial Repression, China & World Economy 20, No. 2:1-17. Prasad, Eswar and Lei (Sandy) Ye The Renminbi s Role in the Global Monetary System. Washington: The Brookings Institution. Xu Yisheng The cost over 1 trillion RMB The mechanism, cost and prospect of PBC s sterilization, Guoji jingji pinglun, No. 4:
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