Interest Rate Liberalization: the Soul of Financial Reform

Transcription

1 Interest Rate Liberalization: the Soul of Financial Reform Introduction Interest rate is the most important price in the financial market, with its liberalization being one of the most debated topics among economists. This article aims to provide an in-depth and updated analysis into the interest rate liberalization in China with a focus on its significance to financial reform, key element for its success and implications for commercial banks. Interest Rate Liberalization Progress China has already made substantial progress in liberalizing interest rates. In 1996, China abolished the upper limit on interbank lending rates. In 1997, China liberalized repo rates. From 1998 to 2004, China gradually increased the upper limit on lending rates. In 2000, China liberalized foreign currency lending rates and deposit rates for deposits over $3 million. In 2006, China launched the Shanghai Interbank Offered Rate (Shibor) with an intention to develop it as the benchmark rate. In 2012, restrictions on the ceiling and floor for deposit and lending rates started to be eased. The lending rate floor for banks was removed in July 2013, which allowed banks to lend at whatever rate they like. In December 2013, China launched the Interbank Negotiable Certificates of Deposits (IBNCD) in the money market, which is expected to inspire breakthroughs in the interest rate reform. The trial is part of China's loosening of controls on deposit rates following its move in July to remove the floor limit of lending rates [1]. After years of reform, however, there still remains ceiling on deposit rates. The deposit rate ceiling, in particular, appears to bind, as deposit rates have remained clustered at their benchmark, and real deposit rates have on average been zero. Hence, there remains one last step towards the liberalization of interest rates the removal of ceiling on deposit [1] PBOC: 1

2 rates. Before we proceed, it is important to understand why interest rate liberalization is so vital to China's financial reforms. Inevitable Move towards Interest Rate Reform First, it will facilitate the competition and hence the development of other funding channels including bond and stock markets. For years, China has adopted a policy of "financial repression". Since loan interest rates were artificially depressed, bank credit accounted for the major source of funding. As of May 2013, the size of the non-bank financial markets is equivalent to the balance of commercial bank credit [2]. Social Funding by Category as of May % 19% 6% 6% 50% Loans issued by banks Insurance industry assets Bond market Stock market Trust products With interest rate liberalization, bank loans are expected to compete more fairly with other financing channels such as bond and stock markets. The competition will facilitate the development of non-bank financial markets with more enterprises raising funds by issuing corporate bond or common stock. Second, interest rate liberalization will help to reduce the imbalance in the allocation of credit and thereby strengthen banks support for small and medium-sized enterprises (SMEs). The control of deposit and loan rates in the past, though effectively protecting commercial banks, should be blamed for the structural imbalance of bank credit assets. When the supply of social funds falls short of the demand, a polarization also takes place in the allocation of commercial bank credit. When supply of funds falls short, financial institutions tend to lend money to three groups credible large state-owned enterprises [2] Jia Kang, Meng Yan. Interest Rate Liberalization, a Reform Much Needed [N]. China Daily, Bank markets Non-bank financial markets

3 (SOEs), local governments and well-known private enterprises. On the other hand, cashstrapped SMEs have found it very difficult to obtain bank credit, because they are usually restricted by their risky characteristics such as a smaller percentage of tangible assets as of total asset, and comparatively unstable cash flow, etc. As a result, they have to rely on shadow lending at a higher cost. Shadow lending refers to a wide range of credit arrangement other than normal bank loans, including loans by trust companies, discounting of commercial bills. However, the liberalizing of interest rates will alleviate such financing problems for SMEs by forcing commercial banks to change their business model, as we will discuss later in the passage. Commercials banks can no longer rely on a stable spread of interest rates but rather need to diversify both their services and client base. The competition will force them to allocate more funds to SMEs as they seek to differentiate themselves from other banks. The increase in supply will contribute to friendlier loan terms for SMEs. Third, interest rate liberalization is the pre-requisite and necessary condition for RMB internationalization. The current progress in RMB internationalization initiates a broad reform towards opening-up of domestic financial system and capital account, leading to side-by-side development in both onshore and offshore markets, and rising role of RMB in the world economy. But there are some note-worthy facts regarding China s RMB internationalization path. Traditionally, in a developing economy with heavily regulated domestic interest rates, capital controls and a non-convertible currency, a normal sequence of financial liberalization would be to deregulate domestic interest rates first, liberalize the capital account next and finally push ahead the international use of one s currency for trade invoicing and debt issuance. But China uniquely reversed this conventional order by launching an ambitious currency-internationalization program in 2009 despite maintaining draconian capital controls and heavily regulated domestic interest rates. The unique decision can plausibly be read as back-door effort to accelerate domestic financial reform. With the creation of a market-driven RMB interest rate offshore, opportunities 3

4 would arise for arbitrageurs to profit from the difference between market-driven offshore rates and administered onshore rates. The only way to eliminate this arbitrage gap would be to dismantle capital controls, thereby forcing convergence of the offshore and onshore rates. Better yet, the interest-rate gap could be largely eliminated by domestic interest rate liberalization before capital controls were removed. In this regard, the premature internationalization of the RMB, although highly unorthodox, serves as a driver to accelerate financial reforms by forcing the liberalizing of domestic interest rates [3]. Preparations Needed Before the Last Move Before fully liberalizing interest rate, key preparation must be in place, which includes deposit insurance system to protect savers and bankruptcy rules for financial institutions so that they can compete more efficiently as financial reforms are set to break the highconcentration of the banking sector. The last element is a market-based benchmark rate and a well-developed money market. Deposit insurance system is a market-oriented system aiming at effectively reducing systematic financial risk. With hindsight from the 2008 financial crisis, deposit insurance system could quickly help government deal with banking crisis. Since 2007, Federal Deposit Insurance Corporation (FDIC) has handled 487 bankrupted banks without a run on the bank and therefore stabilized public s confidence in the banking system. The important role of deposit insurance system is widely recognized around the world since then. So far 112 countries / regions have already established their deposit insurance systems [4]. Such a system is especially important because mainland banks would face greater risk as interest rate liberalization will intensify competition and bad loans are expected to rise amid a slowdown in growth. The second element needed is the bankruptcy laws for financial institutions, with the China Banking Regulatory Commission stepping up efforts for its introduction. As mentioned earlier, interest rates liberalization will bring about structural changes in the banking sector as banks can no longer rely on the stable spread between deposit and loan [3] Arthur Kroeber. A Chinese Trilemma: Renminbi Internationalization, Capital Account Opening, and Domestic Financial Liberalization [Z]. Harvard PIFS China-US Symposia, [4] 张维, 谷政. 加快推进利率市场化 : 主要障碍与政策建议 [J]. 南京审计学院学报,2014,01. 4

5 rates. The intensified competition would therefore motivate more banks to invest in more risky assets. In this regard, bankruptcy laws and rules for financial institutions will push banks to improve their risk assessment and management abilities. In order to build such an exit mechanism for financial institutions, regulators need to start with the current Enterprise Bankruptcy Law, Law of the PRC on Commercial Banks and Insurance Law, with more detailed rules specified for financial institutions on their bankruptcy arrangements. Effective bankruptcy law for financial institutions will facilitate interest rates liberalization by providing an exit mechanism for inefficient banks that failed in intensified competition without spreading runs on the banks. The last element key to the success of interest rate liberalization is a market-based benchmark interest rate Shibor. Shibor is a composite interbank interest rate based on quotations from 18 major banks in China. It is aimed to provide a reference for other interest rates by reflecting the rate at which banks could obtain funds from each other. However, Shibor s status as benchmark interest rate is not well-supported for some reasons. First, partly due to a lack of financial instruments and transactions using the rate especially its longer tenors as a pricing reference, its movement had been limited, failing to reflect actual supply and demand in the market. Second, the usage of Shibor in the balance sheets of commercial banks is very limited. In order to improve Shibor s role as a credible pricing benchmark, the priority is to develop more alternative financial products which are priced based on Shibor. Although Shibor is a quote-driven interest rate without necessary requirement for actual transactions, it cannot function well as the market-based benchmark rate without the support of actual transactions, which is exactly the question facing longer-tenor Shibors. With more Shibor-based financial products such as CDs, interbank deposits, and wealth management products, Shibor will be more accurate to reflect supply and demand and more influential in its role as the benchmark rate. The PBOC announced that effective from December 9, depository financial institutions are allowed to issue large-denomination negotiable certificates of deposit (interbank CDs). 5

6 This will strengthen the role of market-based benchmarks as interbank traders embark on the price discovery process for these new products. As mentioned earlier, one drawback of Shibor is its limited influence over long-end pricing of the yield curve. The development of interbank CDs, in particular those of longer maturities, could therefore further strengthen Shibor s role as the benchmark for the whole interest rate system. Second, regulators should reduce the influence on Shibor from non-market factors, which include external and internal deposit-to-loan ratio assessment. Shibor is also subject to the influence of holidays, and therefore tends to be more volatile around quarter / month ends and important public holidays. Regulators should also ensure the quality of the quotes provided and strictly monitor potential manipulating activities. Implications for Commercial Banks Interest rates liberalization will bring about significant impact on commercial banks, with the biggest impact to be felt by small and medium-sized banks as opposed to their bigger rivals. Commercial banks are forced to shift business strategy and manage balance sheets actively. Traditionally, interest rates spread accounted for more than 80% of total revenues for commercial banks as they can lock an interest rate spread of 3% on average [5]. However, the freedom to set interest rates on deposit and loans is expected to hit banks net interest margin, as we could see from the chart below [6]. % Interest Margin by Banks (09-15E) E 2014E 2015E State-owned Joint-stock City commercial [5] 闾娇蓉. 浅析中国商业银行应对利率市场化改革的策略 [J]. 经济研究导刊,2013,01: [6] 中金公司. 银行 2014 年投资策略 : 黎明前的黑暗 [Z]. 证券研究报告, :

7 To compensates, banks have to adjust their portfolio by lending to risker borrowers such as SMEs. As we could see from the chart below, SMEs in China still have the potential for further leverage compared with developed economies such as Canada and US [7]. As mentioned earlier, SMEs need to pay higher loan rates to compensate lenders for the risk borne. The higher loan rates satisfy banks need to improve profitability to compensate for the narrowing interest margin due to interest rate liberalization. Therefore banks will no longer concentrate on large corporations solely they will cater to the needs of SMEs in the future. This shift in asset allocation therefore calls for better risk management, as SMEs are more sensitive to systematic risk in an economic downturn. Meanwhile, banks also need to develop fee-based business, particularly in wealth and cash management as they see a declining trend in interest income. Given that fee income for Chinese banks is relatively low, any impacts on interest income will have massive effects on their bottom line. This will be particularly severe for the city commercial banks, which rely almost entirely on interest income and have little in the way of earnings diversification. A comparison of fee ratio for different types of banks is provided in the chart below [8]. [7] 中金公司. 银行 2014 年投资策略 : 黎明前的黑暗 [Z]. 证券研究报告, : [8] ChinaScope Financial. China s Interest Rate Liberalization: Impact on Banking Sector [Z]. Daily China News Updates,

8 Fee Ratio Fee-based businesses do not take up balance sheets hence are not subject to interest rate risks. They include payment settlement, bank cards, agency services, consulting and advisory, etc. Among them, high-end services / products such as financial leasing, wealth management and private banking allow banks more pricing flexibility. Meanwhile, Internet Finance is gradually grabbing market shares away from commercial banks with various innovative services, products and channels. In order to stay competitive, banks need to transform their business model from the traditional balance sheet-focused model that relies on deposits and loans to the new asset management-based model, as illustrated below [9]. Commercial Banks Liability Asset Deposit Fund Raising Loan Asset Allocation Creation Transfer In this regard, on the liability side, banks should seek for more diversified capital raising channels which include deposits, wealth management funds, interbank deposits and bond issuance with an intention to increase and utilize user stickiness. On the asset side, asset allocation requires innovative creation of new assets to match the structure of liabilities and to drive profitability. Therefore, future growth will rely more on professional services instead of a large size. However, small and medium-sized banks would in this sense be [9] 招商证券. 从资产负债表冲击看银行转型与重估 [Z]. 证券研究报告, :

9 more vulnerable because of their less developed networks and branding, which might make it harder to expand into new business lines. Conclusion Interest rate liberalization will facilitate the development of bond and stock market by creating a fully competitive environment for various fund raising channels, and it will alleviate financing problems of SMEs by forcing banks to change their business model in the dynamic competitive arena. Meanwhile, interest rate liberalization is the necessary condition of RMB internationalization, which has already made momentous progress so far. Therefore it s the soul of financial reform and ultimately an inevitable move. However, before the last step to remove the ceiling on deposit rates, three elements are needed. First, deposit insurance system is necessary to prevent runs on banks when they failed to survive in the fierce competition. Second, bankruptcy laws for financial institutions must be enacted to create an exit mechanism for failed banks. Last but not least, Shibor s status as the market-based benchmark rate should be strengthened for it to function well as the reference rate for other interest rates. All these priorities are already on the agenda of the central government and central bank. Finally, interest rate liberalization has far-reaching impact and implication on various sectors. Among them, commercial banks are the first to be impacted by the liberalizing of interest rates, with smaller banks particularly vulnerable due to their over-reliance on interest income. Commercial banks are pushed to restructure and rethink their business model to stay competitive in the arena. Effective strategies include adjusting their portfolios by lending to risker borrowers such as SMEs to seek for higher returns, designing and developing innovative fee-based businesses in the form of wealth management products, advisory services, etc. They should transform the way they operate from balance sheet-focused to asset management-based, the key to which lies in professional services, higher quality and innovation. 9

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