Monetary Policy and Interest Rate Reform

Thomas Shik Senior Economist thomasshik@hangseng.com Monetary Policy and Interest Rate Reform The benchmark lending rate set by the People s Bank of China (PBOC) has remained the key reference for banks in determining their own lending rates. But with the Mainland continuing to open up its financial markets, competition is likely to become more intense and banks are likely to see their net interest margin fall. In loosening its grip on interest rates, the PBOC may have to shift to a new target rate to achieve its policy objectives. The implementation of interest rate liberalisation is not only crucial to the banking sector but also to the Mainland s plan for reforming its financial markets. April/May 2015

Is the lending benchmark important? On May 10 this year, the People s Bank of China (PBOC) lowered its benchmark interest rates by 25 basis points and granted commercial banks greater freedom to set their own deposit rates. In reflecting on this development, a number of financial market observers focused more on whether the PBOC s easing which came on the heels of a cut in the required reserve ratio (RRR) and an interest rate reduction in February could counter the Mainland s economic slowdown and less on the central bank s latest efforts to liberalise the economy s tightly controlled commercial bank interest rates. Following this move, the official one-year deposit and lending rates stand at 2.25% and 5.10% respectively. In addition, banks can set their deposit rates up to 50% above the benchmark rate of 2.25%, compared with the previous ceiling of 30%. This means that, although the PBOC cut the deposit benchmark by 25 basis points, the effective ceiling on the deposit rate was actually 12.5 basis points higher (Exhibit 1). Exhibit 1: PBOC February 2015 Rate Cut Before May cut After May cut Deposit rate: 1-year benchmark 2.50% 2.25% Rate cap 30% above benchmark 50% above benchmark Effective 1-year benchmark 3.25% 3.375% Lending rate: 1-year benchmark 5.35% 5.10% Source: PBOC, Hang Seng Bank According to some observers, the PBOC s interest rate reduction is unlikely to result in dramatic change as the 1) effective deposit rate ceiling has been higher and 2) banks were already free to set their own lending rates before this latest development. From this point of view, competition should push banks to lower lending rates, which will in turn put downward pressure on their net interest margin. Therefore, what is important is the effective deposit rate ceiling, as it represents the lowest possible cost of borrowing. April/May 2015 2

The reality, however, is more complex. The PBOC s lending benchmark has remained the primary reference indicator for banks in setting their own rates. According to the PBOC, the proportion of renminbi (RMB) loans that commercial banks offered at a rate below the benchmark was just 11.3% in March 2015. Of even greater note, the majority of loans were actually priced at a rate above the benchmark a trend which has been on an upward trajectory in recent years (Exhibit 2). Exhibit 2: RMB Loans (by lending rates, % share) In our view, there are several reasons behind this phenomenon. First, competition among banks is rising, but not as fast as many may think. The Mainland s four largest banks still own about 42% of the country s deposits and make about 39% of loans, although these figures are down from about 50% and 43% respectively in early 2010 (Exhibit 3). This high concentration has prevented a rapid drop in bank lending rates. Second, the Mainland economy is slowing and the housing market is facing a correction. With gross domestic product (GDP) growth falling to a six-year low of 7% in the first quarter of 2015 and housing inventory remaining elevated, it is not surprising that banks are becoming more prudent regarding lending especially to property projects and are asking for a higher premium over the lending benchmark which has been cut twice by the PBOC since the start of the year (Exhibit 4). Third, the 2007-2008 global financial crisis has led to a tightening up of banking regulations around the world. This may also have contributed to a rise in the cost of funding for banks on the Mainland. April/May 2015 3

Exhibit 3: Market Share of Big Four Banks Exhibit 4: PBOC Benchmark Rates Adapting to change In any event, the fact that the PBOC s lending benchmark has remained a key reference for banks suggests that the banking sector is still in a transition period from highly regulated interest rates to complete interest rate freedom. However, there are now reasons to believe that the pace of change will gradually accelerate. First, the Mainland is continuing to open its financial markets to domestic and international capital. In March 2014, the China Banking Regulatory Commission indicated that it would grant more banking licences to private companies. Since then, it has approved the launch of several privately owned local commercial banks 1. Last year also saw the Mainland government decide to shorten the waiting period between foreign banks establishing operations in the country and being able to apply to conduct RMB business in order to ease market access. 2 These developments suggest that banks are likely to compete more aggressively with each other for deposits and loans. 1 Financial Times, Alibaba affiliate wins approval for bank licence, 29 September 2014. 2 Financial Times, China eases rules for foreign banks, 21 December 2014. The Mainland government also loosened other restrictions, including dropping requirements that a bank should be profitable for two years in a row before applying a RMB licence and that foreign banks should transfer a minimum amount of operating funds from their head office in the Mainland to each new bank branch opened in the country. While foreign banks share in the Mainland s retail banking market remains small, less than 2% in terms of total assets which has been little changed over the past decade, the loosening of rules suggest that the Mainland government remains committed to the opening of the banking sector. April/May 2015 4

Second, the authorities are taking steps to help banks to better price credit risk. With tightly controlled interest rates, banks have tended to lend money to large businesses as they cannot manage higher-risk customers through the use of higher interest rates. With the dismantling of lending rate restrictions, banks should be free to set borrowing costs which appropriately reflect the probability of default. In 2006, the PBOC established a credit reference centre. Since 2013, this centre has been piloting a system that allows banks to access credit data on companies and individuals. 3 The Mainland s ongoing reform of state-owned enterprises (SOEs) should also support the move towards interest rate differentiation as banks should be able to more easily distinguish between stronger and weaker SOEs as regards economic performance. PBOC toolkit The effective deposit rate ceiling will become the lowest possible cost of borrowing if banks start to set their own lending rates. But even this ceiling can be scrapped as the PBOC proceeds with further interest rate liberalisation. Following the PBOC s announcement in May, banks can now set their own deposit rates up to 50% above the benchmark rate, compared with the previous ceiling of 30%. Before November last year, the cap was just 10%. Many are expecting that, for the shortterm future at least, the PBOC will continue to raise the deposit rate ceiling with every subsequent interest rate move. In a recent press conference, PBOC governor Zhou Xiaochuan hinted at an even more aggressive implementation of reforms, saying that the final step to liberalise deposit rates is very close and that the ceiling could be lifted once and for all if there is an opportunity this year. 4 In such a case, the PBOC would no longer control the deposit and lending rates that are applicable to transactions between banks and their customers. This development would see the markets play a decisive role in allocating resources, as pledged by the authorities following the Mainland s Third Plenum meeting in November 2013. 3 http://www.pbccrc.org.cn/zxzx/dsj/dsj.shtml. 4 http://finance.sina.com.cn/china/hgjj/20150312/155421707307.shtml. April/May 2015 5

However, the central bank still has to set a target level for the short-term interest rate in the wholesale interbank market through which it can effect a range of other interest rates in the retail banking market and hence the state of the economy in order to meet its policy objectives such as inflation or employment. The target level of the short-term interest rate, be it the seven-day reverse repo rate or some alternative, would be the PBOC s policy rate and akin to the US Federal Reserve s fed funds target rate or the European Central Bank s policy rate on its main refinancing operations. Generally speaking, central banks determine the quantity of money supply and one of the primary means for doing this is to set the price of base money, which in practice is usually the short-term interbank interest rate. Exhibit 5: Possible Change in PBOC Policy Framework PBOC Interest rate determined by PBOC to meet its objectives Interbank market Retail banking market Interest rate freely determined by banks to attract deposits and meet loan demand Source: Hang Seng Bank Setting a target interest rate in the interbank market would mean that the PBOC has to change its monetary policy framework from adjusting deposit and lending rates to exerting direct influence over the price of base money (Exhibit 5). The PBOC must also reduce its use of direct credit policies such as loan quotas and window guidance if its objective is to stop intervening in the retail banking market. Despite these challenges, the central bank has been trying to make use of interbank rates to shape its policy. In early 2013, it created a new tool called the Standing Lending Facility (SLF) which is comparable to the Fed s discount window for the purpose of meeting banks short-term liquidity needs and thereby acting as a cap to the interbank rate. In September 2014, it launched the Mediumterm Lending Facility (MLF), another new tool offering three-month loans to banks and through which it intends to guide the interbank rate for the medium term. April/May 2015 6

Broader financial reform Interest rate liberalisation, in terms of allowing banks to freely set their own deposit and lending rates and changing the PBOC s toolkit, is only part of broader financial reforms on the Mainland, which also include exchange rate flexibility and capital account opening. However, all these developments are interconnected. Increased freedom for banks to determine retail market interest rates, together with increased flexibility in the exchange rate of the RMB, should help financial markets to discover the real market price of derivatives and structured products. This should allow investors to better hedge their exchange rate risk and, in turn, enable the PBOC to further widen the RMB s trading band. As the Mainland speeds up the opening of its capital account, cross-border capital flows will increase, making it increasingly difficult for the PBOC to continue to control interest rates at the retail banking level. It therefore makes sense for the central bank to shift its focus to targeting interbank rates before lifting all capital controls so that it can continue to make use of its policy tools to achieve its economic objectives. Concluding remarks The PBOC has taken a gradual approach to interest rate liberalisation at the retail banking level. This process should culminate in banks being free to determine the interest rates that they offer to customers. During the transition phase, the central bank must shift its focus from control of benchmark deposit and lending rates towards a target rate in the interbank market. The implementation of interest rate liberalisation is not only crucial to the banking sector, but also to the Mainland s plan for reforming the financial markets. April/May 2015 7

China Economic Monitor Statistics April 2015 GDP Industrial output Fixed asset investment Retail sales Nominal Real Real Nominal Nominal Foreign trade Consumer prices Exports Imports Trade balance Food Non-food RMB bn yoy (%) yoy (%) ytd (%) yoy (%) yoy (%) yoy (%) USD bn yoy (%) yoy (%) yoy (%) 2010 40,151 10.4 15.7 24.5 18.4 31.3 38.7 183.1 3.3 7.2 1.4 2011 47,310 9.3 13.9 23.8 17.1 20.3 24.9 155.1 5.4 11.8 2.7 2012 51,947 7.7 10.0 20.6 14.3 7.9 4.3 231.1 2.6 4.9 1.6 2013 58,802 7.7 9.7 19.6 13.1 7.9 7.3 259.7 2.6 4.7 1.6 2014 63,646 7.4 8.3 15.7 12.0 6.1 0.4 382.5 2.0 3.1 1.5 2015F NA 7.0 8.0 14.0 12.0 8.0 4.0 496.0 2.0 3.0 1.5 Q3 2013 13,875 7.8 10.1 20.2 13.3 4.0 8.4 61.5 2.8 5.3 1.6 Q4 18,208 7.7 10.0 19.6 13.5 7.4 7.2 90.5 2.9 5.5 1.6 Q1 2014 12,821 7.4 8.7 17.6 12.0-3.4 1.6 16.7 2.3 3.5 1.7 Q2 14,083 7.5 8.9 17.3 12.3 5.0 1.6 86.0 2.2 3.4 1.7 Q3 15,086 7.3 8.0 16.1 11.9 13.0 1.2 128.0 2.0 3.0 1.5 Q4 21,656 7.3 7.6 15.7 11.7 8.5-1.6 149.5 1.5 2.6 1.0 Q1 2015 14,067 7.0 6.4 13.5 10.6 4.7-17.6 123.7 1.2 1.9 0.8 Dec 2014 NA NA 7.9 15.7 11.9 9.7-2.4 49.6 1.5 2.9 0.8 Jan 2015 NA NA 6.8 13.9 10.7-3.3-19.9 60.0 0.8 1.1 0.6 Feb NA NA 6.8 13.9 10.7 48.3-20.5 60.6 1.4 2.4 0.9 Mar NA NA 5.6 13.5 10.2-15.0-12.7 3.1 1.4 2.3 0.9 Apr NA NA NA NA NA -6.4-16.2 34.1 1.5 2.7 0.9 YTD 14,067 7.0 6.4 13.5 10.6 1.6-17.3 157.8 1.3 2.1 0.8 Deposits (domestic currency) Loans (domestic currency) New loans Lending rate 1-year Money supply (M2) Forex reserves Foreign direct investment CNY per USD (period end) Total social financing RMB bn yoy (%) RMB bn yoy (%) RMB bn % yoy (%) USD bn ytd (%) RMB bn 2010 71,823 20.2 47,920 19.9 7,950 5.8 19.7 2,847 17.4 6.5897 14,019 2011 80,940 13.5 54,790 15.8 7,470 6.6 13.6 3,181 9.7 6.2940 12,829 2012 91,740 13.3 62,990 15.0 8,200 6.0 13.8 3,312-3.7 6.2303 15,760 2013 104,380 13.8 71,900 14.1 8,890 6.0 13.6 3,820 5.3 6.0543 17,290 2014 113,860 9.1 81,680 13.6 9,780 5.6 12.2 3,840 1.7 6.2055 16,460 2015F 122,969 8.0 91,680 12.2 10,000 5.2 12.0 3,800 2.0 6.30 17,000 Q3 2013 103,090 14.6 70,280 14.3 2,198 6.0 14.2 3,663 6.2 6.1209 3,808 Q4 104,380 13.8 71,900 14.1 1,613 6.0 13.6 3,820 5.3 6.0543 3,322 Q1 2014 109,100 11.4 74,910 13.9 3,010 6.0 12.1 3,948 5.5 6.2171 5,600 Q2 113,610 12.6 77,630 14.0 2,726 6.0 14.7 3,993 2.2 6.2031 4,920 Q3 112,660 9.3 79,580 13.2 1,945 6.0 12.9 3,888-1.4 6.1394 2,280 Q4 113,860 9.1 81,680 13.6 2,098 5.6 12.2 3,843 1.7 6.2055 3,503 Q1 2015 124,887 14.5 85,907 14.7 3,671 5.4 11.6 3,730 10.6 6.1997 4,602 Dec 2014 113,860 9.1 81,680 13.6 697 5.6 12.2 3,843 1.7 6.2055 1,695 Jan 2015 122,406 18.3 83,699 14.3 1,471 5.6 10.8 3,813 29.4 6.2506 2,063 Feb 122,325 16.0 84,722 14.7 1,020 5.6 12.5 3,802 16.4 6.2694 1,357 Mar 124,887 14.5 85,907 14.7 1,180 5.4 11.6 3,730 10.6 6.1997 1,182 Apr NA NA NA NA NA 5.4 NA NA NA 6.2032 NA YTD 124,887 14.5 85,907 14.7 3,671 5.4 11.6 3,730 10.6 6.2032 4,602 NA: not available; (A)= actual; (F)= HASE forecast; yoy= year-on-year; ytd= year-to-date Source: State Statistical Bureau, China Statistical Yearbook, Macrobond, CEIC, Bloomberg, Hang Seng Bank April/May 2015 8

GDP Growth Consumer Price Inflation Urban Fixed Asset Investment Retail Sales Loan & Deposit Money Supply (M2) Benchmark Interest Rates Exports & Imports April/May 2015 9

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