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Beijing loosens grip on rates—will it matter?

Monday, 22 Jul 2013 | 12:44 AM ET
Frederic J Brown | AFP | Getty Images

China took another step towards financial liberalization on Friday, when the nation's central bank scrapped the floor on lending rates for commercial banks, essentially freeing lenders to issue loans as cheaply as they wished.

Authorities hope the move would spur competition among lenders, and allow borrowers access to cheaper money at a time when economic growth is slowing.

While the move reflects the government's determination to push ahead with reforms in the sector, economists say the practical impact on rates would be minimal.

The reason, quite simply, is that Chinese banks don't compete on loan pricing. Majority of the loans in China have been made above the benchmark rate of 6 percent, despite the previous policy which allows lenders to offer loans at up to a 30 percent discount from the benchmark rate.

(Read More: China liberalizes bank lending rates in reform push)

"The scrapping of the lending rate floor will likely have little impact on bank lending rates as banks don't compete on pricing and they rarely lend at lending rate floor," wrote May Yan, head of China banks research at Barclays.

"Therefore, the real economy may not get lower funding cost, and economic growth may not benefit much from this move," Yan said.

(Read More: The long game: Why a China slowdown isn't scary)

According to research by the bank, only 12 percent of loans were priced below benchmark rates in the past decade, with 24 percent at benchmark rates and 64 percent above the benchmark rate.

"Banks have been competing rationally as they know pricing competition is going to hurt the industry and themselves. We do not expect banks to change much of their behavior after the announcement," Yan said.

How China's lending rate move will impact liquidity
Helen Qiao, Managing Director & Chief Economist, Greater China at Morgan Stanley thinks China's move of removing the lending rate floor is a symbolic act with limited short-term benefits.

Wei Yao, China economist at Societe Generale, agrees this is unlikely to have an immediate impact on the real economy.

"Although the step is of great significance, the near term impact is likely to be very limited. We know for a fact that there was barely any loan offered at the lowest permitted levels, as banks see rising cost of funding - rates on deposits, wealth management products as well as interbank borrowing," she said.

What about deposit rates?

Analysts said that interest rate reforms remain incomplete if the central bank does not remove the ceiling on deposit rates, which are currently capped at 110 percent of the benchmark.

"The fact that the central bank announced these reforms on Friday without any change to the band on deposit interest rates may indicate that we will have to wait a bit longer for further deposit interest rate reform," said Mike Werner, banking analyst at Sanford C. Bernstein.

(Read More: China to keep credit growth steady: Central bank)

In the Q&A session that followed the announcement, the People's Bank of China (PBOC) said removing the ceiling on deposit rates is "most risky" as it would lead to more negative market sentiment on Chinese banks given the potential margin squeeze and could add more stress on the banking system, the bank said.

Shares of Chinese banking stocks edged lower on Monday, with major lenders including ICBC, Bank of China, and China Construction Bank falling between 0.4-1 percent in early trade.

Limited impact on bank earnings

For now, however, analysts believe the PBOC's latest move to liberalize lending rates will have minimal impact on bank earnings.

"There is absolutely no change in our viewpoint or earnings forecast for the banks as a result of the reforms. We expect to see no impact on the banks' pricing of loans despite the removal of the floor on lending interest rates," Werner of Sanford C. Bernstein said.

(Read More: China cash rates ease further as central bank stays out of market)

"We view the fact that the banks are pricing loans based on internal risk-based pricing mechanisms and not at the PBOC-set floors to be positive as it shows that the banks are increasingly motivated by profitability in their pricing decisions, and less by government influence," he added.

By CNBC's Ansuya Harjani; follow her on Twitter: @Ansuya_h