China’s interest rate cut is big news. But it is only the beginning. China is moving from economic reforms to financial deregulation – faster than expected.
For two years now, the prophets of doom have forecasted that China is on its way to a hard lending. The reality is that China, like other large emerging economies, is not immune to the debt crises in the West; but it is better positioned to cope with such crises.
During the past three months, I have argued that China is preparing a shiftfrom taming inflation to stabilizing growth. That the stories of gloom and doom have been around since 2008-9; and that such stories are conceptually flawed. And that China is rapidly moving from three decades of economic reforms to financial reforms.
The big story today is not just China’s rate cuts, but that these changes herald accelerated financial reforms.
Liberalized interest rate policy
The headlines are unambiguous: “China cuts interest rates for the first time since 2008.”
Yes, the 1-year deposit rate will drop to 3.25 percent from 3.5 percent. In turn, the 1-year lending rate will fall to 6.31 percent from 6.56 percent.
In the West, the conventional wisdom is that these rate cut represents efforts to fight the economic slowdown, due to Europe’s worsening debt crisis and lingering stagnation in the United States.
Like all conventional wisdom, it is not a bad interpretation. It is partly true. But it’s just part of the story.
First of all, interest rate policy was also liberalized: banks can now offer a 20 percent discount to the benchmark lending rate, which is twice as much as before. They can also offer deposit rates up to 10% above benchmark (in the past: 0%).
In other words, the best 1-year lending rate was reduced substantially from 5.9% to 5.05%, while the best 1-year deposit rate was boosted by 8 basis points. Translation: Chinese policy makers are doing their best to encourage both deposits and lending.
As such, the rate cut was not a surprise. Along with others, I have forecast such reductions for months. These cuts suggest mounting concern over growth slowdown. They may also precipitate impending data that may well reflect further deceleration.
This may be the first cut after 2008, but it won’t be the last one. Another may follow in the course of the summer. But the rate cuts will remain modest and limited. The idea is to stabilize the foundation for growth, not to prepare the ground for inflation. The goal is to achieve 8% growth in 2012.
Last year was a rollercoaster to investors in China. Now the market is at the edge of a rebound.
The idea is to show the big guns to boost the sentiment. The idea is not to use those guns fully yet. It is enough if investors sense that the ammunition is there should it really be needed.
If financial reforms are accelerating, what should we expect next?
Financial reforms ahead
China is moving faster to foster capital account convertibility. The internationalization of the renminbi is not a matter of decades, but a decade. The RMB can be used more internationally while the latter remains partly inconvertible. Meanwhile, Chinese regulators may reserve the right to reduce liberalization at times of turmoil.
Chinese banks will be moving into asset management, trade finance and project finance – areas that used to be Western banks’ exclusive playing fields.
London is becoming China’s offshore RMB center in Europe. China is enhancing the international position of the RMB, while reducing China’s dependence on the U.S. dollar.
China’s banking, brokerage, insurance, and asset management industries have enjoyed robust growth and sound profits for more than half a decade. In the process, equity, bond, and currency markets have expanded substantially. Changes loom ahead.
Today, the 75% ceiling for loan-deposit ratio (LDR) continues to constrain commercial banks from growing their lending.
China’s nascent and fragmented bond market remains too small to fulfill the needs of corporate financing.
Commercial banks are coping with increasing capital adequacy pressure and must raise capital frequently. Securitization of loan portfolios could be one way to alleviate such pressures.
China’s financial markets remain relatively closed to most foreign investors and financial institutions. The gradual lowering of entry barriers could support a secure and gradual internationalization of Chinese financial markets, while boosting competition in the system.
Gradual, but decisive approach
In 2012, much of the financial reforms will occur vis-a-vis pilot programs, which herald acceleration in the equity markets in the coming years.
As China is stepping up market and financial reforms, it hopes to make Shanghai a key global financial hub by the end of the decade.
China is moving toward financial reforms, decisively and gradually – just as it did with the economic reforms.
Dan Steinbock is research director of International Business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore).