Slow growth could impede China’s banking reforms

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China's draft regulations for a bank deposit insurance system could see full interest rate liberalization in as little as two years, but slowing growth might impede reform measures, analysts say.

On Sunday, China's cabinet unveiled draft rules for a deposit insurance system that would cover deposits of up to 500,000 yuan, or around $81,300, for individual and commercial depositors. According to the People's Bank of China (PBOC), the system would cover 99.6 percent of all depositors.

"Deposit rate insurance has been talked about for 20 years, I think the fact that it's come out now reflects how hard it was to get this reform pushed through," Alaistair Chan, Economist at Moody's Analytics, told CNBC on Monday.

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"If the economy slows down further, that's really going to weigh on reformers' case. The government's really going to have to consider whether they're going to fall back on their credit and investment easing," Chan said.

Economic growth in China, the world's second-largest economy, slowed to 7.3 percent in the third quarter – its slowest pace in five years. Coupled with growth readings of 7.4 percent and 7.5 percent in the first and second quarters, Beijing could undershoot its official 7.5 percent 2014 growth target.

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It's prompted analysts to reduce their 2015 outlooks; Goldman Sachs cut its 2015 growth forecast to 7.1 percent from 7.6 percent in September. Meanwhile the International Monetary Fund suggested in July that China should set a 6.5-7 percent growth target for next year.

"As regulators started to reform interest rates in 2013, a time when China's growth was considered to be stronger, the industry and regulators knew that rate liberalization would be one of the the riskiest parts of the country's financial industry reform agenda," Zennon Kapron, managing director of Shanghai-based market research firm KapronAsia told CNBC.

"As China's interest rate reforms continue, banks will compete for loans and deposits and many uncompetitive banks will see net interest margins squeezed," Kapron said. "While this will be somewhat painful for all of the banks initially, it will be especially acute for the smaller banks and their more limited balance sheets," he said.

"In the face of slowing growth, these community banks may run into liquidity problems much faster than their larger counterparts," he added. "Deposit insurance, coupled with margin pressure and slowing economic growth, make it an especially difficult time to be a small or medium sized bank in China."

Two years' time

Growth concerns aside, some analysts believe China is on course to full interest rate liberalization by 2017, in line with comments from PBOC Governor Zhou Xiaochuan, who said in March, "Deposit rate liberalization is on our agenda. Personally I think it's very likely to be realized within one to two years."

"This is a major step toward the introduction of the deposit insurance scheme, which is considered by policy makers a precondition for interest rate liberalization," Citi economists Shuang Ding and Minggao Shen wrote in a note.

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"This, together with measures on November 21 to allow 20 percent upward floating of deposit rates, suggests the rate reform has regained momentum, and full liberalization is likely in two years," the economists said.

Protecting savers with deposit insurance is widely regarded as a step towards liberalization as liberalization would allow banks to compete commercially and could lead to turbulence for smaller banks.

"While we would expect the government still to step in to provide help when commercial banks run the risk of bankruptcy, a move in this direction gives the government more freedom than in the past," Goldman Sachs wrote in a note on Monday.

"This, together with the lifting of the deposit rate ceiling very recently, which gives banks more choice…shows the government's desire to move towards a market based banking system," it said.

Launch time

While Chinese officials didn't say when the program would officially launch, banks have been given until December 30 to comment on the draft. State media reports suggest it could start in early 2015, according to Reuters.

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"If all goes smoothly, the deposit insurance scheme could be introduced next year," the Citi economists said.

"There is still a continued and very strong case for [economic and banking] reform; it will clearly help the economy and boost growth in the longer term," Moody's economist Chan added. "It's really incumbent on the government to push through reforms as fast as quickly can."