Source: Financial Times

The December spike in China’s interbank interest rates, following a similar episode in June, reinforces two widely shared perceptions. The first is that dealing with the current debt overhang will exacerbate volatility; the second is that interest rates are too low. That financial reforms are needed, despite the risks, is beyond dispute. But whether interest rates — specifically deposit rates paid to savers — are actually too low, as many China-watchers have argued, is debatable.

The spikes in interbank rates stem in part from a bifurcated access to household savings deposits. The leading state commercial banks have a large deposit base to tap for lending; while many of the smaller private banks rely on the interbank market, a more costly and less reliable source of funds. The interbank market also serves a melange of bank and non-bank intermediaries engaged in “shadow banking” activities targeted to the private sector for higher, albeit riskier, returns.

Attempts by the central bank to moderate the debt build-up by tightening liquidity in the interbank market contributed to the rate spikes. But policy makers also have a justifiable desire to encourage more support for the private sector by liberalising lending practices.

Higher borrowing rates can help to reduce leverage in the economy; but, at the same time, a cursory comparison of interest rates across countries suggests China’s deposit rates are not too low. In fact, its deposit rates of 3-4 per cent are much higher than those of most leading advanced economies, whose rates are about 0.2 to 0.5 per cent. They are also higher than those of most developing east Asian countries, especially after adjusting for inflation and exchange rate risks.

Some advocates of higher deposit rates dismiss market comparisons and turn to growth models used by economists, which suggest that when an economy is in “equilibrium” the real interest rate should be equal to the gross domestic product growth rate. But this concept is more appropriately applied to lending rather than savings rates, and is more relevant for mature economies with low but stable growth rates than developing economies playing catch-up. It also pertains to a “stationary” economy – one that is neither expanding nor contracting and is closed to external markets. Clearly, China does not fit these conditions.

Many argue, however, that the surge in interbank rates is indicative of the need for higher rates, and that abolishing the remaining ceiling on deposit rates would help. Indeed, simply removing the deposit rate ceiling would likely lead to near-term increases. Private banks facing a liquidity crunch are more inclined to bid up rates since they lack the size and sovereign guarantee advantages of leading state-owned banks in competing for deposits. But in a poorly regulated market, these lenders are also more likely to be involved in speculative activities with greater risks of going bust. So, given distorted financial markets and incentives, interest rate liberalisation does not necessarily lead to better results.

Similarly, those who argue for higher lending rates because of the waste associated with state-owned enterprises overestimate the efficiency benefits, since interest rates play less of a role in shaping long-term investment decisions in China. The bulk of the waste comes from state-owned enterprises making monopoly profits — not transferring their surpluses to the state — and responding to politically driven mandates. Addressing these distortions, along with revamping the governance of the state banks, deepening capital markets and establishing a better regulatory system, should be much higher in the sequence of reform priorities than fully liberalising deposit rates.

Hypothetically, what would be the level of interest rates if state and private banks competed on equal terms and China opened up its capital markets? If capital controls were eliminated, more creditworthy borrowers would begin borrowing abroad at lower rates than available domestically, buoyed in part by limited downside exchange risks. Interest rate arbitrage is already occurring as Chinese companies use their overseas affiliates to gain access to cheaper external funds. Similarly, foreign capital would be attracted to an even greater extent into China, enticed by the higher deposit rates. This would put pressure on both lending and savings interest rates to fall to levels in Europe and the US, and on the renminbi to appreciate.

Put another way, China is unusual in that its ratio of investment to GDP is exceptionally high but its saving ratio is even higher. The surplus in savings shows up as a trade surplus, which is then invested abroad by the central bank. According to the most basic economic principle, the equilibrium interest rate is that rate which equalises savings and investment. In the absence of institutional reforms, interest rates would have to fall to generate a decline in savings or an increase in investment until balance is achieved.

Either on the basis of cross-country comparisons or concepts of “equilibrium” interest rates, China’s deposit rates are too high rather than too low. The mistaken interpretation originates from the perception that the country’s looming property bubble is driven by low deposit rates when it is actually largely the result of capital controls and distorted equity and land markets. All this puts an even greater burden on strengthening governance and regulatory systems as the prerequisites for financial reforms.

This article was originally published by the Financial Times.