The recent elimination of the ceiling for deposit rates coupled with the earlier freeing up of lending rates fulfill central bank Governor Zhou Xioachuan's pledge to reform China's interest rate regime. When financial liberalization began in earnest several years ago, the prevailing view was that the country's interest rates were too low because of what experts call "financial repression," which refers to setting limits to keep borrowing costs low for investors at the expense of households receiving lower rates for their savings. Excessively low interest rates were seen by many China watchers as the reason for the country's unbalanced growth as indicated by its high share of investment-to-GDP ratio and commensurate low share of consumption. It was also seen as the reason for speculation in the housing and equity markets. The belief, therefore, was that liberalizing interest rates would lead to higher rates and a more balanced growth.
What has happened over the past several years suggests that this argument was flawed. Interest rates have in fact fallen rather than increased with financial liberalization, and the economy has nevertheless become more balanced, with the share of consumption to GDP rising. Interest rates in 2013 were too high rather than too low. Lending rates for mortgages and loans to major companies were about 2 to 3 percentage points higher than in the major financial markets in the United States, Europe and Asia, and have since fallen by a point or more. One-year savings deposit rates a few years ago were around 3.3 percent when comparable rates elsewhere were only around 0.2 to 0.5 percent. After lifting the ceilings, deposit rates today have fallen to around 2 percent or less in China.
In a globalized world, interest rates in major financial markets tend to converge as capital moves across borders in search of higher yields, but variations exist because of differing expectations for exchange rate and inflation prospects, capital controls, and political and economic risks. A few years ago, China's inflation rate was not much different from other major economies and trending downward; its overall financial position was better than most countries; and the yuan was expected to appreciate. All this should have made everyone realize that China's nominal interest rates were probably too high rather than too low and likely to decline over time, especially since it was in the midst of a slowdown.
But if China's interest rates were actually too high, why were most market watchers convinced that they were too low? Some analysts pointed to periodic surges in interbank lending rates and said Alibaba was paying its Internet deposit customers more than commercial banks. This paradox is explained by differentiating between the pressures on interest rate movements that come from distorted financial markets and what would happen with sound governance structures and liberalizing capital markets.
Those arguing for higher lending rates because of perceived wasteful investments associated with state-owned enterprises (SOEs) 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 SOEs making profits from monopolies, not transferring their surplus to the state and responding to politically driven mandates. Addressing these distortions, along with revamping the governance and regulatory system for financial institutions are far more effective instruments for improving efficiency than simply increasing interest rates. Moreover, higher rates would have some undesirable consequences. They would worsen already serious debt servicing problems of firms and many local governments, and could even unnecessarily jeopardize the solvency of what would otherwise be viable firms in a period of price deflation.
The easing of capital controls and monetary policies have led to some narrowing of differences in rates between China and the rest of the world over the past several years. The still significant differences have encouraged foreign investors to seek higher returns for their savings in the country. The more creditworthy Chinese firms are borrowing abroad at lower rates than available domestically. Companies are using their overseas affiliates to gain access to cheaper funds abroad, while households and companies in neighboring countries are finding ways to park their yuan holdings in higher paying accounts linked with China's rates. All this has been putting pressure on interest rates to head to levels closer to other major global markets. This has been facilitated by a gradual easing of credit policies given the protracted economic slowdown.
China is unusual in that its ratio of investment to GDP is exceptionally high, but its savings ratio is even higher. Accountants tell us that the surplus in savings will show up as a trade surplus, which is then invested abroad by the central bank. According to the most basic economic principles, the equilibrium interest rate is the rate that equalizes savings with investment. In the absence of institutional reforms, interest rates would have to fall further to generate a decline in savings or an increase in investment until this balance is achieved.
Based either on cross-country comparisons of interest rates or concepts of long-term equilibrium interest rates, China's deposit rates were too high rather than too low a few years ago. The recent decline thus makes sense. All this puts an even greater burden on strengthening governance and regulatory systems as the prerequisites for financial reforms that include freeing up capital controls and allowing rates to move in line with market forces.