By now, most agree that better economic outcomes are achieved when interest rates are market-determined. Market-determined rates allow investors and savers to base their decisions on market conditions and the scarcity of capital and also provide policymakers with clearer signals of market conditions, improving the conduct of macroeconomic policies. For many countries, interest rate liberalisation has also been a necessary building block for further financial sector reforms and development.
China has taken important steps to liberalise its interest rates. Short-term interbank interest rates were liberalised first (during 1996 and 1997), financial and Treasury bond yields were liberalised soon after, followed later by the liberalisation of the corporate fixed income market (PBC 2005, Arora 2008). The creation of the short-term financing bond in 2005 and medium-term financing note in 2008, with unregulated interest rates and liberal issuance criteria, were major advances in the development of the corporate financing market. In 2007, seeking to make interest rates better reflect market conditions and create a more stable benchmark yield curve at longer maturities, the Chinese authorities also launched the SHIBOR benchmark rate system. Ceilings on loan rates and floors on deposit rates were removed last, allowing banks flexibility in setting lending rates above the regulated floor. However, critically, a ceiling on deposit rates and a floor on loan rates still remain in place, with only around two-thirds of loans taking place at rates above this floor.
Interbank interest rates
Currently, the interbank repo market is the deepest financial market in China; its turnover recently peaked at 25% of GDP. While its liquidity is limited beyond short maturities (80–90% of transactions are for seven days or less), the repo market is central to intermediation in China. Lending in the repo market is dominated by the large state-controlled banks, while smaller banks and non-banks rely heavily on the repo market for funding. The People’s Bank of China is also active in this market, undertaking sterilisation and other monetary operations that account for 6% of repo market turnover (Figure 1). While the interbank bond markets (for Treasury, financial enterprise, and corporate bonds) are also relatively large, secondary trading is limited, as most participants hold these bonds to maturity.
Figure 1. China’s repo market
Can we, however, regard China’s repo rates as independent price signals of liquidity conditions and the cost of capital? Certainly these rates are no longer administered. However, markets are interdependent and retail interest rates remain regulated, influencing the supply and cost of funds circulating in the financial system. What would happen if administered lending and deposit rates were increased? Other things equal, one would expect the higher deposit and lending rates to increase both the return on new loans and the cost of funds for banks, thereby leading to a bidding up of the interbank rate.
In Porter and Xu (2009), we examine the determinants of Chinese interbank interest rates and find that short-term interbank interest rates in China are indeed heavily influenced by changes in administered interest rates. Movements in Chinese interest rates are highly persistent. Interbank rates are also subject to seasonal (liquidity) effects depending on the day of the week or time in the month. National holidays also have a major impact on liquidity conditions and, as a consequence, interbank rates. Innovations in interest rates are not normally distributed and, indeed, exhibit “fat tails” as in other financial markets (see Hamilton 1996 and Prati et al 2001). However, after controlling for these other effects, it is clear that changes in administered benchmark interest rates have a significant effect on both the mean and volatility of short-term interbank rates. Specifically, a 100-basis-point increase in both the lending and deposit benchmark rates has an immediate effect of around 30 basis points on the repo rate (eventually raising the rate by 40 basis points given the persistence of the interest rate). These changes in benchmark interest rates not only affect the level of the repo rate but also raise its volatility during the week the change occurs – a 10-basis-point simultaneous increase in both lending and deposit rates increases volatility by almost 50% during that week. What is also interesting is that the level of repo rates do not seem to be influenced by measures of other exogenous policy changes (including changes in reserve requirements and open market operations), although anticipated changes in reserve requirements as well as the timing of initial public offerings do affect interest rate volatility.
The regulation of deposit and loan rates creates multiple distortions. Consequently, much might be gained from further liberalisation. The central bank would gain additional independent information on liquidity conditions from money market rates, easing macroeconomic management. At the same time, further liberalisation would expand the avenues for banks to compete and boost their ability to develop new financial products. Further, if the remaining regulation of interest rates has kept interest rates too low, further liberalisation should also improve the allocation of capital. Finally, since short-term interbank interest rates are central building blocks of other financial asset prices, distortions in these short-term interbank rates also have implications for other asset prices.
Liberalising deposit and loan rates would, therefore, allow the full term structure of interest rates to provide more informative price signals, improve the allocation of capital, and strengthen macroeconomic management tools. However, while the end goal is clear, the process of liberalisation needs to be managed carefully. There are several international examples in which interest rate liberalisation was followed by excessive credit growth and banking system instability. However, this is not a reason to delay reform, as delay carries with it its own risks. Instead, the lesson that should be drawn from these international experiences is that as interest rates are liberalised, monetary policy needs to be proactive in containing excessive lending while supervisory frameworks should remain vigilant to guard against an increase in credit risks (Feyzioglu et al. 2009).
Arora, Vivek (2008), “China’s Financial Sector Policies,” in Innovation for Development and the Role of Government, ed. by Qimiao Fan, Li Kouqing, Douglas Zhihua Zeng, Yang Dong, and Runzhong Peng (Washington: World Bank).
Feyzioglu, Tarhan, Nathan Porter, and Elod Takats (2009), “Interest Rate Liberalization in China,” IMF Working Paper 09/171, Washington.
Hamilton, James D. (1996), “The Daily Market for Federal Funds,” Journal of Political Economy, Vol. 104, No. 1, pp. 26−56.
The People’s Bank of China (2005), “Report on Steady Progress in Market-Based Interest Rate Reform,” Supplement to the China Monetary Policy Report, January.
Porter, Nathan, and TengTeng Xu (2009), “What Drives China’s Interbank Market?,” IMF Working Paper 09/189, Washington.
Prati, Alessandro, Leonardo Bartolini, and Guiseppe Bertola (2001), “The Overnight Interbank Market: Evidence from the G-7 and the Euro Zone,” FRB of New York Staff Report No. 135