Financial system reform?

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If the cash squeeze in June didn’t catch you off guard， perhaps the central bank freeing loan rates did. Just before market close， the People’s Bank of China（PBoC） said it would scrap the floor on lending rates – effective the next day. Banks will now be able to lend below the 4.19% base rate， which was previously set at 70% of the one-year benchmark lending rate of 6%.

Chinese central bank officials are adept at surprise reform. The PBoC has long kept a stranglehold on lending rates and deposit rates， the returns on accounts for average Chinese savers. After eight years of virtual inaction， the central bank lowered the lending floor in early June last year from 90% to 80% of the benchmark and raised the cap on bank deposits to 110% of the benchmark.

Then， only a month later， it dropped the floor again， this time to 70% the benchmark. Deposit rates have remained untouched.

Analysts have called the move an important signal for reforms to come – although a largely symbolic one. Generally， banks have not been competing on lending rates. About 90% of lending in China is at or above the benchmark， according to HSBC.

Also， lending quotas will be tight in the second half of the year. Banks have already lent out nearly 60% of an annual quota HSBC expects will be around US$1.34 bilion（RMB8.5 trillion）. As the money to lend runs out， banks will be able to command higher interest rates， further pushing lending above the benchmark rate.

Some state-owned enterprises （SOEs） that have hefty bargaining power， tight relationships with banks or are particularly low risk might get loans below the former limit. This hardly qualifies as substantive reform.

“We reckon that only a very selected few large SOEs might benefit slightly from this rate deregulation，” Lu Ting， China economist at Bank of America Merrill Lynch in Hong Kong， wrote in a note.

In this sense， banks will take a hit on their bottom lines because lending at lower rates will drive down net interest margins， Moody’s Investors Service noted. Previously， state-owned banks had been guaranteed to pocket at least the difference between the deposit rate cap and the floor on lending rates.

Therefore， ditching the floor will have little real effect on China’s banking system for the time being， and few will benefit from the change.

Real winners in financial reform will be declared when China abolishes the cap on deposit rates. Those winners， of course， will be the Chinese people， who held some US$15.9 trillion in deposits as of the end of March. An artificially low rate on deposits， often lower than the rate of inflation， means that savers are regularly losing money in real terms.

“Deposits rate liberalization holds the key to full liberalization of interest rates，” Qu Hongbin， co-head of Asian economic research at HSBC， wrote in a note.

Such a bold plan for the cap， which is 10% above the one-year benchmark， may have been in the works but was defeated by banks that have few other ways of making money， the Financial Times reported.

The central bank’s game plan is to move from long-abolished controls on foreign currency accounts and recently loosened lending rates to renminbi accounts and deposit rates， said Oliver Rui， a professor of finance at China Europe International Business School in Shanghai， over the phone.

Liberalization of foreign currency accounts started in 2000. By 2004， both the lending floor and the deposit cap had been removed on those accounts. Now， with the lending rate floor removed on renminbi accounts， the deposit rate cap is the last element of the reform.

Analysts have pointed out that several roadblocks still stand in the way of that final component to interest rate liberalization.

Chinese banks have been highly profitable due to the wide spread between lending and deposit rates. For banks dealing with high rates of nonperforming loans， narrowing that margin could be dangerous.

To mitigate these risks， the government should first implement a system for deposit insurance and bankruptcy protection， both of which appear to be on the horizon， London-based Capital Economics stated in a note.

Overall reform to the state-owned sector will also need to continue before the caps can be completely ditched，“otherwise deposit rate liberalization may not help result in rational behavior，” according to a note from Barclays Research. Rational behavior could imply accounting for risk in lending rates， which could open up access to credit to smaller， more efficient firms that desperately need cash.

That said， the PBoC could have a number of tricks up its sleeve， and it may not wait for every segment of the market to be completely prepared. Few people foresaw the back-to-back drops in lending rates in June and July of last year. Fewer still could have predicted the central bank’s refusal to pump cash into the system in June this year.

After all， in a February 2012 statement that outlined future financial reforms， policymakers at the central bank said specifically that if they waited for all the conditions to be right， they would “never find a suitable time to liberalize the capital account.”