China move to free lending rates puts focus on low saver returns

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A woman monitors prices at a securities exchange hall in Shanghai.

The biggest step yet by China's new leaders to move the nation's financial system toward market-set lending rates heightens focus on what the central bank says is an even tougher reform: lifting restrictions on savers' returns.

The People's Bank of China ended a floor on borrowing costs previously set at 30 percent below the benchmark, it said July 19. The limit on mortgage rates will stay to curb property speculation, the PBOC said. Also unchanged was a 10 percent limit on what banks can offer over PBOC-set deposit rates.

Forcing banks to compete for funds would offer consumers more spending power, while undermining the model of state-directed, subsidized credit bequeathed to Premier Li Keqiang, who took office in March. At stake is phasing in reform without exacerbating a slowdown in the world's second-largest economy.

"Reducing controls on deposit rates would have a far bigger impact, boosting household income but also raising costs for large borrowers that have become addicted to cheap credit," said David Loevinger, former U.S. Treasury Department senior coordinator for China affairs and now an emerging-markets analyst at TCW Group Inc. in Los Angeles.

The PBOC itself said three days ago that deposit-rate reform is "the most risky" part of liberalization. The central bank currently sets the one-year lending rate at 6 percent, with a one-year deposit rate of 3 percent. Prospects for a narrower interest margin may hurt Chinese bank stocks this week, according to Macquarie Capital Securities Ltd.

Stock slide

The Shanghai Composite Index (SHCOMP) of stocks slid 2.3 percent last week amid concern China's slowdown has yet to bottom out. A government report showed gross domestic product rose 7.5 percent in the second quarter from a year before, extending the longest streak of sub-8 percent expansion in at least two decades.

While removing the floor for lending rates offers the prospect for cheaper funding -- after a record liquidity squeeze last month -- banks haven't been availing themselves of the leeway they previously had to charge less. In the first quarter of 2013, about 11 percent of bank loans were made below the benchmark rate, and about 64 percent above it, PBOC data show.

The figures indicate last week's announcement won't lead to a "meaningful decline" in lending rates, although it may help reduce borrowing costs for some state-owned enterprises who are seen as less risky, UBS AG economists led by Hong Kong-based Wang Tao said in a July 19 note.

Suffering savers

Savers have for years suffered artificially low deposit rates as the government subsidized state-owned enterprises through the banking system by giving them cheap credit to spur investment and economic growth. Freeing those rates would benefit households and help the government's long-stated goal of rebalancing the economy away from its dependence on investment and exports and toward consumption.

Returns on savings that have lagged behind inflation have encouraged them to boost savings to meet target income levels, according to a 2011 International Monetary Fund working paper by Malhar Nabar.

The report, which calculated that China's urban household savings rate rose to 30 percent of disposable income in 2009 from 19 percent in the mid-1990s, estimated a 1 percentage-point increase in the real rate of return on bank deposits would lower the savings rate by 0.6 percentage points.

Liberalizing deposit rates "could boost personal income by at least 5 percentage points as a share of Chinese GDP and play an important role in the long awaited pro-consumption rebalancing," said Stephen Roach, a senior fellow at Yale University's Jackson Institute of Global Affairs and formerly chief economist at Morgan Stanley.

Banks' competition

For banks, such a step would spur competition at a time when savers are already being lured away by riskier short-term wealth management products offering returns as high as 6 percent compared with the PBOC's 3 percent benchmark one-year rate.

China Construction Bank Corp. (939) and Bank of Communications Co. may be the two "worst positioned" for the end of the cap on lending rates, according to Macquarie Capital Securities.

"Many will comment that banks' net interest margin will be under further pressure," hurting sentiment toward Chinese banks, said Victor Wang, a Hong Kong-based analyst at Macquarie. "In theory, large banks with higher exposure to large corporate lending have more to lose and are therefore more exposed."

The nation's listed banks slid last month, sending their valuations near the lowest on record, after a cash crunch in the interbank market exacerbated investors' concern that earnings growth will stall and defaults may surge as the economy slows.

Bond market

At the same time, removing the lending floor will help banks who may have been losing market share to the corporate bond market, where big Chinese companies could get cheaper financing, said Robert Sinche, global strategist at Pierpont Securities Holdings LLC in Stamford,Connecticut.

"This move allows them now to free up the rates at which they are lending, so they can compete if they think it's appropriate," he said.

The PBOC began an overhaul of deposit rates in June last year, when it allowed banks to offer as much as 10 percent above the benchmark. The next step should be to raise the ceiling to 30 percent, the IMF said last week in its annual assessment of China's economy released before the PBOC's announcement.

China isn't ready to free up deposit rates, the PBOC said in a statement July 19, highlighting that the nation lacks a deposit-insurance system.

"˜Most risky'

"According to successful international experience, opening up deposit rates is the most critical and the most risky part in interest-rate liberalization, and must be implemented gradually and in an orderly process," it said.

The U.S. phased out caps on deposit rates in the 1980s.

The PBOC hasn't publicly given a timeframe for introducing a deposit-insurance system, which would protect savers by returning a portion of their deposits when a bank fails. Tao Zhang, China's IMF executive director, wrote in a statement last week that it is "a priority for this year."

There's no consensus on deposit-rate reform, Song Guoqing, an academic adviser to the central bank, said at a conference in Beijing on July 20. "Had there been a unified view, it would have been announced" on July 19, he said.

"A truly meaningful interest-rate liberalization" must involve lifting controls on bank deposit rates, said Lu Ting, chief China economist at Bank of America Corp. in Hong Kong. "The PBOC will likely make some progress in this regard in coming years but markets will have to be patient."

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