The People's Bank of China last year allowed banks to offer rates as much as 10 percent above the benchmark set for deposits and let financial institutions offer loans at a discount of 30 percent below the benchmark lending rate.
China eliminated the lower limit on lending rates offered by the nation's financial institutions as economic growth slows and authorities expand the role of markets in the world's second-biggest economy.
The change, effective today, removes a floor set at 30 percent below the current 6 percent benchmark, according to a People's Bank of China statement yesterday.
While the move temporarily jolted world stocks higher, the PBOC acknowledged that it was a limited step and said that freeing up deposit rates would be more important. The shift came as central bankers and finance ministers from Group of 20 nations gathered in Moscow, and after a cash squeeze in money markets curbed a record expansion in China's credit.
"While deposit-rate liberalization is still possible, the fact that a decision was made to just remove the lending-rate floor suggests that more aggressive liberalization proposals were defeated, or at least delayed," said Ken Peng, senior economist at BNP Paribas SA in Beijing. "This decision shows that some reform is being done, but may actually reduce the chances for deposit-rate liberalization in the near term."
Raising the deposit-rate ceiling would improve household incomes and reduce the attractiveness of non-traditional wealth management products while threatening banks' profit margins, Peng said.
Yesterday's move will lower companies' funding costs and boost financial institutions' pricing capabilities, the PBOC said. In March, only 11 percent of loans were priced below the lending benchmark, according to central bank data.
In a separate statement today addressed to financial institutions, the PBOC said banks must "actively adjust" to liberalized lending rates and "reasonably" determine lending rates based on market supply and demand, taking into account lending terms and credit risk.
The MSCI World Index of stocks reversed losses immediately after the announcement. It gained 0.2 percent as of market close in New York yesterday. The Bloomberg China-US Equity Index of the most-traded Chinese stocks in the U.S. climbed less than 0.1 percent for a second weekly rally.
Twelve-month non-deliverable yuan forwards strengthened 0.08 percent to 6.2768 per dollar in New York. It has risen 0.15 percent in the last five days, the biggest gain in eight weeks.
The nation's economy grew 7.5 percent in the second quarter from a year earlier and is at risk of the weakest expansion in 23 years. Yesterday's announcement builds on pledges by PremierLi Keqiang to expand an overhaul of interest rates, tagged by the World Bank and the International Monetary Fund as a priority in financial reform.
Lu Ting, head of Greater China economics at Bank of America Corp. in Hong Kong, said the announcement seemed a "token" move after the interbank liquidity squeeze in June and "a real move" will involve deposit rates.
China's one-year benchmark lending rate has been held at 6 percent since the last reduction in July 2012. The PBOC last year allowed banks to offer rates as much as 10 percent above the benchmark set for deposits and let financial institutions offer loans at a discount of 30 percent below the benchmark lending rate.
The nation's overnight interbank rate jumped to a record 12.85 percent on June 20 as the PBOC withheld cash and restricted its communication, spurring speculation policy makers wanted to expose banks using short-term funds too aggressively for longer-term investments.
The latest move "will have important meaning in terms of encouraging financial support for economic growth and economic restructuring and upgrading," the central bank said in its statement.
China is not yet ready for freeing up deposit rates, the "most risky" part of interest-rate liberalization, the PBOC said, adding that the nation lacks a deposit insurance system.
"We do not think this is a new policy initiative in response to the growth slowdown," said Zhang Zhiwei, chief China economist at Nomura Holdings Inc. in Hong Kong. "Credit and monetary growth will remain weak" in the second half of the year amid deleveraging, he said.
When Li took office in March, he pledged to open the economy to market forces and strip power from the government. He said at the time that the process would be "very painful and even feel like cutting one's wrist."
A key Communist Party meeting later this year may tackle reforms to the financial sector, fiscal system, land tenure, prices, income distribution and household registration.
A majority of analysts surveyed by Bloomberg News in March projected China this year would relax or remove the cap on deposit rates or the floor on lending rates. The government said in March it would this year "roll out new measures in promoting interest-rate and exchange-rate liberalization as well as in developing a multilevel capital market."
PBOC Governor Zhou Xiaochuan, who was reappointed in March after a record tenure of 10 years in the job, said in November that changes to the interest-rate system should be made at a "moderate" pace.
"This is not the same as a rate cut and the impact will be very limited," said Helen Qiao, chief Greater China economist at Morgan Stanley in Hong Kong. "Liquidity conditions are very tight -- we weren't seeing companies getting funding at anything close to the lower band before this change, so we're unlikely to see this will induce an immediate drop in rates. Lending costs come down only when funding becomes abundant."
China will maintain the floor for mortgage rates because the government will continue to curb speculative home buying and investment, according to a separate statement from the PBOC.
The central bank also said it will remove the cap on lending rates offered by rural cooperatives and also scrap controls on bill discount rates.