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China's interest rates

2014-11-25 13:01:47

The right call

Nov 21st 2014, 17:35 by S.R. | SHANGHAI

CHINA has cut interest rates for the first time in more than two years, a

powerful signal that the government wants to step up support for the slowing

economy. As fate would have it, a rate cut was the very thing we had called for

in our leader on Chinese monetary policy this week. But we cannot claim to be

clairvoyant. We had not expected the central bank to move so quickly. Nor, for

that matter, had most analysts or investors hence the big gains for stocks,

commodities and currencies sensitive to Chinese demand in the hours following

the announcement.

It is tempting to look at the rate cut through the simple lens of GDP: lower

rates mean China is switching policy to a pro-growth footing, or so the

conclusion would go. While there is undoubtedly some truth to that, two aspects

of the decision show it is more complicated, and indeed more interesting.

First, the People s Bank of China was at pains to stress that it was not, in

fact, about growth. The economy is growing within a reasonable range , it

said. Instead, it emphasised the need to reduce corporate financing costs to

help struggling companies. A knee-jerk criticism of the rate cute is that debt

in China is already too high and this will only encourage yet more borrowing.

But over the past year, rates have been too lofty for companies to be able to

deleverage. Because producer prices are in deflationary territory, the real

financing cost for many has been above 8%. With lower rates and a little more

inflation, companies will be able refinance more cheaply and, in time, lessen

their debt burdens.

This is certainly not the first attempt by the Chinese government to reduce

financing costs. Since September it has provided nearly 800 billion yuan ($131

billion) in medium-term loans to banks on the condition that they lower

borrowing rates for small businesses. Just this week the State Council, or

cabinet, promised to loosen a rule that limits banks loans as a proportion of

their deposit base, freeing up more cash for them to lend. The central bank has

also been quick to make short-term cash injections whenever the money market

has been gummed up. But as we wrote in this week s article, these efforts have

come up short. They have been far too narrowly focused and the PBOC s lack of

transparency has caused confusion about its real aims. Friday s announcement is

a welcome change in tack. It would now be surprising if China did not follow up

with more rate cuts and more cash injections.

Second, this is an important step on the path towards interest rate

liberalisation in China. Previously, banks were allowed to set deposit rates

10% above the benchmark level; that has now been raised to 20%. Competition

among banks to attract savers should ensure that banks offer the

highest-possible rates. One-year deposit rates were effectively 3.3% before the

rate cut (10% above the 3% benchmark). They are likely to remain 3.3% (20%

above the new 2.75% benchmark). At the same time, the benchmark one-year

lending rate has been cut to 5.6%. Theoretically, lending rates have already

been liberalised, with no floor on them; in reality, bankers say they still

price loans off the benchmark.

By narrowing the margin between deposit and lending rates, the PBOC is forcing

banks to pay savers something that is closer to the actual market price for

cash. The central bank also simplified the benchmark structure it will, for

example, no longer post a five-year rate. This gives banks more flexibility to

chart their own course in setting rates.

Zhou Xiaochuan, the long-serving PBOC governor, previously vowed to usher in a

full liberalisation of interest rates within two years. That is still an

ambitious goal, but China is now a little closer to it. An oft-heard view in

recent months was that the PBOC could not ease policy because doing so would

undermine its campaign to unleash more market forces in the financial system.

This always rang hollow. The rate cut shows that reform and easing can go

together.