The EconomistApril 4th 2020 Finance & economics 67I
n 1979 , whenPaul Volcker started jacking up interest rates to
quell inflation in America, China launched a radical experiment
of its own: it created commercial banks. Deng Xiaoping was trying
to steer the country away from central planning. Four decades on,
Mr Volcker’s job long done, China’s transition is still unfolding. For
evidence of this, look at its interest-rate muddle amid the corona-
virus-induced slowdown. Ask a Chinese economist what the
benchmark rate is today—a simple question in most countries—
and brace yourself for an avalanche of acronyms and numbers.
There are, to name the main contenders, the one-year deposit
rate (now 1.5%), the seven-day reverse-repurchase rate (known as
the dr007, 2.2%), the medium-term lending facility (mlf, 3.15%)
and the one-year loan prime rate (lpr, 4.05%). Each, depending on
one’s focus, has a claim to benchmark status. Sorting through all
these rates is not merely an exercise in banking esoterica. It is a
window into how China manages its financial system.
Start with the basics. China’s central bank is highly interven-
tionist, by design. For years it set loan quotas for banks, told them
what sectors to support and dictated the rates at which they took
deposits or extended loans. To varying degrees, it still wields these
powers. But with the economy ever bigger, Chinese officials know
such a broad remit is untenable. So their goal, first declared a quar-
ter-century ago, is interest-rate liberalisation: to let banks make
their own decisions. In a fully liberalised system, the People’s Bank
of China would focus on a single rate that anchors the economy,
adjusting it as needed—the Platonic ideal of any central bank.
Over the past few years China seemed to make strides in this di-
rection. The central bank began phasing out its fixed lending and
deposit rates. In their place it emphasised more flexible rates. It
developed a wide corridor for guiding rates, anchored by the
dr007 (the rate at which banks lend to each other) and the mlf(a
monthly open-market facility). Meanwhile the lpr, the rate for
lending to prime customers, became the new standard for all
loans. Its pricing was based on the mlf, which in turn reflected the
dr007. It might sound like a right mess. But squint hard enough
and it looks like modern central banking: the People’s Bank keeps
interest rates within a target range by managing the level of cash in
the financial system.
Yet the covid-19 crisis has shown that this is only part of the
story. The central bank has cut its newer, more flexible rates to low-
er lending costs. But the current debate, fuelled by the central bank
itself, is over when it will cut the benchmark deposit rate—that is,one of the traditional fixed rates. That makes it clear that interest
rates in China are not yet liberalised. The central bank still has a
firm grip on rates paid to savers (the benchmark deposit rate) and a
strong, if more nuanced, hold on lending rates (the dr007-mlf-
lpralphabet soup).
Why is it so hard for the government to let go? The explanation
can be found in two striking facts about Chinese interest rates.
First, they are much lower than one would expect for an economy
growing so quickly, coronavirus notwithstanding. The real one-
year deposit rate is negative. This is not new. China has long been
an exemplar of financial repression, limiting savers’ returns in or-
der to make cheap funds available to finance sky-high investment.
Second, despite the low interest rates, Chinese banks are im-
mensely profitable. According to the latest data, they account for
17% of the market capitalisation of the domestic stockmarket but
39% of the profits of all listed firms. The secret of their success is
the spread between what they pay savers and charge borrowers, or
the net interest margin. It is not that they are so brilliant at manag-
ing their books. Rather, the lack of true rate liberalisation assures
them a net interest margin of two percentage points.Thank a banker
Their giant profits mean that banks are often a lightning-rod for
criticism in China (evidence that in these troubled times, more
still unites the world than divides it). In a report in February, the
People’s Bank mounted a defence. Fully 60% of banks’ profits go to
replenishing their capital, which lets them extend more loans to
businesses and households. Everyone thus benefits, it argued.
In the Chinese context it has a point. Where banks go, so goes
the economy. Banks’ assets are worth 175% of gdp, more than in
any other country, according to a core measure used by the World
Bank (see chart). Many analysts think that China’s banks can ex-
pand their loans by about 10% a year while making big enough re-
turns to preserve their capital buffers. In a normal year these new
loans would be expected to generate economic growth of about
6%, with a mild rise in total indebtedness. The link between lend-
ing and growth is a closed loop that works, assuming no major cap-
ital outflows and no sustained declines in asset quality.
Even the coronavirus shock need not break this loop. Of course
growth has suffered. But because credit demand is determined by
the volume of investment approved by the government, and not
animal spirits, loans might accelerate. Such state-led lending is
likely to lower efficiency, but that is a long-term problem.
True rate liberalisation constitutes a bigger short-term threat.
China got a taste of that over the past decade. The rise of more in-
vestment options for savers, such as online money-market funds,
forced banks to compete more for deposits. They got around rate
caps by marketing investment products with higher yields. But
higher funding costs led them to find riskier clients and to in-
crease their own leverage. The dangers were made plain last year
when the government helped to rescue three overextended, if pe-
ripheral, banks.
So in the name of financial de-risking, regulators have steadily
pushed banks back towards the plain-vanilla business of taking
deposits and extending loans. Hence the pressure on the central
bank to cut deposit rates at the same time as it lowers lending rates.
This way, the closed loop—from new loans to new deposits to bank
profits, and around to new loans again—will remain intact. And
the liberalisation of China’s banking system can wait for a sunnier
day, as it always has—and, as a cynic might say, always will. 7Free exchange Chinese rate trap
What its interest-rate muddle says about China’s financial systemPick a number, any numberSources: Wind Info; World Bank6 5 4 3 2 1 020191817162015China, interest rates, %Medium-term lending facilityOne-year loan prime rateOne-year deposit rateSeven-day reverse-repo rateUnited
StatesGermanyBritainJapanChina200150100500Bank assets*
2017, % of GDP*Claims on domestic non-financial borrowers