Rates to be fully freed in 2 years

China will lift all controls over interest rates in two years to follow up on its top leaders' announcement last November that they will allow the market to play a "decisive role" in the nation's economic development. So pledged Zhou Xiaochuan, governor of the People's Bank of China, the nation's central bank, on Tuesday as he met with the press on the sidelines of the annual session of the National People's Congress.

"Liberalization of deposit rates is on our agenda," Zhou said. "I personally believe this is likely to be done within a year or two." China already axed its control over lending rates in July 2013. Removing the control of deposit rates will make its rate liberalization complete. But experts said that such a reform will create an unprecedented challenge to China's major banks, all of them State-owned at the moment, in risk management.

Chinese commercial banks used to rely on interest rate spreads for easy profits, Wen Bin, director of macroeconomic research at the Bank of China's institute of international finance, pointed out. In 2013, they posted a profit of 1.42 trillion yuan ($231 billion), equal to 2.5 percent of the nation's total GDP.

Following the interest rate reform, however, banks' rate spread will inevitably narrow, and they will have to learn new ways of doing business, Wen said. As banks would be offering their most favorable rates to large corporate clients, they could charge higher rates only to clients from small and medium-sized enterprises. But lending to SMEs is less protected by collateral and third-party guarantees, and it would require a higher level of risk management on the part of the lenders. In a pre-emptive move, some commercial banks already have adopted new methods of risk management.

They are developing new customers among the SMEs along the supply chain of the large, more financially secure companies. The commercial banks also should diversify their sources of revenue by developing more intermediary businesses such as trade finance and capital transaction. Wen said China is in the process of establishing a deposit insurance system by creating a fund to better protect investors against possible failure of the banks.

The fund will be supported by the central government and financial institutions. "The banking industry has reached a consensus that individual clients will receive full compensation for deposits below 100,000 yuan if a deposit institution goes bankrupt," he said. Li Jianjun, deputy dean of school of finance at the Central University of Finance and Economics in Beijing, said the banks should improve managing their short-term capital via the interbank lending market to ensure financial stability when they begin varying their rates in fiercer competition for deposits — especially current-account deposits. He said that the banks "strengthen their management of short-term liabilities, estimate more frequently the degree of sensitivity of the loan-deposit gap to interest rates and readjust their asset structure to match debt maturity to asset life".

Many experts agreed that the rise of Internet finance has significantly accelerated the process of China's interest rate liberalization. "The impact of Internet finance on bank liabilities is far beyond that of the capital market," said Wen, who estimated that about 2 trillion yuan of current-account deposits will be diverted to wealth management products offered on the Internet.

This will hasten more defections from traditional banks and affect their expected profit growth in 2014. The central bank has so far welcomed the burgeoning online financial service industry despite a recent CCTV commentator's call for a crackdown on the industry. Zhou, the PBOC governor, praised "market forces" — including "various types of emerging businesses" — for pushing forward China's interest rate liberalization.

"When the market seeks high-yield opportunities, interest rates may go up within a certain period. But in due time, the market will return to an equilibrium between supply and demand," he said. As for broadening the use of yuan in the world, Zhou said China is not ready to make a timetable or set a target for its speed. He noted that investors in the foreign exchange market have varying views on the trend of yuan versus US dollar. From the central bank's point of view, he said, "we do not need to take sides."