New benchmark rate system is needed

The liberalization of deposit rates promised by Zhou Xiaochuan, governor of the People's Bank of China, at a recent press briefing at the just-concluded annual session of the National People's Congress, will mark the country's final step in allowing banks to set their own interest rates.

"Deposit rate liberalization is on our agenda. Personally I think it is very likely to be realized within one to two years," Zhou said. China's current ceiling on deposit rates is 110 percent of the benchmark set by its central bank and its controls on deposit rates are expected to be lifted sooner than anticipated. This will mean the basic completion of China's market-based interest rate reforms.

China has never stopped taking steps toward the marketized reform of its interest rate mechanism, which started in 1993, and has achieved significant progress. Except for the upper ceiling put on deposit rates, China has so far imposed very few restrictions on its interest rates. For example, the prices of China's currency and bond market, including inter-bank borrowing, national debt, as well as financial and enterprise bonds, are all free of government regulations. Marketized rates for foreign currency deposits and loans have also been adopted in China. Especially since the suspension of the bottom limit for lending rates in July last year, regulatory measures that have been preserved for the country's credit market are only the upper ceiling on deposit rates.

Such gradual marketized rate reforms have strengthened the market's role in the formation of interest rates, but the actual effects have not been as good as expected and the distortion of the market pricing mechanism and inefficient distribution of resources are still very common. In other words, China has achieved superficially significant progress in its push for the marketized reform of interest rates, but it has failed to straighten out the distorted interest rates pricing mechanism over the past two decades. It has neither formed an effective rates pricing mechanism for its financial market nor remarkably raised the operating efficiency of the domestic financial system. On the contrary, the rural economy, the private sector and small and medium-sized enterprises that should have benefited more from rate liberalization have not got more room for development than before.

At the same time, some financial innovations created in this process have not been used to raise the financial sector's capability of serving the real economy, instead they have been used as a tool for evading financial monitoring or for circulating funds within the financial sector in search of greater profits. For example, the recently-popular Yu'ebao, a kind of Internet financial product, seems to have broken government limitations on deposit rates and will increase investors' returns, but it is actually a form of financial resources self-circulation within the financial system. Its creation will help break the current interest rates regulations and push for rates marketization, but its positive effect on the real economy will be very limited.

Quite a few financial innovations have not played a role in promoting the development of the real economy. Instead, their creation, by further extending the money chain, has resulted in excessive credit expansion and thus weakened the role of the financial sector in supporting the real economy and considerably increased the risks of the whole financial system. For example, the current excessive credit expansion by some banks, a serious financial disintermediation, the prevalence of shadow banks, the financing vehicles of local governments, a unreasonable financing structure, as well as a booming Internet financial business, swollen real estate bubbles and the two-track interest rate system are all related to the serious distortion of the pricing mechanism in the domestic financial market and the sluggish marketized reform of interest rates. All these mean that marketized rate reform in China should not be just accelerating deposit rates regulation alone, the country should also try to address a series of thorny institutional problems.

In developed economies such as the United States and European countries, benchmark rates regulated by central banks usually comprise an official benchmark and a marketized benchmark, with both acting as benchmark prices to guide the price changes in their financial markets. However, in China, only one-year deposit and lending rates act as the benchmark. Different from developed economies where their financial market prices can influence their benchmark rates, the prices of financial products in China are all based on its benchmark rates. For example, the prices of China's government bonds yield curve are not based on non-risk returns, but based on its benchmark rates. As far as the country's one-year deposit and lending rates are concerned, it remains unclear what determinants, whether a subjective decision of the leaders or a compromise of interests distribution or data analyses, lead to their final adoption. Under such circumstances, it is difficult for China to ensure an equilibrium price for its financial products as is the case in developed countries.

Aside from lifting the control on deposit rates, China should set a new benchmark rate system to replace the current one-year benchmark rates as a more substantial step toward pushing for the final liberalization of rates. The lack of such a system will seriously hamper steps toward marketized rates reform. The country should also gradually suspend the upper ceiling put on deposits as a key way of accelerating the liberalization of deposit rates. At the same time, a deposit insurance system and the exit and bankruptcy mechanism for financial institutions should be adopted a soon as possible to offer sound institutional arrangements for the marketization of deposit rates.

The author Yi Xianrong is a researcher with the Institute of Finance and Banking with the Chinese Academy of Social Sciences