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The People's Bank of China made a bold step towards overhauling China's financial system Friday by announcing the end of government-determined lending rates. Buried within the accompanying statement, however, are hints that far more wide-reaching, transformational changes – ones with major implications for Canadian investors – may be on the immediate horizon.
Previously, Chinese banks were restricted from offering loans at less than 70 per cent of the PBoC benchmark interest rate which is currently six per cent. This rule has now been scrapped.
Mark Williams, chief Asia economist with Capital Economics, does not believe the policy change will have a major impact on lending rates, but does constitute an important step in broader credit market reform:
"In practice, the immediate difference will be small. The rapid growth of the corporate bond market has provided an alternative source of credit…. Nonetheless, this is a significant development for China's financial sector in the direction of having interest rates determined by market forces."
But the PBoC statement also hinted that far bigger financial reform news – dropping restrictions on bank deposit rates – may be on the immediate horizon (emphasis added):
"The reform this time does not expand the floating range on deposit rates. The main consideration is that deposit rate reforms will be more profound and need higher conditions."
Regulatory change allowing bank deposit rates to rise – as part of a government strategy to boost consumption at the expense of infrastructure investment – would be a pivotal moment in China's financial history.
Princeton economist Paul Krugman writes , "the Chinese economy is suddenly faced with the need for drastic "rebalancing." …Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump."
As professor Krugman notes with the phrase "diminishing returns," China is now at the point where more investment in infrastructure is leading to less growth – they've already built everything that makes economic sense.
Reforming the restrictions on the interest rates banks pay on savings – currently limited to 110 per cent of the PBoC benchmark rate – would be a huge step in moving the economy from an investment focus to one based on consumers, who have until now been only bit players in China's growth story.
To date, deposit rates have been kept artificially low – often well below the inflation rate – to provide banks with a cheap source of funding. Banks pay depositors six per cent on their savings, and then lend money to companies at rates of ten per cent or more.
Paradoxically, allowing deposit rates to rise would spur consumption. Chinese savers currently lose spending power because interest rates are often below the rate of inflation. This forces them to sock away even more of their income to afford down payments for expensive items such as cars and houses. As a result, China's savings rate is the world's highest at 51 per cent of disposable income, compared with the global average of 20 per cent. Higher interest rates on savings accounts would have an extremely positive effect on consumer wealth and spending as a result, because with their savings building faster, they would reach their downpayment targets earlier, and buy those big-ticket items sooner.
However, this consumption benefit would occur at the expense of corporate lending. Higher deposit rates means a higher cost of funding for banks, and reduced profits on corporate loans. Corporate credit, and infrastructure growth, would be restricted as a result.
The investment implications of China's ongoing credit reform are potentially enormous. The manufacturing and construction sectors that have driven the Chinese economic miracle to its dizzying heights will fall to the wayside, starved for easy credit.
The basic resources suppliers that have fed the infrastructure and real estate booms would see a sharply lower demand, at a time when they've just increased production capacity.
Retail sectors could explode higher if reforms are successful. Companies feeding cars, dishwashers, toasters, fast food or anything else into a Chinese consumer resurgence might find almost unlimited demand.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
Scott Barlow