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Our Long-Term View on Rate Liberation in China

There's significant risks in further reform under the current situation

Iris Tan, CFA 9 December, 2011 | 5:05PM

Despite a weakening economic outlook, Chinese banks recorded robust earnings results year to date in 2011. However, bank deposit balances grew at their slowest pace in recent years, stalling growth in new loans and interest-bearing assets. Meanwhile, the Reserve Bank of India started to free banks to determine their own rates of interest paid to savings account holders in late October. One of the major factors pushing the Indian deregulation is long-term negative interest rates driving funds out of bank deposits, resulting in irrational asset price increases. The similarities between the inflation and deposit growth trends in China are causing investors to pay attention to headway in interest rate liberation.

The Chinese banking sector experienced dramatic changes during the past 30 years, evolving from an antiquated, mono-bank system to the country’s pillar industry, channeling more than half of total social financing with more than a thousand commercial banks. However, China’s banking system is still heavily regulated and closely guided. The government has a strong influence on interest rates, lending quotas, and even the lending structure. Instead of setting the interbank rate, the central bank set the borrowing and lending rate along the entire yield curve.

The regulated rates set by the central bank serve as an effective tool to finance the country’s infrastructure development and manufacturing base (research by Morningstar analyst Daniel Rohr showed that investment in China accounted for a remarkable 46.8% share of real GDP from 2008 to 2010, versus 43.7% share from 2001 to 2010). On the other hand, the exploding liquidity and inefficient use of cheap credit breeds inflation.

Since 2003, the regulated deposit rates have lagged behind inflation more often (during the 106-month period up to October, negative real rates represented 36% and 71% of time, respectively, during the periods before and after 2007). Chinese depositors are constantly losing purchasing power because of the negative rates, leading to a further decline in consumption share of real GDP to 34.6% from 2008 to 2010, from 45.6% from 1991 to 2000. The fat “bank spread” (the standard one-year lending rate minus the one-year deposit rate historically stayed above 3%) and cheap rates result in robust lending demand and banks’ overemphasis on growth, forcing the government to take quantitative-based instruments of monetary control. However, the quantitative controls distort the government’s influence on the market-determined money market rates (the seven-day Shibor rates saw greater fluctuations since late 2010 when China tightened the monetary policy and the gap between Shibor and one-year deposit rate surged to a staggering 270 bps in mid-2011).

The monetary tightening tends to drive out more lending to SMEs than to SOEs, as banks have little incentive to grow the SME business because of the fat spread protection. As a result, the country’s monetary tightening more often ends up with a bankruptcy wave of private firms, as we saw in 2008 and recently. This indirectly suggests that the lack of market-determined interest rates robs regulators of critical information on macroeconomic and liquidity conditions.

Since interest rate reform began when the upper limit on interbank lending rates was abolished in 1996, most of the necessary steps toward liberation have been already taken. Now the final step still remains to lift the ceiling on deposit rates and the floor on lending rates and there’s little progress since 2004. Despite strong financial results of banks thanks to regulatory protection and strong loan demand driven by negative rates, financial disintermediation and resulting anaemic growth in household deposits seemed to impose some hidden costs of interest rate liberation for Chinese banks. First, Chinese banks experienced the slowest year-on-year deposit growth in September and October since 2003, with household savings growing much slower at 10% (a mere 4% YTM growth from the year beginning), the second-lowest growth only after the last inflationary period in mid-2007.

As more than half of 15 listed banks recorded a loan/deposit ratio near or exceeding the regulatory limits of 75%, the strength in banks’ deposit franchises become the key determinant of profitability and asset growth. By the end of September total loan balance and interest-bearing assets of listed banks merely increased 2.6% and 0.4% sequentially. Second, as depositors adjusted their asset allocation in search of higher-yield assets, cash and deposits with banks as a share of Chinese households’ total financial assets fell to 70% from 85% in 2005, while the share of wealth management products mainly offered or marketed through banks climbed to 12% from 8%. Banks have been fiercely fighting for deposits through offering higher-yield, short-term wealth management products or illegally giving out customer rebates for large deposits.

Further interest rate reform has been put on the government’s agenda since China’s 12th Five-Year Plan promised to gradually promote deregulation of deposit interest rates. Other countries’ liberation experience showed governments were often forced to implement deposit rate liberation when banks faced greater competition for deposits from other fixed-income types of securities (such as bonds and money market funds). Though this shares a similar situation in China, we believe the government still has room to speed up deposit growth by cutting the record-high deposit reserve ratio and spurring lending growth. More importantly, we believe there are still certain conditions that need to be met, including macroeconomic stability and less reliance on social financing on the banking system.

Given the struggling economic restructuring, European sovereign debt crises, and a heavy dependence on the banking system in the provision of social financing (bank lending contributed about 63% of new social financing for the first three quarters), there’s significant risks in further reform under the current situation. Regulators should be aware that reforms often cause banks to enter too-risky business or balloon their loan scale, resulting in a credit crisis afterward. Besides, successful reform requires market-based pricing mechanisms and further improvement of monetary policy transmission, which in turn requires enhancing the depth and breadth of the debt market (in China, the debt market accounts for more than one third of the total bank lending).

Based on our economic outlook we believe good timing may occur after late 2012, when the global financial crisis abates and China starts showing positive signs of economic rebalancing, in which the booming private economy and household consumption should ensure the smooth transition in bank loans’ mix to higher-priced SMEs and consumer lending, from lending to SOEs and infrastructure projects. Also, the relatively abundant liquidity (M2 to GDP stood at record high of 180% in 2010, and we project it will stay high in the subsequent years) and normalised monetary stance should help the banks ease the upward pressure on deposit rates after the liberation.

We expect reform will be slow in China, given the importance of the banking system and its meaningful contribution to the country’s fiscal income (the top five state-owned banks paid out CNY 119 billion to their largest shareholders, Central Huijin and the Ministry of Finance, representing 1.4% of the country’s 2010 fiscal income, besides dividend payments to other SOE shareholders). Like many other countries, lending floor and longer-term deposit rates are likely to be liberalised first. We don’t expect it to have significant impact on banks as currently longer-term deposits and loans at below-standard rates account for less than 7% of total deposit and bank loans, respectively. They should be able to offset each other to some extent, thus we expect the liberation of near-term deposits should have meaningful impact on the banks. Theoretically banks’ net interest margin will narrow due to rising funding costs right after the liberation, while it will pick up as banks gradually change their loan mix. We believe the long-term trend in NIM largely depends on how the economic rebalancing will play out.

An empirical study from the IMF working paper “Interest Rate liberalization in China” by Tarhan Feyzioglu, Nathan Porter, and Elod Takats showed that the elimination of deposit rates often leads to lower concentration in the deposit market, as smaller banks offer higher deposit rates to entice depositing at larger banks, while large banks tend to shrink deposit bases in correspondence to rising funding costs. The cost of interbank funds, upon which the central bank has great influence, should place an effective cap on the deposit rate after liberation. As the lending market has been largely liberalised, impact on the lending side should be smaller and more gradual. We expect greater divergence among banks due to different levels of competitive advantages and management executions.

So based on our outlook, if there’s no server inflation or strong competition from a higher-yield, deposit-like product making it difficult for banks to grow deposits, we expect the reform to be gradual, which should have limited profitability erosion to the sector in the short run. The deregulation of longer-term deposit rates will result in a lower portion of demand deposit in banks’ deposit mix and help lower the debt/deposit ratio. We expect banks with a strong deposit base (such as Industrial and Commercial Bank of China, because of its dominating position in retail banking, and Agricultural Bank of China, thanks to its strong foothold in the underserved rural market), banks with greater exposure to non-interest income (such as Bank of China, with a broad range of financial services) will experience smaller impact in the deposit side. Meanwhile, banks with a competitive edge in retail banking and SME lending, including China Merchants Bank and China Minsheng Bank, will be backed by their first-mover advantages in the above-mentioned business lines.

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About Author

Iris Tan, CFA  Iris Tan, CFA, is a senior stock analyst with Morningstar.