China takes step forward on interest rate reform with rate change

The decision to expand the floating interest rate range marks an important step forward for China's market-oriented reform, known as interest rate liberalization, economists said.

The decision was announced on Friday by the People's Bank of China (PBOC) together with interest rate cuts, the first time this has been done since July 2012.

The deposit rate ceiling was raised to 120 percent of the one-year benchmark deposit rate, which stands at 2.75 percent, from the previous 110 percent "in support of market-oriented interest rate reform", the PBOC said in a statement.

Until June 2012 when the 110-percent deposit rate ceiling was introduced, China's commercial banks were generally not allowed to offer deposits rates higher than the benchmark.

"With the expansion of the upper limit of the floating range for deposit interest rates, financial institutions will have more room in pricing (deposit rates) on their own," the PBOC said in another statement.

It will also help establish a mechanism in which the interest rates are decided by the market, the PBOC said.

The central bank also canceled the five-year benchmark deposit rates, and is merging the one-/three-year and three-/five-year benchmark lending rates into a single rate at 6 percent.

"In making these changes, we think the PBOC is trying to hit two birds with one stone -- lower borrowing costs and accelerate interest rate liberalization," HSBC chief China economist Qu Hongbin said in a note.

UBS chief China economist Wang Tao echoed his view. The PBOC reduced the types of different lending and deposit rate benchmarks available, taking another step towards eventual full interest rate liberalization, she said.

Interest rate liberalization has been high on the agenda of China's overall reform. A reform masterplan, adopted at a key meeting of the Communist Party of China last November, promises to speed up the interest rate reform and allows the market to play a decisive role in resource allocation.

In March this year, central bank governor Zhou Xiaochuan said during China's annual legislative session that the country is very likely to ease its grip on banks' deposit rates -- the last and most important step of interest rate liberalization -- in the coming one or two years.

In July, Zhou reiterated that China is likely to have fully-liberalized interest rates within two years, but the timetable will depend on economic circumstances at home and abroad.

Overall, the PBOC has been following a step-by-step approach in the interest rate reform.

Last December, the PBOC allowed interbank trading of certificates of deposit (CDs), a financial instrument that gives commercial banks further market-determined pricing power, following the removal of the floor on lending rates last July.

Xiang Songzuo, chief economist at the Agricultural Bank of China, one of the country's big four lenders, said Friday's rate change was "a positive shot by the PBOC to eventually abolish the benchmark deposit and lending interest rates".

Qu of HSBC said both the simplification of the interest rates and the higher upper bound are welcome steps towards interest rate liberalization.

The rate-change decision demonstrated the central bank's commitment to push forward interest rate liberalization even as it pursues monetary easing, Qu said.

Many in the market argued, incorrectly, that the PBOC's commitment to the interest rate liberalization process should preclude monetary easing. This argument blurred two conceptually distinct economic phenomena. With Friday's decision, the PBOC proved that it can easily make this distinction, Qu said.

Wang Tao agreed. "As we have argued, rate cuts and interest rate liberalization can be compatible," she said.

On Friday, the PBOC also said that the next step will be a gradual introduction of CDs to individuals and companies, and continues to liberalize deposit interest rates in an orderly manner.