In December 2015, the People’s Bank of China (PBoC) finally removed the ceiling on time deposits, ushering in a new era of full interest rate liberalization. Chinese commercial banks now have full flexibility to set their own interest rates for deposits and loans—based on their individual risk and return expectations—rather than being required to use official interest rates prescribed by the central bank.
As expected, the interest rates offered by different commercial banks have now begun to deviate from the official rates quoted by the PBoC. Banks’ credit quality and financial strength have emerged as the key determinants of the rates they offer—with weaker banks offering higher time deposit rates, while the “big five” commercial banks (as befits their status as systemically important institutions) offer the market’s lowest, albeit still higher than official PBoC policy rates.
This new era—of interest rate flexibility, limited government deposit guarantees and increased market risks—has created challenges and uncertainties for investors more familiar with the certainties and constraints of the preceding policy.
What does this mean for corporate investors in China?
Interest rate liberalization has diminished the power of a central bank policy rate change. Historically, when the PBoC moved key policy rates (e.g. one-year deposit and lending rates), it sent a strong signal and had an immediate impact on the cost and supply of liquidity. Despite the continued economic slowdown, the PBoC has not cut policy rates or the reserve requirement ratio in almost a year. The PBoC is aware that rate cuts could further encourage currency depreciation and stimulate asset price bubbles—both outcomes it would like to avoid. Instead, the new interest rate regime, requires investors to pay closer attention to the other tools the PBoC is now utilizing to implement policy.
The PBoC is now proactively using open market operations (OMO) to signal policy changes and adjust the price and supply of market liquidity. These operations include repurchase agreements (repos), reverse repos, a medium-term lending program and a short-term lending facility.
The outer bounds of the PBoC’s short-term interest rate corridor are determined by the standing lending facility (the ceiling rate at which commercial banks can borrow from the PBoC) and the excess reserves rate (the floor rate at which commercial banks can lend to the PBoC).
Within this wide range, the PBoC uses repo and reverse repo rates with different tenors to set new, unofficial targets. By changing the size of repo and reverse repos it offers, the central bank can boost or tighten market liquidity; adjusting repo rates and tenors allows it to signal its intentions to the market and adjust the cost of funding.
For investors, the range of commercial bank products and rates has expanded exponentially, with many more attractive interest rates available than previously. However, the risks and effort to secure the best rate and to minimize counterparty risk have become significantly more challenging.
Source: Bloomberg and J.P. Morgan; as of 31 August 2016.
Source: Bloomberg, Wind and J.P. Morgan Asset Management; as of 31 August 2016.