A Blast from the Past on Interest Rate Liberalization

Nicholas Borst (Federal Reserve Bank of San Francisco)



During a recent press conference, the People’s Bank of China (PBoC) spokesperson gave an interesting response to a question about the progress of interest rate liberalization. After acknowledging that liberalizing deposit rates was the most important part of interest rate liberalization, the spokesperson stated that it was also potentially the most dangerous and that conditions were not ripe.

Rather than immediately moving forward with deposit rate liberalization, the PBoC will instead focus on the creation of interbank negotiable certificates of deposit (NCD). This will allow commercial banks to issue and trade large sum deposits among each other to manage their funding needs. Once a stable NCD market is established in the interbank market, these products will then be expanded to corporations and individuals.

NCDs are not new in China. They were first approved in the mid-1980s and were offered to individuals. Due to interest rate restrictions, these products were not especially popular. This changed in 1996 when the PBoC loosened restrictions on interest rates and revised approval procedures. As May Yan at Barclays notes, this led to a host of problems, including banks promising excessively high interest rates and issuing more NCDs than their allotted quotas allowed. Due to these problems, the PBoC decided to suspend the approval of new NCDs in 1997.

The reauthorization of interbank NCDs now, however, is more about legalizing a behavior banks are already engaging in. Over the past several years interbank deposits (同业存款) have been growing extremely rapidly. The 2013 China Financial Stability Report shows that interbank deposits grew 30 percent last year to over 12 trillion renminbi.

The driver behind their growth is a form of regulatory arbitrage. Originally interbank deposits were intended to be used mainly for transaction clearing purposes. In 2005, the PBoC lifted interest rate restrictions on these deposits, allowing banks to freely negotiate the rate and maturity. Subsequently, interbank deposits have transformed into a method of informal lending. Interbank deposits are exempt from most of the requirements and constraints on time and amounts placed on normal interbank lending. The lack of transparency and poor regulation of interbank deposits makes it a relatively risky source of funding for banks.

By giving the banks an official channel for interbank deposits, the central bank is hoping to bring this activity out of the shadows. NCDs, which are openly reported and freely tradable, should prove to be more stable. This will also be a source of support to banks that rely heavily on the interbank market for funding.  NCDs will hopefully be a more predictable source of funding and less prone to the sudden spikes seen in the interbank market when liquidity becomes tight.

From a broader perspective, the significance of allowing NCDs will depend on how quickly they are expanded to enterprises and households.  The approach of the PBoC to liberalize long-term, large sum deposits is sensible. However, to achieve the government’s goal of rebalancing, the rollout of NCDs beyond the interbank market should not be delayed for years. Compared to the Wild West interest rate liberalization already occurring via wealth management products, NCDs offer a much safer option for moving forward.

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