China's Wild West Interest Rate Liberalization

Nicholas Borst (Federal Reserve Bank of San Francisco)



China is conducting a large experiment with interest rate liberalization, albeit in an uncontrolled and seemingly unplanned way. The pace of official interest rate liberalization has been glacial since 2004, only recently revived with the decision to increase flexibility around the benchmark deposit rate.

Instead, an alternative system of unregulated deposits called wealth management products (WMPs) has developed. WMPs are financial products that act as a substitute to traditional bank deposits and offer savers (both consumers and enterprises) a higher rate of return. Banks sell WMPs directly or on behalf of third parties such as trust companies.

WMPs are structured in a couple different ways, with fixed or floating interest rates and with or without a principal guarantee (保本).  WMPs take savers’ money and invest in the money market, bonds, real estate, the stock market, and foreign currency investments.

WMPs have grown tremendously since 2008 and the market is getting large enough to have a significant impact on the financial system. According to Fitch Ratings, WMPs outstanding are now greater than 10 trillion renminbi and equal to 12.5 percent of total deposits.

The rapid increase of WMPs is problematic for several reasons. First, these products may turn out to be a bad deal for savers. The attraction of WMPs is the premium they offer over traditional deposits. China Bankrate (CN) lists the average rate for 6- to 12-month WMPs issued in May as 5.14 percent, compared to 3.5 percent for one-year savings deposits.

However, experienced investors know that the nominal premium is only part of the picture. What’s really important is the risk-adjusted return. Here many of the WMPs come up short. The interest on many of these products is floating and subject to declines, unlike normal savings deposits, and for most products the principle is not guaranteed. These funds often provide only murky explanations of the risks of what they invest in.

Even many of the “guaranteed principal” products are riskier than they first appear. The Chinese press is now full of stories (CN) of savers who have taken losses on their guaranteed WMPs due to deceptive fine-print put into the sales documents by banks. Given that many WMPs invest in highly speculative assets, i.e., the stock market, savers should demand an even higher premium over normal savings deposits for the risk they are taking. Regulators have already begun calling for greater transparency (CN) on the risks associated with these products and much more investor education will be needed to help protect savers.

WMPs are also potentially problematic for the financial system as a whole. Interest rate liberalization is one of the trickiest tasks facing developing countries as they modernize their financial systems. Uncontrolled interest rate liberalization in the form of WMPS is a risky approach.  The low and often negative real interest rate environment created by China’s policymakers has led savers to seek investments beyond low-yielding savings deposits, most notably in residential real estate. Banks are desperate to keep hold of these deposits and high-yielding WMPs are one way to do this. WMPs are also attractive because they allow banks to make money off sales and management fees. To pay for the higher returns on WMPs, money is invested in riskier assets such as real estate and the stock market.

Competition for deposits also forces smaller banks (CN) to offer more WMPs and higher rates of return to compete with the large banks that have more established branch networks.  This puts more pressure on their balance sheets at a time when they are already under strain from the slowdown in the real estate market. The more WMPs grow, the greater the risk will be for the buildup of systemic risks amongst smaller regional banks.

A better way forward would be to expand the flexibility around the benchmark deposit and lending rates at a more rapid pace. Greater flexibility on deposit rates will bring savers back into the formal banking system and away from risky financial products. Interest rate flexibility on both lending and deposit rates will give banks an ability to compete based off their risk-pricing ability rather than the size of their branch network. Having all of this occur within the formal banking system and under the watchful eye of regulators will help defuse the risks that are currently developing in the WMP market.

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