Financial reform is the most important economic challenge that China’s new leadership faces as it seeks to sustain reasonably rapid economic growth over the next 10 years. For some time there has been a consensus that the growth model of the Hu Jintao-Wen Jiabao era is broken. Hu and Wen presided over an economy in which the investment share of GDP rose by more than 10 percentage points, reaching the astonishing peak of 48% in 2011-12. But economic growth based on a super-elevated level of investment and systematic suppression of private consumption is not a viable long-run growth model. Consumption expenditure must become a much more important source of demand.
Let ’em rise
Reform of the financial sector is the single most important prerequisite for sustained economic rebalancing in favor of consumption. The key element of financial reform is not the introduction of complex financial instruments or further opening the domestic market to foreign financial institutions. It is rather eliminating the remaining government controls on interest rates on both deposits and loans, commonly referred to as market-oriented interest-rate liberalization. The People’s Bank of China has long set ceilings on deposit rates and floors on lending rates. In sharp contrast with the Jiang Zemin-Zhu Rongji era, when the central bank set these rates so that households earned an average real interest rate of 3% on one-year deposits, average real returns in the Hu-Wen era were negative.
Interest-rate liberalization began under Jiang and Zhu, but was largely suspended in 2004 when the central bank allowed financial institutions to adjust their lending rates upward without limit from the benchmark rates. The ceiling on deposit rates remained unchanged until June 2012, when the central bank allowed banks to pay interest rates up to 10% above newly established, slightly lower benchmark rates on deposits. Although this small relaxation only had a marginal impact, competition for depositors compelled banks to push their deposit rates to the top of the new permitted range, suggesting strongly that market-determined deposit rates lie higher. This view is shared by leading Chinese bankers such as Xiao Gang, chairman of the Bank of China, China’s fourth largest commercial bank. He has strongly supported market-oriented interest-rate liberalization, even though he anticipates it will cut net interest margins of banks by up to half.