Ceilings and floors are not always structurally sound. In China’s banking system, for example, interest rates on deposits are subject to a ceiling, which limits the income of savers. Lending rates, meanwhile, are subject to a floor, which leads to inefficient investment and excess capacity. Both need to change, urgently.
Under its reform minded governor Zhou Xiaochuan, the People’s Bank of China has consistently stressed the need to embrace more market-oriented rates of interest. Between 2004 and 2008, the PBoC made some progress, scrapping ceilings on lending and floors on deposits, while encouraging new entrants and new instruments in less highly-regulated money markets. Yet the pace of liberalisation has stalled since the global financial crisis – perhaps as a result of clashes with less market-friendly factions at the National Development and Reform Commission. Sunday’s response to March’s higher-than-expected inflation number – another increase in banks’ reserve requirement ratio – confirmed that China would rather adjust the quantity of money in the system, rather than the price of it. Since January 2010, when the current tightening cycle began, adjustments to the RRR have outnumbered deposit rate and lending rate increases by two to one.
Allowing deposit rates to float upwards could temper inflation by absorbing excess cash, and might also gradually enable the market to price in expectations of interest-rate rises. Liberalising lending rates, meanwhile, would allow banks to compete on their ability to price risk, rather than on their ability to skirt a benchmark. China’s banking sector has grown very rapidly: the ten biggest lenders expanded their total loan books by an average of 63 per cent between December 2008 and December 2010. Now it needs to grow intelligently. Fixed loan-deposit spreads have given banks an “iron rice bowl.” It is time to take it away.