China frees interest rates

BOFIT Viikkokatsaus / BOFIT Weekly Review 2015/44

Effective last Saturday (Oct. 24), the People’s Bank of China eliminated its last remaining interest rate limits – the interest rate ceiling on deposits of less than one year. Following deregulation of credit interest rates in 2013 and the ending in August of the rate ceiling on deposits of more than a year, the era of limits on bank interest rates is now formally over. Freeing of interest rates is seen as a major step on China’s road to a market economy; it promotes financial market competition and allows further liberalisation of capital movements. Progress in actual deregulation of deposit rates is going to have the salutary effect of reducing demand for the more problematic and hard-to-regulate investment instruments of the shadow banking sector.

Deregulation of interest rates also encourages the shift to monetary policy implementation used in developed economies, i.e. use of true monetary policy interest rate as the main policy tool. Lacking this tool, China has been left with adjustment of reserve requirements as its main monetary policy option while the role of current reference rates is unclear. Further muddying monetary signalling is the fact that the central bank still provides funding directly to certain enterprises via state development banks. Moreover, bank lending remains directly subject to “window guidance,” which is neither transparent nor well suited to market economy rules.

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