Chinese government officials, academics and policy advisors have been debating heatedly the sequencing of China’s financial reforms. The official line is to implement the different reforms simultaneously in a coordinated way. But some senior officials dispute this, arguing for a sequenced approach. This split in official opinion has caused confusion in the markets about the pace and depth of the reforms. Some investors are skeptical about the overall reform process, while others are optimistic that ‘big bang’ reforms are unfolding.
Some of this optimism is justified. China’s leaders have created a strong reform momentum by tolerating slow growth, waging a war against corruption and forcing deleveraging in the economy. However, recent evidence shows that they are erring on the side of caution. In light of this, investors should be realistic about their expectations on China’s reform delivery.
Take the renminbi (RMB) trading band-widening in March. Optimists hailed it as a big step toward financial liberalisation, but it was in fact a widely-expected small step. Arguably, the band-widening has not gone far enough. The People’s Bank of China (PBoC) still set the daily fixing rate, which is based on the past 10 trading days’ average closing rate plus a degree of discretion which allows the PBoC to set the direction of the exchange rate, irrespective of the trading band width.
In addition to widening the trading band, the PBoC could have tied the daily fixing rate to the previous day’s closing rate. This would have given the market more influence in the direction and pace of the RMB’s movement. But a ‘drastic’ change like this looks unlikely in the short-term. Beijing, as announced in the senior leaders’ policy addresses for 2014, ranks exchange rate reform below other ‘major priorities’, such as fiscal reform, urbanisation and interest rate liberalisation.
Despite the hype generated by PBoC governor Zhao Xiaochuan’s recent comment about completing interest rate liberalisation within two years, progress towards this goal can hardly be described as ‘big’. Even in the senior policy circles, some officials believe that China is not yet ready for free-market interest rates because the soft budget constraints that local governments and state-owned enterprises (SOEs) are still enjoying have made market interest rates irrelevant.
Optimists who believe the only interest rate control remaining is the savings deposit rate cap, set at 10% of the official benchmark rate, should think again. It took China 17 years to liberalise interest rates to the current extent. In 1996, the ceiling on interbank lending rates was scrapped; in 2004 the ceiling on all lending rates and the floor on all deposit rates were abolished; and in 2013 the floor on all lending rates was scrapped. Just scrapping the lending rate controls took nine years. Things may speed up now, but scrapping the ceiling/floor on rates is not enough because there are hidden controls.
Consider this. With all lending rate restrictions being abolished, why does Beijing still keep the supposedly non-binding constraint of the benchmark lending rates? The reason is that SOEs and local governments still borrow at the benchmark rates, and they remain the only entities that have access to these preferential rates.
One set of official data shows that local governments account for over 90% of all domestic investment; other official data shows that SOEs account for over a third of domestic investment. There is no detailed data breakdown to clarify the overlapping. The point is that these entities, with their soft budget constraints, are still driving most domestic investment. Retaining the benchmark lending rates mutes the effects of interest rate liberalisation and is representative of the hidden interest rate controls.
Clearly, much preparatory work remains that requires the leadership to break the political logjam and overcome the vested interests before it can complete financial liberalisation. In the meantime, risk-averse Beijing will probably not engage in ‘big bang’ reforms.
Senior Strategist, BNPP IP
This blog was originally published for BNPP IP’s professional investor clients. | 21 May 2014 – 1