Camille Accad*

 

CHINESE officials recently announced policy measures that would reduce liquidity tensions in the country and boost economic growth.



The country’s benchmark lending and deposit rates were cut by 25 basis points to all-time lows of 4.6% and 1.75% respectively, which will lower financing costs and boost fixed-asset investment.



Additionally, the banks’ reserve requirement ratio (RRR), a policy tool that determines banks’ holdings of reserves, was also lowered by 50 basis points.



The RRR cut is estimated to release more than RMB600 billion ($94 billion) into the banking system. The latest moves eased concerns about the Chinese slowdown and reassured markets that the government is determined to support the economy.



As a result, by the end of last week, stock markets were no longer declining anymore like in the previous couple of days.



At the same time, a key reform was implemented. The Chinese central bank removed the interest rate ceiling for deposits with a maturity of one year and above, but kept ceilings unchanged at 1.5x the benchmark rate for short-term deposits.



The central bank had been gradually liberalizing the deposit rate this year, increasing the ceiling from 1.2x, to 1.3x and 1.5x the benchmark rate in March and May respectively.



The previous changes have increased the variation of interest rates offered by Chinese banks, but the latest move has taken China inches away from full interest rate liberalization, an inconceivable feat just a year ago.



The implications are huge. The lending rate has been liberalized since 2013, but because the deposit rate was fixed, the fluctuations in the cost of borrowing capital, determined by the interbank rate, were small.



This ultimately restricted banks from freely setting their rates. As a result, returns from deposits have not been competitive and Chinese individuals have been forced to seek better returns elsewhere.



With restrictions on investing abroad, cash has been allocated in either non-regulated financial assets, property or the stock market, resulting in numerous bubbles.



Restriction in the interest rates was one of the major reasons behind the Shanghai stock exchange bubble that preceded the recent sell-off.



With the latest move, if banks are in fact given full control of their rates, the increased competitiveness will improve the allocation of capital, reducing pressure on other assets that might have overheated otherwise.



But the Chinese government still needs to ease restrictions on foreign investment. Another positive factor behind the latest measure is that it will allow the central bank to exercise a more traditional monetary policy, in which it can target, and be judged, by interbank rates, determined by demand and supply factors.



More importantly, it gives the central bank more transparency to its policies, a core aspect that has been lacking, exacerbating the correction in Chinese stocks.



The positive aspect of the correction is that it has forced the government to accelerate some measures. In the last year or so, China has been increasingly liberalizing the economy, injecting liquidity at the same time.



The five policy rate cuts executed since November 2014 have been accompanied by various reforms, including the claimed RMB deregulation and the opening of the stock market to foreign investors.



The latest measures fit with the government’s objectives of implementing reforms while trying to minimize economic and financial instability; and more are expected to follow.



The central bank’s chief economist suggested that short-term interest rates would soon be liberalized too. Although still far from the final line, China has not given up on turning its economy into a liberalized consumption-based one.



And although it will continue to rely on traditional investment-based stimulus, China is too far from the starting line to reverse its course of action.



At this stage, Chinese authorities need to work on their credibility, and more importantly on their transparency, as they continue on their path to open their economy to the outside world.



* The writer is an economist at Asiya Investments Company