A forward step

China has made a tentative step on the long road towards market-determined interest rates. In addition to cutting the benchmark interest rates on loans and deposits on Thursday, the central bank widened the bands around the benchmarks.

Until now, banks had to offer depositors the benchmark deposit rate, now 3.25 per cent for one year. But the People’s Bank of China has given them permission to offer as much as 10 per cent more. The big five state-owned banks, struggling to attract funds, don’t want to lose to competition. They announced they would keep their deposit rates at 3.5 per cent. Ningbo Bank, a smaller lender, pushed its rate up to the 3.57 per cent maximum.

On the lending side, banks can lower rates up to 20 per cent below the new 6.31 per cent one-year benchmark, up from a previous 10 per cent. The lowest one-year borrowing rates will now be 5.05 per cent.

Beijing has to change because the old way of controlling the supply of credit, by setting lending targets, has become less effective. Despite quantitative loosening measures, the growth rate in the M2 money measure, which reflects new loans, has fallen below the central bank’s 14 per cent target. It suggests the main factor constraining credit growth is no longer loan quotas. So, the authorities need to cut rates to boost credit demand.

The reduction in the officially guaranteed spread between lending and deposit rates will hurt the banks’ profitability. Deutsche Bank calculates that 2012 profits would be 10 per cent lower than previously estimated if all banks push deposit rates up to the maximum, while cutting the lending rate by the minimum. But Chinese banks are probably too profitable — net earnings of the 13 listed institutions accounted for almost half the total earnings of 1,800 listed companies, according to Thomson Reuters.

The move is small, in keeping with China’s gradualist approach to reform. But it is welcome. The narrower spread and rate flexibility contributes to a helpful sort of financial liberalisation, forcing banks to become more efficient and more commercial.