In the Twelfth Five-Year Plan outlined on the Fifth Plenary Session of the 17th CPC National Congress, a paragraph is dedicated to the financial reform. Its first sentence reads: “a counter-cyclical framework for financial macro-prudential management will be built”. I spoke on this topic in Peking University the day before yesterday, and today I would like to offer some thoughts on the second sentence of the paragraph, which is about “gradually promoting the market-based interest rate reform”.
1. Why we are to promote the market-based interest rate reform?
First, the availability of market-based interest rate is an important component in enabling market allocation of resources. In 1992, to build a socialist market economy became an objective of the reform program, and the market was meant to play a fundamental role in resources allocation so as to maximize the latter’s efficiency. Interest rate, as an important gauge of price of capital, should play a role in this process, to optimize the allocation of capital. Meanwhile, interest rate also serves as a benchmark for pricing many other financial products.
Second, market-based interest rate reform should reflect financial institutions’ autonomy to price their products. Since the onset of the reform, autonomy of enterprises has always been emphasized, including the pricing autonomy, the most essential form of autonomy. In the financial sector, all financial institutions but policy ones operate on a fully commercial basis, and an important sign of their autonomy is to independently price their products and services.
The third reason is that the market-based interest rate reflects the right of choice on the customers’ side. Customers of financial institutions, including households, enterprises or various other types of entities, have the right to choose in a competitive market. It is perfectly all right if they are satisfied or not satisfied with services and prices offered to them, if they choose company A instead of B, and if they go for similar but differently priced financial products as substitutes. Due to the market-based interest rate reform, financial institutions are obliged to offer a wide variety of financial products and services.
Fourth, market-based interest rates reflect demand and supply relationship of financial products and services, as well as risk-taking and risk pricing of financial institutions. In a market economy, financial products, like other merchandise, are diversified, and products of different brands and specifications are on offer and target different customer groups. At the same time, financial institutions might have different judgments on risks of the same project and the same client, which is reflected in the product price.
Finally, macroeconomic management necessitates the market-based interest rate reform. Macroeconomic management, in particular monetary policy of the central bank featuring indirect adjustment in a socialist market economy, needs an effective transmission mechanism to influence price discovery in the marketplace.
2. Process of the market-based interest rate reform
The market-based interest rate reform is a process. Since the Asian financial crisis, the interest rate reform has gone through the following phases.
First, interest rates on foreign currency-denominated deposits and loans were liberalized step by step. This happened largely before 2004.
In the second step, banks were given a bigger autonomy in determining deposit and lending interest rates. Before 2003, banks were free to offer interest rates within a band 30 percent below and above the prescribed benchmarks, and the ceiling of lending rates was expanded to 1.7 times of the benchmark rates in 2004. In October 2004, the ceiling of lending rate was lifted, but the floor lending rate was capped at 0.9 times of the benchmark rate and not fully liberalized. At the same time, the floor of deposit rates was abolished.
In the third step, interest rates on enterprise bonds, financial bonds, commercial bills and transactions on the money market were priced by the market. The development of notes and corporate bonds, especially the growing transactions on the OTC and the secondary market, has made prices more market-oriented. A lot of enterprises, in particular efficient ones, were able to get financing by issuing notes and bonds, and the prices were no longer bound by the benchmark interest rates on loans.
Fourth, the band of interest rates on commercial housing mortgage loans was further expanded. In August 2006, the floating band was expanded to 0.85 times of the benchmark interest rates. After the devastating Wenchuan earthquake in May 2008, the People’s Bank of China (PBC) gave more autonomy to financial institutions in mortgage interest rates to support the post-disaster reconstruction, lowering the floor of commercial housing mortgage rate to 0.7 times of the benchmark rate. However, we have observed that in practice financial institutions were not very keen to determine mortgage rates on their own.
3. Conditions for furthering the market-based interest rate reform
The interest rate reform is interconnected with other reform programs. To further the reform, we need to discuss what conditions should be created and how to support it.
First, market-based interest rates are the outcome of market competition; therefore, a market environment for fair competition is needed. When financial institutions price their products and services in a competitive market where there are a wide spectrum of products, though it is possible that pricing is skewed, the prices are generally reasonable and at an equilibrium level.
The first and foremost condition for market competition is strict, rather than soft, financial constraints. Considerable problems will occur if enterprises with soft financial disciplines compete with enterprises with strict disciplines. Between 2003 and 2004, the below question was debated: problems would emerge when policy banks and commercial banks that fell short of capital adequacy requirements compete with compliant banks. Financial disciplines of commercial banks and policy banks are completely different, and fair competition is impossible between subsidized and non-subsidized institutions, between institutions with capital disciplines and those without. Therefore, the first and foremost condition is strict financial discipline. This is especially important in China as the market exit mechanism is yet to be established, market disciplines are not so effective, and implicit guarantee for depositors is still prevalent.
Apart from strict disciplines, desperate competition should also be avoided, which means that problems-ridden institutions tend to take excessive risks, and compete with others by offering abnormal interest rates. This round of financial crisis has shown that financial institutions, when in difficulty, usually try to attract deposits with high interest rates or high-yield products to get funds to cover problems on their balance sheets. Quite a few institutions acted like this during the crisis, and similar phenomenon happened in China too. For example, some problematic securities firms issued grossly huge amount of OTC bonds at very high interest rates. This was against the rules, and was a symptom of desperate competition that disrupted normal competition order.
The second condition is acceptance of market interest rates by bank customers. In a goods market, consumers usually shop around to compare prices. However, in the financial market, due to many years of command economy, some customers are not used to differentiated pricing of bank products. When unsatisfied with a particular price, the customer complains to or blames the government in a hope that the government would intervene. Coming back to massive government intervention would be retrogression, and would make product pricing a political behavior of the bank rather than an outcome of market competition. This would deprive the market of a competition mechanism and autonomous pricing power that are indispensable for the interest rate reform.
Third, commercial banks should take responsibilities for their own risk pricing. Commercial banks determine prices based on their independent judgment of risk premium. In this process, if the price is set too high, they run the risk of losing customers and market share. Commercial banks should carefully weigh and judge independent pricing and maintaining customer base (and market share), and customers should no longer simply attribute prices to the central bank or the government. The international trend is that commercial banks have shifted the focus of competition from winning customers and market share to more comprehensive goals. In China, customers base and market share are still the major goals of commercial banks. This situation should change; otherwise, banks would not use pricing autonomy for fear of the ensuing responsibilities.
The fourth condition is to make the entire financial products and services price system more market-oriented. Prices are always an organic whole, with different prices interconnected with one another. In the goods market, an enterprise is faced with a system comprising of prices of upstream, downstream and alternative products. In the price system, if some prices are fixed or administered by the government, and others are decided by market forces, enterprises will find it difficult to price their products and services in a market-oriented manner. To reduce the share of income from interest rate spread in their total income, they need to consider not only determining interest rates on deposits and loans, but also prices of intermediary products and services linked to deposits and loans or alternative products and services.
As for pricing of some intermediary products and services, some people still advocate for continued government control, and some customers do not like the prices offered, and want the government to intervene. Therefore, if interest rates are left to the market to decide, and if prices of connected intermediary products and services continue to be administered, then new distortion would occur, and commercial banks would not have enough incentives to develop intermediary business. As such, interest rates are prices of many related financial products and services. We need to reform the interconnected pricing system before the market-based interest rates are truly market based.
The fifth condition is to further improve the monetary policy transmission mechanism. In a normal economic environment or during a crisis, when the monetary policy of the central bank is fully transmitted, policy intention will have an effective route to impact the financial system and the real economy. This way, interests at the macro- and micro-levels will be coordinated, and social benefits will be maximized and side effects minimized.
Sixth, the interest rate reform also involves sharing the costs incurred in the reform of the banking system. How to cover and absorb the costs of the banking reform is very relevant for the interest rate reform, and successful resolution of the historical problems can create favorable conditions for the reform in the future.
Seventh, the roles of the government and the media in the market-based interest rate reform are very important.
4. Considerations about further promotion of the market-based interest rate reform
How to further promote the market-based interest rate reform in the Twelfth Five-Year Plan period? Currently discussions have already come about, and the Twelfth Five-year Plan outline is being framed as well. Here I would like to give some initial considerations.
The first is to select financial institutions with strict disciplines, and let them determine prices in a competitive market, while at the same time excluding institutions with soft financial disciplines to some extent. As mentioned above, when we started to reform the state-owned commercial banks in 2003, the reform progress was uneven, and the self-discipline of banks also differentiated. Some banks had already accomplished financial restructuring, with relatively high capital adequacy ratios and relatively strong capital disciplines, while others had negative capital adequacy ratios and no capital disciplines. Under this condition, competition was severely undermined. Things have changed a lot since the recent massive reform of financial institutions. Almost all the large and medium-sized commercial banks have been replenished with capital and become public companies, and their corporate governance has been considerably improved. In 2010, the listing of the Agricultural Bank of China and the China Everbright Bank signaled preliminary success in the financial restructuring and shareholding reform of commercial banks, and has laid foundations for further market-based interest rate reform.
The second is to establish compulsory standards for financial institutions to be considered financially-disciplined in line with requirements for macro-prudential management, and those substandard ones shall be viewed as inadequately disciplined. During the process of the market-based interest rate reform, it is inappropriate to give a lot of pricing autonomy to financial institutions with soft disciplines and those "ill" or "severely ill" ones; otherwise, these institutions might disrupt market order by offering overly high deposit interest rates or market disruption. That is to say, only those financial institutions that reach the standards of self-disciplines can be granted more pricing power. Then what standards should we set? It is feasible to establish soundness standard in line with the orientation of this round of reform and using several macro-prudential standards as a benchmark, accommodating the need of macro-prudential management. In addition, it is also necessary to differentiate systematically important institutions from non-systematically important ones, and capital categories and quality. This bears on the basis of fair competition and the ability of loss absorption. To those financial institutions that have reached the standard, more pricing powers should be granted.
The third is to have market players competing on an equal footing, including banks, customers and etc. When selecting market players able to compete fairly, it is necessary to find out whether they have unresolved historical burdens and unexposed off-the-balance-sheet liabilities. As long as the market players—banks and customers— have unresolved historical problems, their pricing behavior might go against fair competition, and therefore should be excluded.
The fourth is to consider gradually liberalizing the prices of alternative financial products. This may not be achieved at one go; however, on the whole, the market-based interest rate reform should cover the full spectrum of financial instruments. Therefore, with the liberalization of deposit and lending rates, the pricing of other products, up-stream and down-stream products, and alternative products should also be left to the market. In this connection, the attitudes of administrative authorities and regulators towards arbitrage are also an important matter.
The fifth is to avoid excessive cross subsidies for bank products. Some financial institutions adopt cross subsidies among different business lines in order to maintain their market shares. By doing so, those seemingly well-priced products find their way to subsidies through channels difficult to identify, therefore obtaining unfair competitiveness and distorting the pricing system. The same thing happens in the goods market as well. For example, although on surface certain products are properly priced, the products are actually subsidized from the supply of low-cost spare parts and consumables, which will compromise pricing and competition.
The sixth is to strengthen publicity and education of customers. Except for those key accounts who possess certain bargaining power, the majority of small-and medium-sized enterprises and retail customers are only price takers. They need to adapt to price formation in a competitive market and understand their rights of independent choice and protection, and should not look to administrative intervention of the government to satisfy their own expectations. This is the same with investor education in the securities market.
What needs to be mentioned here is the central bank’s credit information system. It contains client information, and therefore offers a basis for risk pricing. The problems to be addressed are: firstly, the improvement of the system itself; secondly, there should be a proper correction mechanism to deal with faulty information in the system. Now is the information age, and when wrong information from unidentifiable sources is copied back and forth, the record cannot be set straight, thus annoying customers. And the credit information is used to determine prices of products and services offered by banks to the clients concerned.
The seventh is to establish and improve a self-disciplined competition order. How to realize fair and just competition and the resulting fair prices? Apparently, there is the need for regulators to maintain order, because sometimes competition is unfair or even vicious. Some might use cross subsidies to compete unfairly, and those saddled with problems during economic downturn might resort to desperate competition. Self-regulatory organizations and self-regulation are irreplaceable in dealing with these problems. Self-regulation can, to some extent, keep price competition within a normal range and restrict violations.
The eighth is to further enhance market-based pricing, and strengthen financial institutions’ capability of risk-based pricing. There should be positive incentives to encourage them to realize strict financial self-discipline, independent operation and risk-taking, and to guide them to move towards this direction in a healthy way so as to better promote the market-based interest rate reform.
In all, we will firmly promote the market-based interest rate reform in a well-planned and well-sequenced manner. China is still an economy in transition, and many problems exist, such as soft financial disciplines, the transformation of government role, the yet-to-be improved monetary policy transmission mechanism, and clients’ lack of understanding of the pricing of certain financial products and services. The market-based interest rate reform involves interaction and efforts in other areas, all of which are part of the entire process of economic transition. The solution of these problems is part of the interest rate reform, and they are connected. In the Twelfth Five-year Plan period, we will continue to promote the market-based interest rate reform in the principles of selected scope, incentives provision and strengthened self-discipline.
Thank you! (End)