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How Deregulation Could Save China's Economy

By Walt Lund – Mar 29, 2014 at 12:00PM

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As privately owned and smaller business play a growing role in China's economy, the country's monetary policy is changing to foster their growth.

Headquarters of the People's Bank of China in Beijing. Source: Wikimedia Commons.

With China's economy expected to grow more slowly this year, China is planning to implement financial reforms to help shift the economy's backbone from investment and exports toward consumption and market forces.

China's GDP growth is projected at 7.5% this year, but disappointing first-quarter figures have stoked fears among investors that actual growth may fall short (the Dow fell 200 points on March 13 in reaction to, among other things, soft data from China). Policymakers recognize the need to balance slowing growth with job creation in the long term. New regulatory policies are necessary to improve conditions for privately owned firms and small and medium enterprises (SMEs), which together account for more than 60% of GDP.

Small steps forward
Over the next two years, the People's Bank of China plans to liberalize interest rates and allow for the establishment of privately owned official banks in order to increase the economy's reliance on domestic consumer demand. Zhou Xiaochuan, governor of the PBOC, has announced that the Central bank will remove its ceiling on bank deposit rates -- the most significant remaining restriction on interest rates -- in order to force banks to compete for customers by offering the best terms.

Interest rate liberalization is a necessary reaction to market forces' playing an expanding role in China's economy. China currently has a (government-mandated) ceiling of 3.3% annual interest for yearly household deposits. This leaves Chinese households poorly compensated, as deposit rates often fall short of the rate of inflation, stifling SMEs. Meanwhile, state-owned banks lend money at low rates to state-owned enterprises, giving them a competitive edge against private businesses and foreign competitors while minimizing risk to banks.

The fallout is that households lose money on the interest rate ceiling, pushing them to invest in riskier assets such as property. State banks, for their part, are left lacking the skills to assess credit risk. Meanwhile, private enterprise and SMEs, unable to obtain credit from banks, turn to informal lenders, shadow banking, or other sources.

China's authorities have been forced to recognize popular innovations attempting to circumvent central regulation and give SMEs space to breathe. For example, the Internet money market fund Yu'ebao, which offers a seven-day annualized interest rate of 6%, attracted 81 million users, with deposits estimated at $81 billion, over a period of only nine months. Partly in response to such developments, the Chinese government has thus far approved the creation of five new privately owned banks catering to SMEs, to be established by private investors (among the bidders is Alibaba (NASDAQOTH: ALBCF), the e-commerce business behind Yu'ebao).

Risks and benefits
It is expected that liberalizing interest rates and creating independent banks can spur the competition necessary to keep growth apace. Deregulation carries both risks and benefits.

As restrictions on rates are lifted, banks will be free to charge what they want on loans. Facing newfound competition for funds, banks will likely raise lending rates to minimize losses as their loans become riskier. Local governments and companies struggling to repay debt would then be under increased pressure, threatening China's economy in the short term.

On the other hand, domestically, interest rate liberalization will make more capital available to ordinary investors. Banks will be forced to analyze risks more carefully, and more direct lending will be available to private firms willing to pay higher rates. In the longer run, transforming China's economy to one depending more on services and consumption will help provide both jobs and continued growth.

The takeaway
The PBOC hopes market forces will eventually determine interest rates. What this will mean for the currency-exchange value of the RMB and therefore U.S. investment remains to be seen. Assuming that looser restrictions take hold across the country and invigorate China's economy, an increased money supply could mean a slightly weakened Chinese renmibi in relation to the U.S. dollar, but it would also encourage higher U.S. investment. By itself, this is a bold, if unavoidable, reform for China, which is gradually recognizing that SMEs are the backbone of economies whose growth can last in the long run.

Walt Lund has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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