Interest and exchange ates take center stage

A lot is riding on the deposit insurance program to ensure stability

The slowdown in Chinese economic growth in 2014 may have marked a major watershed in the Chinese, and possibly the global, economy in the coming decade. With a slowdown in the housing sector, industrial output and exports, many feel that China is in urgent need of a new round of financial reforms to reboot its economy.

The recent jump in Chinese A-shares market is unquestionably a promising development along this line. Establishing a broad and mature capital market has always been one of the top priorities in Chinese financial reform. With a buoyant stock market and hopefully bond market, Chinese enterprises and local governments can find much needed channels to alleviate their growing debt problems. Needless to say, another benefit of a booming stock market is that, many promising startup companies will have an easier time to access the capital market and contribute more positively to the economy and employment.

Nevertheless, with China's growing debt problem and many entities' reliance on debt financing, interest rate liberalization remains a central area for financial reform. On the one hand, interest rate is the price of capital, one of the most important and prevalent productive factors. On the other, given the Chinese legacy as a centrally planned economy, interest rates have remained heavily regulated. Many of the problems that are hindering the Chinese economy, such as overcapacity, local government financing vehicles, or LGFVs, and state-owned-enterprise reform, can all trace their roots back to regulated and distorted interest rates. Hence the call for urgent need to liberalize interest rates.

The People's Bank of China's recent announcement to roll out a deposit insurance program is an encouraging development. The program, which has been contemplated since 1993 and long expected to launch, could have significant implications to the Chinese financial system and Chinese economic growth in the coming decades.

The insurance program was first implemented in the United States after the 1929-1933 Great Depression to prevent bank failures and resulting disastrous consequences to households and corporations.

Under such a mechanism, all banks are required to pay certain premiums to an independent insurance entity, which will in turn cover part or the entirety of a depositor's losses in the event of a bank failure.

On the surface, the insurance mechanism is intended to ensure the financial soundness of all Chinese households and corporations. According to the proposed plan, all deposits up to half a million yuan will be fully covered. This coverage, according to the plan, would cover more than 99 percent of deposit accounts and hence protect the safety of most depositors.

More importantly, the launch of the deposit insurance program comes at a timely moment. With ballooning debt problems and a faltering real estate sector, ensuring the health and stability of the financial system becomes pivotal to next-stage reforms.

Needless to say, another significant implication of the deposit insurance program is that it paves the way for Chinese interest rate liberalization.

Unlike the current practice under which Chinese banks compete implicitly for the scale of deposits, especially toward the end of each quarter and each year, banks and financial institutions can compete directly with each other by offering more competitive interest rates.

Because banks competing with more attractive returns may induce banks to take on considerable risks, the process of interest rate liberalization may expose many savers to risks that they are unwilling, or unable, to handle. Such risks may not only hurt households and savers, but also cause systematic financial risks to China's banking system.

The launch of the deposit insurance program will require savers, especially savers with balances larger than 500,000 yuan to take responsibility for the safety of their own savings and thereby diffuse some of the increasing risks in the Chinese banking sector.

It is worth noting that the transparent interest rate liberalization in the main banking sector will also have a considerable ripple effect on the booming shadow banking sector in China. Trust products, peer-to-peer lending, Internet financing, such these "innovative" financing methods have become popular in China over the past couple of years that regulators and observers all voice their concerns about the transparency and sustainability of these products. With banks' savings rate becoming transparent and competitive, shadow banking will inevitably face direct competition from banks.

Once prevailing interest rates increase as a result of interest rate liberalization, every corner of the Chinese economy will feel its impact. Households will probably be on the receiving side, enjoying higher interest rates and greater peace of mind when investing in various financial products offered by banks and bank-like financial institutions.

On the other hand, borrowers, most notably state-owned enterprises and local government financing vehicles, may face increasing risks and headwinds. Therefore, the interest rate liberalization will redistribute social welfare between depositors, banks and borrowers. Companies within sectors with excessive capacities, local government financing vehicles, and state-owned enterprises, which have been relying on cheap financing as their lifeline, will have to discipline and reform themselves to survive in the new regime.

Given interest rate's central role in determining Chinese funding allocation, the risk profiles of banks, trust companies, state-owned enterprises, and many local governments will all shift drastically.

Consequently, the progress of interest rate liberalization is bound to take place at a gradual pace in order to avoid and contain potential risks. Two other major areas of financial reform, capital account liberalization and yuan internationalization, may provide useful channels, through which incremental reform can be pushed through and additional risks better managed.

The financial reforms in the Shanghai free trade zone, for example, have the potential to equilibrate the cost of capital across borders. If corporations can have more flexibility in raising capital in the free-trade zone, it will help form shadow prices for raising capital within the rest of China. Related to the free trade zone, the recent development of several off-shore RMB centers, such as London, Frankfurt and Singapore, can possibly achieve capital account liberalization and the yuan with the assistance of international investors and reserve banks.

By linking the Chinese financial system more closely to that of the rest of the world, Chinese companies and households will have more freedom in choosing their financing and investment destinations. This empowerment will not only help further integrate the Chinese financial system into the global financial system, but also gives Chinese companies and households opportunities to gradually learn to cope with a truly open and market-determined economy and financial system.

With Chinese domestic interest rates becoming more liberalized, the need for capital account restrictions would decrease accordingly. Eventually, Chinese domestic interest rates and the yuan's exchange rate will be fully determined by the market, by which time the need to regulate either diminishes to the minimal.

If the Shanghai-Hong Kong and Shenzhen-Hong Kong connect program can fully link and integrate China's equities market with that of the international equities market, and a more developed bond market and credit rating system can properly set the price for different types of risks, then the Chinese financial system will eventually reach its goal of"letting the market playing a decisive role".

The author is deputy director and professor of finance at the Shanghai Advanced Institute of Finance. The views do not necessarily reflect those of China Daily.