China's interest rate challenge

China's successful transformation from a middle-income country to a modern, high-income country will depend largely on the reforms that the government undertakes over the next decade. Financial reforms should top the agenda, beginning with interest-rate liberalization. But liberalizing interest rates carries both risks and rewards, and will create both winners and losers, so policymakers must be prudent in their approach.

In 2012, the People's Bank of China allowed commercial banks to float interest rates on deposits upward by 10 percent from the benchmark, and on bank loans downward by 20 percent. So, if the PBOC sets the interest rate on one-year deposits at 3 percent, commercial banks can offer depositors a rate as high as 3.3 percent. Many analysts viewed this policy, which introduced a small degree of previously non-existent competition among commercial banks, as a sign that China would soon liberalize interest rates further.

But any further move toward interest-rate liberalization must account for all potential costs and benefits. Chinese policymakers should begin with a careful examination of the effects of current financial repression (the practice of keeping interest rates below the market equilibrium level).

The degree of financial repression in a country can be estimated by calculating the gap between the average nominal GDP growth rate and the average long-term interest rate, with a larger gap indicating more severe repression. In the last 20 years, this gap has been 8 percentage points for China, compared to roughly 4 percentage points on average for emerging economies and nearly zero for most developed economies, where interest rates are fully liberalized.

Developing-country central banks keep interest rates artificially low to ensure sufficient low-cost financing for the public sector, while avoiding large fiscal deficits and high inflation. But, in the long run, such low interest rates may also discourage households from saving, lead to insufficient private-sector investment, and eventually result in economy-wide underinvestment, as occurred in many Latin American countries in the past.

In many ways, China is breaking the mold. Despite severe financial repression, it has experienced extremely high savings and investment, owing mainly to Chinese households' strong propensity to save and massive government-driven investment, particularly by local governments.