If China Really Is Serious About Financial Reforms It Needs To Liberalize Deposit Rates

Earlier today, the People's Bank of China announced that it was removing the floor on lending rates.

The move surprised markets and many experts pointed out that this was a significant step towards interest rate liberalization.

However, it didn't lift the ceiling on deposit rates.

Last summer, we pointed out that China's move to allow commercial banks to offer up to 10% premium to the benchmark deposit rate from 0% previously was under-reported. This was a important step towards liberalizing interest rates.

"It is the ceiling that is placed on deposits that acts as a powerful source of "free" funds to the Chinese banking system benefiting borrowers at the cost of lenders (depositors)," Arthur Dong, professor of strategy and economics at Georgetown University told Business Insider.

"This is nothing less than an act of financial suppression that stymies the Chinese household sector and dampens household consumption because depositors feel poorer as they are getting negative returns on their deposits."

Correcting this would create a wealth effect, he pointed out, which could help rebalance the economy towards consumption and away from investment.

It would however pressure banks' margins.

Interestingly, he points out that China's crackdown on shadow banking, though important to cutting down systemic risks to the financial system, will impact depositors.

"It may also be seen as a move to suppress higher-yielding alternatives to the traditional banking system thus forcing households back into the lower-yielding traditional bank accounts."

The bottom line however is that if policymakers are serious about rebalancing the economy and liberalizing interest rates they need to remove the ceiling on deposit rates.