China’s move to loosen interest-rate controls is insufficient to cut corporate borrowing costs in coming months as the economy expands at the slowest pace since 1990, according to Barclays Plc and UBS AG.
The People’s Bank of China scrapped the floor on the rates banks can charge customers on July 19 while keeping a cap on deposit rates. Yuan forwards rose and Chinese stocks trading in the U.S. posted the first back-to-back weekly gain since May as the change signaled policy makers’ commitment to market reforms.
While the move represents a step toward letting the market set interest rates, the initial impact will be limited because banks have little incentive to lower borrowing costs below the current 6 percent benchmark, Barclays’s analysts wrote in a report July 19. Total lending fell to a 14-month low last month amid a cash squeeze that led to higher interbank funding costs.
“You cannot say this is credit loosening when the total financing is lower,” Bhanu Baweja, the global head of emerging-market fixed income and foreign exchange at UBS, said by phone from London July 19. “It’s not the price of the money that matters in China, it’s the quantity that matters.”
Twelve-month non-deliverable yuan forwards strengthened 0.08 percent against the dollar on July 19, extending the advance last week to 0.15 percent. The Bloomberg China-US Equity Index of the Chinese stocks in the U.S. added less than 0.1 percent for a weekly gain of 2.8 percent to close at 89.95, the highest since June 7.
The Shanghai Composite Index (SHCOMP) of domestic shares closed 1.5 percent lower before the PBOC announcement, extending the decline last week to 2.3 percent.
Premier Li Keqiang, who took office in March, is accelerating financial reforms to revive the economy after gross domestic product growth slowed to 7.5 percent in the second quarter. Policy makers raised the limit for foreign investment in China’s capital markets this month and are planning to set up a pilot free-trade zone in Shanghai.
Before last week’s move, China regulated how much banks can pay to depositors and how much they could charge borrowers, ensuring a profit margin for lenders. Banks are allowed to offer up to 10 percent above the official deposit rate, currently at 3 percent, and before the limits were removed could issue loans at as much as 30 percent less than the benchmark 6 percent.
The practice led to lending to unprofitable projects and the growth of unregulated banking that policy makers say increases risks in the financial system. The World Bank and the International Monetary Fund have said an overhaul of interest rates should be a priority in financial reform.
The PBOC said July 19 that the removal of the lending floor will lower companies’ funding costs and boost flexibility for financial institutions. The conditions aren’t ripe yet for freeing up deposit rates, the more important and “most risky” part of interest-rate liberalization, the PBOC said, adding that the nation lacks a deposit insurance system.
Barclays’s analysts said the removal of the lending rate floor “is more signal than real” when it comes to borrowing costs because most lenders didn’t use the 30 percent discount allowed.
As of March, only 11 percent of loans were priced below the lending benchmark, according to central bank data. The average lending rate was 6.65 percent, or 0.65 percentage points above the official benchmark, according to Barclays’s calculations.
“We do not expect it to lead to a significant or immediate change of banks’ lending practices and lending rates,” Barclays economist Jian Chang wrote in the note. “The lending floor was not binding and banks still have significant pricing power.”
Louis Kuijs, Royal Bank of Scotland Group Plc’s chief China economist in Hong Kong, said the new policy won’t have “a major immediate impact” on lending volume as slowing growth reduces loan demand.
“Corporate borrowing is affected a lot by subdued demand in a context of weak profits and spare capacity in many sectors,” Kuijs, a former World Bank economist, wrote in a report.
The interest rate overhaul came one month after the PBOC acted to curb credit expansion. Policy makers refrained from adding cash to the banking system, causing interbank borrowing costs to surge.
That helped reduce aggregate financing, the broadest measure of credit, to 1.04 trillion yuan ($169 billion) in June, the lowest since April 2012. Bank loans accounted for 83 percent of the total lending, up from 52 percent a year earlier, suggesting that non-traditional financing through the shadow banking system has been squeezed.
The interest rate reform will help curb unregulated banking by giving more freedom to commercial lenders to decide borrowing costs, according to Kuijs.
“Interest rate liberalization should be helpful in, over time, improving the level playing field between core bank activity and shadow banking,” Kuijs wrote.
John-Paul Smith, an emerging market strategist at Deutsche Bank AG, who anticipated the selloff of equities in China and developing nations this year, said the reform won’t change his bearish view on Chinese assets. Interest-rate distortion has been so entrenched that it will take a long time to clean up, he said in a phone interview on July 19.
“I don’t think this is a dramatic act that will change anything,” said Smith. “The big picture is that sentiment toward China is deteriorating and deteriorating fast.”
The iShares China Large-Cap ETF (FXI:US), the largest Chinese exchange-traded fund in the U.S., gained 0.3 percent on July 19 to $33.73, extending its gain last week to 1.6 percent.
Qihoo 360 Technology Co., (QIHU:US) a Beijing-based software developer, said it is in initial talks to buy Sohu.com Inc. (SOHU:US)’s Sogou unit to help it compete with Baidu Inc. for Internet searches in China.
Qihoo, owner of the most-used web browser and the second-biggest search engine, rose 1.8 percent to a record $58.34 on July 19, extending its weekly advance to 10 percent, the most in two months. Sohu, the third-biggest web portal, added 5.5 percent last week to $68.73, the strongest level since October 2011.
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