While it is true that interest rate cuts in China are usually prompted by 1) slowdown of the economy and 2) excessive inflow of speculative foreign capital, I believe there is a third reason behind the most recent cuts. Interest rate liberalizationaEUR"arguably the most important financial reform in a decadeaEUR"is now underway.
By eventually removing deposit rate ceilings and lending rate floors, the PeopleaEUR(TM)s Bank of China will provide Chinese banks with more flexibility when setting the interest rates they offer to their customers. This represents some serious challenges for Chinese banks. Prior to the reform, net interest income equaled 80 percent of their revenue. Now that the government has eased controls on interest rates, banks are now subject to more intense competition. They will also need to explore other sources of revenue in order to stay profitable and competitive.
Prior to the reform, China's interest rates mostly remained negative in real terms. This leads to a lack of efficiency in investment. Interest rate reform is a milestone on the path toward better allocation of resources in China's tightly controlled capital markets, one that will tremendously benefit the Chinese economy in the long run. However, the timing of this reform is tricky. Both lending and deposit rates will increase due to the reform. This is good news for savers, but bad news for businesses and households with debt. Rising interest rates can exacerbate an economic downturn. The two recent interest-rate cuts can be viewed an attempt to counter the negative impact interest rate liberalization may have on the Chinese economy.
ChinaaEUR(TM)s deposit rates are mostly negative in the past decade
So why has the Chinese government chosen to promote this reform when the economy is slowing down? Those who closely follow developments in China probably have noticed that many important reforms have been pushed through during the past several months, including liberalizing interest rates, allowing issuance of high yield bonds, and allowing cross-border renminbi loans in Qianhai, just to name a few. These measures to liberalize ChinaaEUR(TM)s financial markets have been on the governmentaEUR(TM)s agenda for a long time but were put on hold because of the global financial crisis. The current leadership seems eager to push these reforms forward before the regime change scheduled at the end of the year. More quiet, albeit radical, moves may be underway.