Dangers Lurk in China’s Must-Do Bank Reforms

Dangers Lurk in China’s Must-Do Bank Reforms

ALEX FRANGOSBy 

March 11, 2014 7:16 a.m. ET

China is pushing through with reforms to its financial system. Whether it survives them unscathed is another matter.

Central bank chief Zhou Xiaochuan said Tuesday that China expects to fully liberalize state-directed deposit interest rates in “one or two years.” He said deposit insurance for the banking system, seen as a prerequisite for letting interest rates float, and promised for ages, would come within a year.

That may sound like more stalling by an overly cautious Communist apparatus, but it is actually the first time China has given a clear timeline for either reform. For Mr. Zhou, a favorite in international financial circles who won back influence during President Xi Jinping‘s ascent to power last year, it puts his own political capital at stake in the process.

Other parts of the financial system remain protected. There’s no timeline for making the yuan into a fully international currency, he said. And to anyone who thinks China will lift strict capital controls in the foreseeable future, Zhou offered a splash of cold water. It makes little sense for China’s leadership to expose the banking system to the vicissitudes of global markets during the fragile period when it shifts to market-driven rates.

The sequencing outlined by Mr. Zhou makes sense. Doing otherwise would repeat the mistakes of others. The history of interest-rate liberalization is littered with crises. Sweden, Norway and Finland all liberalized interest rates while reducing capital controls in the 1980s. Banks and shadow lenders quickly competed by offering easy loan terms while accessing funding from abroad. This culminated in ruinous housing bubbles and recessions, according to an IMF survey of interest-rate liberalization.

A closer analogy may be U.S. savings & loans, which had deposit rate ceilings lifted starting in 1980. A scramble followed to make high-interest loans to compensate for the higher deposit rates they paid. Loose regulation led S&Ls to make reckless investments in property and financial assets that went sour, requiring a massive government bailout.

The lesson that China has internalized is to take things slowly. Given the rapid accumulation of debt and the hard-to-monitor ways that banks and shadow lenders have extended credit and obscured liabilities the past few years, choosing a rip-the-Band-Aid-off approach could cause terrible pain. Yet the timing isn’t entirely up to Beijing. China is being dragged to the task by the emergence of trust products, wealth-management products and Internet money market funds run by the likes of Alibaba and Tencent that pay considerably more than plain vanilla bank accounts.

Moving forward with market-determined prices in the banking system is critical to wringing out China’s poor allocation of capital and putting more money into the pockets of savers. If history is a guide, however, the road could prove rocky.