A clerk counts banknotes at a rural commercial bank in Tancheng, Shandong Province, on August 13 (XINHUA)

The "new normal" is coming, but that's not news. After China's economic growth further slowed to 6.9 percent in the third quarter of 2015, the People's Bank of China (PBOC) launched the fifth reserve requirement ratio (RRR) reduction and the sixth round of interest rate cuts since last November.

The PBC cut benchmark one-year lending and deposit rates by 25 basis points each to 4.35 percent and 1.5 percent respectively from October 24. Meanwhile, the RRR for all financial institutions was also cut by 50 basis points. The RRR now stands at 17 percent for large financial institutions and 13.5 percent for small and medium financial institutions.

The rate cuts aim to alleviate deflationary pressure by tackling the outflow of capital and cementing stable growth, said Xu Hongcai, an economist at the China Center for International Economic Exchanges. According to the National Bureau of Statistics, in September, the consumer price index (CPI) stalled at 1.6 percent, and producer price index (PPI) fell 5.9 percent year on year, marking the 43rd straight month of decline. Statistics from the State Administration of Foreign Exchange show that, in the first three quarters, the foreign exchange settlement and sale by banks witnessed a deficit of $301.5 billion.

The further loosening of monetary policies will release in the near future about 700 billion yuan ($110.11 billion) of liquidity, said Dong Ximiao, a visiting research fellow at Renmin University of China's Chongyang Institute for Financial Studies.

In addition to the rate cuts, the PBC moved a step toward full interest rate liberalization by announcing the removal of the 50-percent upper-bound for deposit rates, which in principle gives banks the freedom to set their own deposit rates. At the same time, efforts will be made to promote the marketization and regulatory mechanism of the interest rate, to strengthen the regulation and supervision of the interest rate system and boost the efficiency of conducting monetary policies.

"The removal of the deposit rate ceiling will improve the allocation of financial resources, which has touched the core of China's financial system," Lu Lei, head of the PBOC's Research Department told Economic Information Daily .

Filling in liquidity gaps

According to the PBOC, the move to cut interest rates and lower the RRR shares the same goal of releasing liquidity but is somewhat different from the Federal Reserve's quantitative easing (QE), which central banks use to stimulate the economy when standard monetary policy proves ineffective. QE is often resorted to when a central bank cuts interest rates, almost to zero, but the cut fails to spark recovery. The PBOC's recent move is a conventional monetary measure given that its interest rates are way above zero, said the PBC in a statement.

The declining CPI and the receding PPI are testimony to the fact that the overall price level is descending. In response, benchmark interest rates also need to be adjusted downward, which is reasonable and expectable, according to the PBOC.

On the other hand, the funds outstanding for foreign exchange keep decreasing, revealing a gap of liquidity. According to the PBC, these funds dwindled by 723.8 billion yuan ($113.85 billion) in August, and shrank a further 761.3 billion yuan ($119.75 billion) in September. Against this backdrop, the RRR needs to be lowered to ensure reasonable and adequate liquidity.

Interest rate liberalization

"Regardless of the price fluctuations in the capital and foreign exchange markets, China continues to carry forward the financial reform in the China (Shanghai) Pilot Free Trade Zone and shows no sign of slowing the move toward interest rate liberalization because the nation is confident in the operation of its financial and economic situation," said Lu.

At the Third Plenary Session of the 18th Central Committee of the Communist Party of China, the central leadership stressed that the success of restructuring the economic system depends on maintaining a proper relationship between the government and the market, leaving the latter to play a decisive role in making price a key factor in more reasonable resource allocation.

"The removal of the deposit rate ceiling is a milestone on the road toward interest rate liberalization and a symbol of entering into a period of macro-micro linkage, which is conducive to improving the efficiency of financial resource allocation," said Lu.

Entities in the real economy will be capable of negotiating prices in obtaining financial services, and banks will be stimulated to supply financial products and services, as well as improving their capability to manage risks. Since the traditional revenue model of solely feeding on interest rate spreads is not viable any more, banks will be forced to conduct independent research and development and establish a pricing model. Horizontal competition will also push forward the formation of a self-discipline pricing mechanism, which will harness unfair competition and practice.

Free fluctuations of interest rates will accurately reflect the supply and demand of capital in the financial market, which will facilitate the regulation and control of the macroeconomy; non-competitive earnings will be reduced, and competition among financial institutions will be fiercer, which can spur the innovation of financial products and services, said Su Kunquan, Deputy Director of Yingda Futures Co. Ltd.'s Research Department.

From a macro perspective, eliminating the upper-bound will trigger a reform on the methods, tools and reference system of the central bank's macro-control. In the days to come, the PBC will maintain the convention of publishing benchmark lending and deposit rates as a reference for financial institutions to set interest rates. In the long term, an array of revolutionary measures will be implemented to reform the existing formation mechanism of benchmark interest rates, interest transmission mechanism, the coordination of local and foreign currency policies, etc.

Of course, these bold steps are secured by some necessary precondition. On May 1, a deposit insurance scheme was launched. The measures protect the rights and interests of depositors and safeguard the steady and healthy development of the financial industry in order to eradicate the possibility of systematic financial risks.

Without the interest ceiling, will the deposit interest rate skyrocket in the near future? Probably not. Liquidity is now abundant, and the central bank will try to lead the fluctuations of the deposit rate by giving guidance and putting in place a self-discipline mechanism, said Dong.

The coincidence of cutting interest rates and removing the deposit rate ceiling means banks are unlikely to drive up interest rates in order to compete for deposits. At the same time, the interest rates of banks will vary from each other due to their differences in client structure and liquidity management, said Wen Bin, a research fellow at China Minsheng Banking Corp. Ltd.

However, the move is just a part of China's financial reform. The next stage should see the financial market and financial institutions gradually reduce their dependence on benchmark rates in pricing their financial products and refer more to the Shanghai interbank offered rate, return rate of national debts and base interest rate, said Ma Jun, chief economist of the PBC's Research Department.

Beyond that, measures should be taken to optimize the interest rate transmission mechanism and make short-term interest rate changes effectively influence deposit and loan interest rates and the return rate on bonds, said Ma.

Copyedited by Calvin Palmer

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