Impact of Interest Rate Liberalisation on Chinese Economy - Essay Example

Impact of Interest Rate Liberalisation on Chinese Economy 1.0 Introduction China has been a Communist nation since 1949, however, a series of reforms and changes in processes put it on a path to alignment with the Capitalist world around her (Chow, 1994: 38). Under the strictly Communist regime, the country was ran only by state owned enterprises (SOEs) and these entities were funded by the People's Bank (Pekkanen and Tsai, 2005: 178). China is currently a key player in BRICs (Brazil, Russia, India, China and South Africa) and is a signatory of major international agreements (Peng, 2009). This has put pressure on the country to liberalise its interest rates and cause it to be determined by the forces of demand and supply. This project takes a critical look at the changes in the interest rate of China and its impact on the Communist Structures of Country viz Savings, State-owned Enterprises and other systems of the controlled economy. 1.1 Motivation for Research A controlled economy maintains pre-determined rates that are fixed by the leaders in order to attain a given target. However, with the pressure on the country to use the forces of demand and supply to fix macroeconomic policies, the Communist structures and the Capitalist world come face-to-face. This research seeks to examine the impact and implications of this conflict on structures in the Chinese economy. Also, it will examine a real case involving the impact of these static interest rates on the Bank Capital Adequacy Ratio. The inferences and conclusions of this research will provide authoritative text and information about the trends in the nation under review. Through this, other scholars and researchers would be able to build on it and benefit from it. In other words, this project seeks to bring new knowledge into the world. 1.2 Aims and Objectives The aim of the paper is to examine “The Dynamics of Changes in China's Interest Rate Liberalisation and its impacts on the Communist Structures of economy: SOEs, Savings and Investments and the Measures to be Taken and The Impacts on Bank Capital Adequacy Ratio”. In attaining this end, the following objectives will be examined: 1. Identification of the main structures of banking sector reforms and related factors. 2. Assessment of the trends in the interest rate liberalisation and reserve ratio changes and its meaning. 3. Analysis of the challenges that the country faces as a result of these changes. 4. Empirical analysis of the relationship between regulated interest rates and bank capital adequacy ratio. The hypothesis tested in the research is that: “The Chinese Economy is doing quite well under the Communist Structures. The introduction of interest rate liberalisation is going to disrupt the system and lead to major adjustment problems. This will have an adverse impact on bank capital adequacy ratio.” 2.0 Literature Review 2.1 Background of Interest Rate Liberalisation Financial repression was common in nations after the Second World War (Shaw, 1973). Government set ceilings for interest rates and this determined the range of interest rate (McKinnon, 1973). However, these two authorities and many other writers argued against financial repression. The main argument against financial repression was that interest rate ceilings were detrimental to the economies. So they presented a case for the use of real interest rates, which were interest rates determined by the market forces of demand and supply (Shaw, 1973: McKinnon, 1973). Gibson and Tsakalotos (1994) argue that the use of real interest rates determined by the forces of demand and supply led to increased savings. This means that it caused an increase in investment which stimulated economic growth (Gibson and Tsakalotos, 1994). This brought down inflation and helped to spark a boom in the economy. 2.2 Interest Rate Liberalisation “The objectives of interest rate liberalisation are to promote savings and efficient investment to deepen financial markets” (Tseng and Corker, 2001) .Positive real investment rates promotes financial over non-financial savings and this helps to consolidate the financial markets. Through an efficient financial market system, productivity of investment is assured and the economy of a nation grows at a very fast rate. Interest rate liberalisation is vital for the growth of national economies. This is because when it is set subjectively by the state, as the case may be in some Socialist and Communist nations, it could be done in a way and manner that inefficiency would be promoted. And this prevents the growth of viable corporate entities and encourage waste and poor performance. In examining the case of Turkey, Odekon identifies that in the period before the liberalisation of interest rates, the rates were negotiated below the market rate (2005). This leads to a trend where there is a negative real interest rate due to financial repression. Due to this, the realities were not presented and the economy appeared to give a totally different picture from what actually existed. Due to this, businesses borrowing and trends were not right and inefficient investments got sponsored at the expense of real investments that could produce real results. With such a financial market, Turkey was bound to remain inefficient and the interest rate was to remain in a certain range. This was clearly detrimental to the position of efficient firms and businesses had to operate within a limited scope. 2.3 Practical Matters in China's Interest Rate Liberalisation Drives China, being a Communist country is ran by numerous state-owned-enterprises (SOEs) which are meant to provide the needs of the Chinese people as a matter of right, rather than through a cash and carry basis (Lee, 2009). In other words, these entities traditionally, have to serve the best needs of all citizens whether they have money or not. And the SOEs are ran by people who remained loyal to the Communist party and showed a better sign of helping the Chinese people rather than promoting the profit motive (Lee, 2009). Thus, these entities are able to exist through loans given at very low rates, and in some cases, through subventions (World, Bank, 2011). Due to this, there are major risks with liberalisation of the interest rates. However, China is opening up to foreign investors and its membership of the World Trade Organisation and the Organisation of Economic Corporation and Development means that it would have to liberalise its financial sector and this begins by liberalising the interest rate (Lee, 2009). In order to avoid issues with the interest rate liberalisation, the World Bank made the following recommendations to the Chinese government as a logical foundation to the liberalisation of the interest rate: 1. The state sector must be financially sound. 2. Banks must maintain a positive net wroth. 3. Bank management should be of high quality. 4. Regulatory and supervisory standards of both banks and corporate world must be sound. 5. Government must be prepared to introduce interest rate deregulation gradually but not in an instant. 2.4 Real Interest Rates and Interest Rate Spread Real interest rate is a rate that is adjusted to remove the effects of inflation and reflect the real cost of funds to consumers (Mensah, 2011). This means that the data shows the rate of interest and its linkages to inflation and shows the true worth of borrowing and how much an investor earns less inflation. Real interest rate allows to find out the true worth of investing in a given nation and it shows how well the markets are interacting. Interest rate spread shows the differences between lending rate and deposit rate and it is used in a country where the banking sector is regulated (Dickson, 2008: Mensah, 2011). It gives an indication of how the government wants to regulate the interest rates of the Central Bank. 2.5 Bank Capital Adequacy Ratio Bank capital adequacy risk is a measure of the ratio of a bank's capital to its risk (Paddington, 2010). Capital Adequacy Ratio = [Tier 1 Capital + Tier 2 Capital]/Risk Weighted Assets Tier 1 Capital = [Disclosed Free Reserves + Statutory Reserves + Paid Up Capital] – [Equity Investments in Subsidiary + Intangible Assets + Current Losses + Losses Brought Forward] Tier 2 Capital = [Undisclosed Reserves + General Loss Reserves + Hybrid Capital Instruments + Subordinated Debts} According to the Basel Accords, an ideal BCAR should be around or above 10% (Paddington, 2010). In China, Bank Capital Adequacy is not very strictly managed due to the fact that the commercial banking sector is being developed and there is already a huge level of supervision and regulation (Yuanjuan and Shishun, 2012). Due to this, most banks use the legally prescribed model because it is a regulatory requirement to operate legally in China. 3.0 Further Analysis The People's Bank of China released information about the trends and actions in the interest rate and its trends in the Chinese economy. Figure 1: Chinese Interest Rate & Its Implications [Source: The Wall Street Journal] From the benchmarks identified in the left hand side of the diagram above, it is apparent that the Chinese government has kept an average of 3% between the deposit rate and the lending rate. This determines the interest rate of China. And the difference enabled the country to maintain an appropriate environment for the growth of the economy. 3.1 Critical View of the Fixed Interest Rates Deposit Rate Base Market Rates Term Deposits 3 months 2.60% 6 months 2.80% 1 year 3.00% 2 years 3.75% 3 years 4.25% 5 Years 4.75% Lending Rates 6 months 5.60% 1 year 6.00% 1 – 3 years 6.15% 3 – 5 years 6.40% Over 5 years 6.55% Figure 2: Chinese Term Deposit and Lending Rates (Jingu, 2012) This diagram above shows a fairly straightforward method of earning interest on savings and the cost of borrowing. It is very much structured and when compared to other nations, it seems that the Chinese system is quite easy and relaxed. The cost of capital remained very moderately priced and this allowed all the existing entities to get loans and not be exploited by these financiers. This also seem to give the Communist government a strong grips over the economy because they could always control things and keep state-owned entities running. 2007 2008 2009 2010 China 3.3 3.1 3.1 3.1 Russia 6.6 5.15 5.3 6.8 United States N/A N/A N/A N/A United Kingdom N/A N/A N/A N/A Figure 3: Lending Rate Minus Deposit Rate (Source, World Bank, 2012b) The figure above shows the spread of the interest rate and the lending rate in four countries. Since the Chinese government maintains elements of a controlled government, it continues to set the ceiling and floor for lending and deposit rates. The difference between the highest deposit rate and the lowest deposit rate, which is known as the spread is quite low. It hovers around 3% and effectively, that is the cost of borrowing in China. So for entities that borrowed in the period under review, the rate was between 3.1 and 3.3% However, in Russia, which also inherited structures of a controlled economy, the rates were higher and ranged from 5.15% and 6.8%. This shows that there was a wider spread. However, the United States and the United Kingdom, which run a free market economy with no regulation of interest rate, have no figures on this. This means that they are open and the financial markets are run by the forces of demand and supply which keeps the system operational and regulated through productivity. Incidentally, the interest rate of other countries where the forces of demand and supply have fairly narrow spread at the level of China. The only difference is that their ceilings are not regulated and the scope of transactions determine the interest rate that operates in the economy. 2009 2010 2011 Canada 3.23 3.24 2.79 Germany 3.22 2.74 2.61 United States 3.26 3.21 2.79 United Kingdom 3.65 3.61 3.12 Figure 4: Interest Rate of Developed Countries (Source: Standard and Poors) 4.0 Practical Case Analysis: Data and Methodology In the operational research, we examined the relationship between the interest rates of China and the bank capital adequacy ratio of commercial banks. The idea is to see how the BCAR responds to changes in interest rates and how they are affected by them. Data was taken from the People's Bank of China and statistical methods were chosen. A sample of seven of the major commercial banks were studied over the period of 2005 to 2010. The means of their bank capital adequacy rates was collated as the dependent variables whilst interest rates were the independent variable. The findings can be used to judge the possibility of liberalising the interest rate and ascertain what could happen if the government decides to cancel interest rates altogether or vary it in the future. 4.1 Data 4.2 Statistical Model Bank Capital Adequacy Ratio is directly related to the following factors which have a direct correlation with the figures that make up the components of the BCA Ratio. They include: Component Indicators Bank Profitability Return on Assets (ROA), Return on Equity (ROE) & Earnings Per Share (EPS) Bank Liquidity Deposit-Loan Ratio (DLR) Quality of Bank Assets Non-Performing Loan Ratio (NLR) Bank's Level of Risk Capital Adequacy Ratio (CAR) To this end, the following statistical model applies to Bank Capital Adequacy Ratio: Thus, CAR relates to the different components of the bank and its ways of making money and increasing revenue. 4.2 Linear Regression The R Squared figure of 0.44 shows a moderately strong correlation between the variables. This implies that some degree of predictions can be made from this although some of the variables, lie way out of the region. From the regression, we can deduce the following equation: Bank Capital Adequacy = 75.27 (Interest Rate) + 7.24 This means that at an interest rate of 0%, Bank Capital Adequacy will be 7.24%. This shows that holding all other factors constant, if the People's Bank is to reduce interest rates to zero, Bank Capital Adequacy would remain at 7.24%. This shows that the Chinese banking sector is not really under threat. This is because in most free market economies, Bank Capital Adequacy Ratio is often under 10% where the model uses risk weighted assets and excludes state regulatory frameworks. The Basel Accords recommend that the ideal BCAR should be around 10%. With 7.24% at a 0% interest rate, there is a mitigated risk for bank capital issue. This means that every 1% increase in interests, leads to 0.7527% in the bank capital adequacy ratio [75.27 * 0.01]. This means that all other things being equal, a Chinese Commercial Bank that maintains an interest rate of 3.7% will be able to attain [75.27 (0.037) + 7.24] which is approximately 10.02499% in Bank Capital Adequacy Ratio. This means that in the event of liberalization, most banks can survive with interest rates that are at an average of 3.7%. This shows that there is no significant risk to the bank capital adequacy if the government stops regulating interest rate. This is because the banks can remain capitalized and profitable to a reasonable degree even if there are no regulatory directives on interest rates. In other words, fixed interest rates do not really play a significant role in determining bank capital adequacy and Chinese banks can comfortably operate below the government's mandatory interest rates and remain adequately capitalised. 4.4 Data Validation Although the ANOVA suggests that there is a limited relationship between the variables, the Durbin Watson model indicates that there is some degree of auto correlation whilst Von Neumann Ratio indicates that there is a positive auto relationship between the two variables. 4.5 Comparison with Existing Research & Discussions The Wall Street Journal identifies that the GDP of China has grown continuously by 10% per annum under the new arrangements (Orlik, 2012). They use cheap capital to get the investments of the economy running. Orlik identifies that household consumption fell by 34.9% from 45.4% a decade ago. From the analysis, it appears that the banks can remain stable even if regulation of interest rate ceases. However, the risk is that the banks might focus on more profitable ventures and this might affect the industries that produce for the Communist economy with a vision of improving welfare only. Moreover, Moody's identifies that the Chinese economy has strong financial markets and good regulations (Global Credit Research, 2012). However, the systems have not been tested in an unregulated environment before. The country has been run by governments that are motivated by choices that are not based on economic rationality (Global Credit Research, 2012). On the other hand, Moody's reports that 13 Chinese Commercial Banks account for 60.5% of the bank system's loans and 63.6% of loans (Global Credit Research, 2012). This means that the economy is quite stable and bank can be allowed to set their own rates and they can be easily monitored as well. And in line with these, the Chinese government could have some control over the banks even if there is liberalisation. This can help them pursue their Communist agenda even after liberalisation. Conclusion From the research, it is conclusive that the Chinese government's control of interest rates has led to a high degree of stability in the Chinese economic sector. This stability has ensured a steady growth in the economy. In order to become a completely free market, the Chinese government would have to stop its regulation of the lending and deposit rates. This means they cannot continue setting the ceiling for interest rate. Also, they would have to allow the bank reserve rates to be fixed by the forces of demand and supply. From the data analysis, it is conclusive that if the Chinese government ceases to regulate the interest rates, there would be no significant reduction in bank capitalisation and profitability. However, it is apparent that when this is done, there would be major disruptions and this would mean that investment is going to be selective and Chinese people are going to store their money in banks that would give the highest returns on investments. References China Market Research Report (2008) China Banking Industry Report Singapore: China Knowledge Press. Chow, G. (1994) Understanding the Chinese Economy Shanghai: World Scientific Press Dickson, B. (2008) Finance Surrey: Edward Elgar Publishing. Gibson, H. D. and Tsakalotos, E. (1994) “The Scope and Limits of Financial Liberalisation in Developing Countries: A Critical Survey” Journal of Development Studies pp578 – 628 Global Credit Research (2012) “Moody's: Chinese Banks Face Increasingly Liberalized Market Rate Regime” 16/10/2012 [Online] Available at: http://www.moodys.com/research/Moodys-Chinese-banks-face-increasingly-liberalized-interest-rate-regime--PR_257669 Accessed: December 4, 2012. Lee, S. C. 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(2012) “Effectiveness of China's Commercial Banks' Capital Adequacy Ratio Regulation: A Case Study of the Listed Banks” Interdisciplinary Journal of Contemporary Research in Business May 2012 Vol 14 No 1. Read More