Hopes and False Hopes in China's Interest Rate Reform
The Chinese central bank has recently dropped hints that it will quicken the pace of interest rate reforms towards a market determined regime. This has raised many hopes, both inside and outside the country, from improving efficiency to reducing China’s so-called excessive savings and current account surplus.
The hopes about efficiency are reasonable, but this reform alone will not achieve the intended goal, and some complementary reforms outside the central bank’s controls must take place in concert. The hopes for a much-reduced current account surplus are fundamentally misplaced and will be dashed.
What does it take to improve resource allocation?
The current interest rate regime places a ceiling on the deposit interest rate, implicitly imposing a tax on savers, but puts a floor on the lending rate. The biggest beneficiaries of this scheme are large state-controlled banks, since the gap between the two interest rates gives them a fat profit margin. The biggest losers are savers who suffer from the implicit tax and firms, especially private-sector firms, which face a higher cost of capital than necessary.
This reform will likely result in a lower (real) lending rate, and a higher (real) deposit rate. (The actual nominal interest rates will also depend on the country’s prevailing inflation expectation.) It appears logical to think that the reform should necessarily lead to a better allocation of resources.
However, in the absence of further reforms on the state-owned enterprises (SOEs), the interest rate liberalization could exacerbate rather than reduce inefficiency. Specifically, SOEs often overinvest, because their senior management is rewarded for scale and size instead of just pursuit of profit. If the interest rate liberalization reduces the cost of capital, their urge for scale could result in more overinvestment. This problem is aggravated by the fact that many SOEs do not pay a market price for using natural resources and do not pay the full social cost of compromising the environment.
In short, reforming SOEs and imposing adequate social costs of using environmental and natural resources are necessary complementary reforms needed to achieve efficiency improvement. One challenge is that these reforms are outside the purview of the central bank.
Will the reform drastically reduce China’s current account surplus?
A popular theory in some Washington-based think tanks is that the current interest rate regime is the key culprit behind China’s high savings rate and current account surplus. The supposed logic is that the low real interest rate on bank deposits has caused people to raise their savings rate to compensate for the lost interest income. This has then led to a current account surplus (Lardy, 2012). By this theory, the interest rate reform would reduce drastically China’s current account surplus.
This theory is false both logically and empirically. Logically, a lower interest rate produces two effects, with opposite signs. On the one hand, because the reward for savings is lower, people would save less. On the other hand, because interest income is lower, people feel poorer and may choose to consume less and save more. While the net effect appears ambiguous, both experimental evidence and statistical analysis of people’s actual savings choices overwhelmingly suggest that the first effect dominates. That is, a lower interest rate leads to less savings. Otherwise, the ultralow interest rate in the United States would have produced a savings boom. This means that the Chinese save a lot in spite of a low interest rate, not because of it. The interest rate reform per se may very well raise China’s savings rate and current account surplus.
The Chinese current account surplus is not a mystery. Two factors are especially noteworthy. The first is China’s accession to the World Trade Organization (WTO) in late 2001, which, by itself, tends to reduce the domestic return to capital, generating incentives for the country to park a greater portion of its wealth in foreign assets during a transitional period of about six to seven years. My research with Jiandong Ju and Kang Shi suggests that this has contributed one-third of the surplus we observe.
The second factor is a rising ratio of marrying-age young men to young women since 2002. This imbalance has caused young men, and especially their parents, to raise their savings rate in order to compete better in the marriage market. The same force has also contributed to a rise in the corporate savings because more parents with an unmarried son and more young men themselves have chosen to be entrepreneurs. Given the difficulty in getting a bank loan, new entrepreneurs and small firms must rely on self-savings to finance their operation and expansion. Together with Xiaobo Zhang and Qingyuan Du, I estimate that this force has accounted for another one-third of the current account surplus.
To be sure, other factors also matter. But each perhaps plays a smaller role than commonly assumed. Collectively, they account for the remaining one-third of the surplus. Because the gradual reforms associated with the WTO accession have been completed, the part of the surplus due to this factor is naturally winding down. In contrast, because the sex ratio imbalance is going to rise over the next decade, the part of the surplus due to this factor is not going away any time soon.
In sum, while the interest rate reform may carry many benefits, reducing the country’s current account surplus is not one of them.
A shortened version of this commentary originally appeared on FT.com.
Research articles referenced in the essay:
Nicholas Lardy, 2012, “Analyzing China’s External Imbalances,” presentation at the IMF.
Jiandong Ju, Kang Shi, and Shang-Jin Wei, 2012, “Trade Reforms and Current Account Imbalances: When Does the General Equilibrium Effect Overturn a Partial Equilibrium Intuition?” NBER Working Paper #18653.
Qingyuan Du and Shang-Jin Wei, 2013, “A Theory of the Competitive Saving Motive,” NBER Working Paper #18911.
Shang-Jin Wei, and Xiaobo Zhang, 2011, “Sex Ratios, Entrepreneurship, and Economic Growth in the People”s Republic of China,” NBER Working Paper #16800.