China's 5 year financial sector and the new 5-year plans

As with its predecessor, the new 5-year Development Plan attaches importance to continuing financial sector reform in four main areas: (i) strengthening financial institutions, (ii) development of financial markets, (iii) improvements to monetary policy instruments, and (iv) enhancement of the supervisory framework.

However, this 12th 5 Year Plan remains disappointingly general as it lacks important specifics such as the role of foreign investors and a clear chronogram for financial reform.

In any event the Plan appears to introduce two major breakthroughs in financial reforms. The first is interest rate liberalization , which is clearly stated in the Plan. The second is capital account liberalization although one really needs some good will from the part of the reader to understand that it will be happening based on the wording of the Plan.

Regarding interest rate liberalization, the key and more and more urgent change is to free the ceiling on the deposit rate. Currently, the PBoC maintains a ceiling on deposit rates for all tenors and a floor on lending rates expressed as a fraction of 0.9 of the benchmark rate (in 2004 the ceiling on lending rates was removed). It is anticipated that the deposit rate will be allowed to fluctuate first, which will imply an upward movement as banks compete among themselves for funds. As for the lending rate, while competition should already exist today (there is actually no ceiling for lending), evidence shows that bank borrowers are generally charged the minimum lending rate. If that minimum lending rate were to disappear after the deposit rate is liberalized - which should be the logical order to follow - price competition would increase, probably resulting in a decline in real interest rates. Finally, a precondition for a successful freeing of the deposit rate is to reduce the liquidity in the system so that banks have an interest in bidding up the interest rate to attract depositors.

The introduction of interest rate liberalization will probably have major implications for the financial sector landscape due to an increase in competition and the related decline in margins and, thereby, in profitability. However, the Plan should also create new business opportunities in the financial sector based on the extension of banking services to the household and SME sectors. The former implies a much bigger role for retail banking, especially in consumer finance and wealth management. The increasing number of businesses related to serving households and SMEs while allowing for more competition should, in principle constitute an important opportunity for foreign banks but, again, their role is not clearly stated in the Plan, which raises doubts about the authorities’ intentions.

Finally, as regards the second key reform, namely capital account liberalization, the path outlined in the Five Year Plan is even less clear on paper. However, the progress made with the internationalization of the RMB (both in terms of trade settlements in RMB and bond issuance in RMB) concentrates on the off-shore markets and tends to forget the onshore one, which does not seem like a sustainable model. This is why there does not seem to be any other option other than pushing for the internationalization of the RMB market as well.