China liberalizes interest rates

China raised the ceiling on deposit rates to 110 percent of the benchmark from 100 percent. This is in addition to the parallel 25-basis-point cut in the benchmark deposit and loan rates.

"Interest rate deregulation will mean risks can be more accurately priced by banks and means that credit can go to areas where it is most needed," said Gigi Chan, a fund manager at Thread needle Investments, which has over $120 billion in assets under management.

"This illustrates a willingness on the part of the policy makers to break the mold in order to address underlying structural imbalances within the economy and as such we remain sanguine on China's longer-term growth potential."

With the benchmark one-year deposit rate now at 3.25 percent, the change now gives banks the freedom to offer rates of up to 3.575 percent.

Operating with a government mandated lock on the rates they can charge, the banks were historically never incentivized to lend to risky, yet promising corporations.

As a result, for years, small to medium-sized enterprises that hire about 80 percent of China's workforce have complained about being shut out of its credit market, accusing state-owned lenders of extending loans only to government-linked companies that already have access to piles of cash.

With that guaranteed spread now narrower, banks will face a stronger incentive to seek out riskier borrowers willing to take loans at higher rates.

"This is banks being required to take on some sacrifice to achieve several things, such as supporting SME lending," said Jim Antos, an analyst at Mizuho Securities. "I would be very stunned if we don't see more moves to encourage banks to lend more to SMEs."

The changes may actually raise average borrowing rates for many sectors of the economy. PBOC will now let banks lend at 20 percent below the benchmark lending rate floor, compared with 10 percent before.

"The lower floor gives space for the government to direct some preferential credit to cash-strapped local government financing vehicles, thereby boosting infrastructure investment. But banks will probably try to offset such subsidized loans with higher rates on commercial loans," Arthur Kroeber of Beijing-based consultancy GK Dragonomics wrote in a note to clients.

The average lending rate was already 8 percent in the first quarter, well above the previous benchmark of 6.56 percent.

Analysts including those from CCB International said BoCom is likely to be the worst hit by the liberalization as its loan-to-deposit ratio is already close to the 75 percent ceiling, which could force it to pay more for deposits and eat into its margins.

Other banks also had their earnings forecasts cut, with Citi analysts saying they expect overall earnings in the Chinese banking sector to decline 9.5 percent this year.

The liberalized rates could also encourage banks to bring otherwise hidden loans back onto their balance sheets, instead of hiding them in a pool as money collected from the sale of investment products that offer higher yields.

Before the move that eased deposit rate restrictions, banks were already competing for funds by offering so-called "wealth management products" with yields far above official interest rates.

Due in part to the competition from such products, growth in bank deposits has slowed in the last two years, and deposits actually declined by about 0.6 percent, or 457 billion yuan, in April.

At the same time, issuances of wealth management products more than doubled last year. CITIC Securities says there are more than 18,000 such products in circulation, with an outstanding value of about 15 trillion yuan.

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