China scrapped the ceiling on its deposit rates late last year. The move ended a long period of explicit interest rate controls, but China still faces a long journey ahead towards building a truly market-based credit system. The US provides a prominent example of how a continent-sized economy can liberalize interest rates. In this report, we try to draw some insights for China from the US.

In the US, an interest rate cap was put on deposits in the aftermath of the Great Depression. Enforcement started to face challenges in the 1970s when inflation and market rates picked up sharply. Interest rate controls were finally phased out over 1980~86, along with the rapid development of money market funds. The deregulation led to:

Higher deposit rates, narrower interest rate spreads, and more banking differentiation.

Improved intermediation efficiency, increased innovation & risk taking, and further concentrated market structure.

However, the US also experienced major episodes of financial instability after the deregulation. The savings and loan crisis resulted in the bankruptcy of >1,000 thrifts, with total assets of >US$500bn (11.5% of GDP), and cost taxpayers >US$160bn. Personal bankruptcies also rose significantly. Nevertheless, these setbacks did not lead to a redeployment of rate controls but new prudential measures to ensure financial soundness.

Interest rate liberalization is more than a removal of rate controls. From the US, we see the need for China to:

Keep regulations in tandem with changing financial landscapes. Rate deregulation will promote bank competition and financial innovation. Adequate supervision and proper regulations should be in place and be able to adjust to the evolving environment. They need to be directed at limiting the sources of excessive risk taking.

Centralize regulatory supervision. Lack of coordination among regulators could lead to a regulatory vacuum in which risky activities may grow and could erode the effectiveness of policy responses to market disruptions.

Reform the monetary policy framework. Moving from a quantity-based policy framework to a price-based one, the PBoC will need to choose its policy rate, develop tools to guide it, and improve its transmission to economic aggregates.

Improve corporate governance and market discipline of financial institutions. Prevalent incentive distortions, such as the cozy relationships between SOEs and big banks, will undermine market signals. There is also a need to establish a market-based mechanism for failed institutions to exit.

Indeed, a key difference between China and the US is the dominance of state-owned institutions in China’s financial system. How responsive are these institutions to changes in interest rates and risks, especially considering implicit government guarantees and soft-budget constraints? Can an effective market really be built among a group of state players? Interest rate liberalization in such a state-dominated setting is unprecedented. In any event, a broad and diversified participant base will facilitate the price discovery process. This points to the urgent need for SOE reforms in the financial sector.