Important reforms accompany PBOC easing

China's easing measures on Friday were accompanied by the removal of the mandated deposit rate ceiling, the final and riskiest piece of financial rate market liberalization.  The required reserve ratio (RRR) was lowered 0.50% to 17.5%, potentially unleashing $80 billion USD of funds into the lending market.  Benchmark rates were also cut, bringing the 1 year deposit benchmark to 1.50%, below the latest inflation reading of 1.60% in an effort to boost consumption.  HSBC expects all easing measures last week to release roughly $110 billion of liquidity into credit markets.  The potential boost to overall economic activity will come in 2016, as easing measures take months to spread.

But, it is important to note that easing measures over the last year have done little to boost overall credit growth as policy measures to rein in shadow banking and clean up local government debt have amounted to credit tightening.

Interest rate market liberalization moves accompanied the easing measures.  According to the PBOC, evidence shows that financial liberalization in the midst of low inflation while lowering rates reduces the riskiness of financial reforms.  ICBC, China's biggest lender, had a deposit rate below the mandated ceiling, in an indication that banks are not fully utilizing deposit rate flexibility yet.

China began interest rate liberalization in 2013 by removing mandated lending rate ranges.  With the removal of the mandated deposit rate based on the PBOC's benchmark rate, policymakers have effectively allowed for markets to set interest rates.  However, not all control has been given up with the liberalization moves.  The PBOC still has significant control over banks and has indicated that it will "discipline" banks that use unusually high interest rates and disrupt the market, and reward those with low deposit rates.  Rates have been officially freed-up, but the PBOC will probably exercise influence in other ways.

Liberalizing rates is a milestone for reforms intended to roll back decades of financial repression, whereby households subsidized rapid growth in industry and investment via cheap loans funded by artificially low bank deposit rates.  The rate cuts last week followed a similar pattern to the currency devalue in August: Lower the rate, but allow markets more control.  The moves were a trade-off between short-term stimulus and reform advancement.