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"Goldilocks" liberalization: the uneven path toward interest rate reform in China.

Nearly two decades after central bankers began to call for interest rate liberalization, the central bank continues to impose stringent rules on the fluctuation of deposit interest rates. This seems an unlikely outcome given widespread endorsement of liberalization by technocrats and experts both in and out of the government, China's accession to the World Trade Organization, and the technocrats' insulation from popular pressure. To be sure, local interests and central bank lobbying have driven gradual liberalization of interest rates. However, senior Chinese technocrats held on to control over interest rates because of their need to maintain state banks' dominance and to mobilize bank funds in times of economic downturns. As such, progress toward interest rate liberalization only took place during "Goldilocks" phases when the economy enjoyed healthy growth without high inflation. KEYWORDS: monetary policy, China, interest rate, technocrats, interest groups, authoritarian regimes, reform


INTEREST RATE LIBERALIZATION HAS BEEN THE RALLYING CALL OF REFORMERS both inside and outside China for decades. However, despite decades of discussion by the academic community and by technocrats in the central bank, full liberalization of interest rates remains out of reach. In sharp contrast to the "Chicago Boys" reform carried out in Chile (Silva 1996), insulated technocrats made incremental progress toward full interest rate liberalization while retaining key macroeconomic levers with which to deal with the main threats of inflation and slow growth. Although interest rate liberalization would have reduced the cost of governance for central bankers, short-term political incentives retarded interest rate liberalization. In the long run, liberalization of lending interest rates would have reduced the need for central bank bureaucrats to ration credit to politically powerful state-owned enterprises. Although it provided the central bank discretion over an important policy area, credit rationing was a political minefield that some central bank technocrats sought to avoid. Furthermore, liberalization of the deposit interest rate would have reduced the likelihood of runs on the banks, which central bankers have had to combat when inflation rates were high.

Yet, in the short term, central bankers and their bosses in the State Council faced enormous pressure to maintain fixed interest rates, especially when there was high inflation or slow growth. High inflation repeatedly led to spontaneous interest rate liberalization as depositors withdrew money from the state banks, which paid negative real interest rates, in favor of underground banks paying market rates. To maintain the state banks' oligopoly, central technocrats time and again suppressed these unregulated financial institutions, thus stifling de facto interest rate liberalization. Negative shocks to growth required technocrats to pump billions into local infrastructure projects and into large state-owned enterprises (SOEs), which enjoy the backing of senior leaders at the Politburo Standing Committee level. To fulfill the demands of these powerful interests while maintaining bank profitability and limiting fiscal deficits, senior technocrats needed to maintain interest rate restrictions, especially on deposit rates. Thus, to the extent that there has been significant liberalization of interest rates in the past twenty years, they have occurred during "goldilock" years when inflation was low and growth was robust. (1) When these two conditions were met, significant interest rate liberalization took place either through spontaneous interest rate liberalization at the local level and lax enforcement of interest rate regulations or, after the 1990s, the formal relaxation of interest rates for borrowers and depositors. However, because of numerous episodes of high inflation and negative growth shocks in the past twenty years, interest rate liberalization has proceeded in a halting fashion with major movement in interest rate liberalization occurring only in the early 1980s, early 1990s, late 1990s, and the years 2003-2005. During high inflationary episodes in the mid-1980s, late 1980s, mid-1990s, and 2007, and during regional and global financial crises in 1999-2001 and 2008-2010, central technocrats demanded strict control over interest rates in order to maintain the system of credit rationing to priority industries and investment projects. Progress in interest rate liberalization was halted in these uncertain periods.

Why Slow Interest Rate Liberalization?

While the economic rationale for interest rate liberalization is quite clear, the reason why official interest rate liberalization has proceeded at an incremental pace seems puzzling, especially given that it remains incomplete nearly two decades after prices liberalized for nearly every other good or service (Wedeman 2003). The general consensus on interest rate liberalization among both Chinese and Western economists, as well as among a large contingent in the central bureaucracy, suggests that ideas cannot explain this slow pace of reform (Williamson 1994; Harberger 1993). As the following discussion shows, ideas may have shifted the manifestation of liberalization from spontaneous flight of capital from the official banking system to formal revisions in interest rate regulations. The ideational framework, however, cannot explain why senior-level technocrats at the Politburo level repeatedly intervened to halt progress in interest rate liberalization. Although the story to a large extent is one of capture by rent-seeking interest groups in the state-owned industrial and banking sectors, interest rate liberalization did take place from time to time. Moreover, the top leadership has time and again shown its ability to trump the rent seekers through manipulating the party nomenklatura and by giving out selective incentives (Shirk 1993; Shih 2008). But they were reluctant to do so in this case. Explanations that involve proreform technocrats or an insulated elite implementing reform also hold no water here, because interest rate liberalization has been repeatedly frustrated by senior technocrats insulated from popular pressure (Nelson 1995; Rodrik 1996). Although there is a dedicated group of technocrats lobbying for reform, they repeatedly failed to carry out full liberalization due to intervention by higher-level technocrats and politicians.

Rather, the story of interest rate liberalization is one of complex interest group lobbying in the context of a hierarchical authoritarian regime, where the top political leadership considers both long- and short-term concerns when coming down on one side or another in a policy debate. Although interest group competition in this case is not based on various strata in society, it still involves various actors within the Chinese Communist Party (CCP) regimes who stand to gain or lose depending on how monetary policy is implemented (Lieberthal and Oksenberg 1988; Lieberthal 2004). These interest groups all enjoyed patronage of individual members of the political elite at the Politburo level or above (Swaine 1986; Lieberthal and Oksenberg 1988). Thus, we ultimately saw some movement in interest rate reform in recent years due to competing groups with divergent interests and ideas on the issue of interest rate liberalization (Haggard 2000).

As can be expected in an economy emerging gradually from central planning (Naughton 1996), numerous powerful interest groups favored the continuation of financial repression, whereby cheap deposits from households are channeled to large state-owned enterprises at artificially low interest rates (Li 1994; Demetriades and Luintel 1997). Arrayed against these powerful interests was the People's Bank of China (PBOC), which gained prominence in the reform era due to the increasingly important role that banks played in China's growth strategy. Although the central bank had little executive power, it increasingly set the parameter of the debates on monetary policies. Interest rate liberalization never disappeared from the agenda due to persistent lobbying and agenda setting by central bank technocrats. They were even able to advance their agenda when favorable economic conditions convinced top-level policymakers that interest rate liberalization would not lead to undesirable outcomes.

Political incentive of the top economic technocrats at the premier and vice-premier level seems to provide a key piece of the puzzle to China's halting interest rate liberalization. Top technocrats are evaluated by their colleagues in the Politburo Standing Committee on the basis of their ability to solve pressing economic issues and to protect special interests patronized by senior politicians at the Politburo level or above. Thus, control over interest rates allowed senior technocrats to fulfill a host of objectives, especially their ability to minimize explicit central deficit, to pump massive funds into infrastructure projects and large SOEs favored by other Politburo members, and to maintain short-term solvency of the banking sector during cyclical downturns. During times of high inflation, when depositors earned negative real interest rates in the formal banking system, they sought out higher returns in the informal banking system, thus threatening the survival of the repressed formal banking system. Technocrats in the State Council had a strong incentive to crack down on informal banking in those periods, thus preventing de facto interest rate liberalization. Had the formal banking system collapsed, senior technocrats would have found it difficult to ration credit to strategic SOEs and to finance costly counter-cyclical investment drives, both of which are important to their Standing Committee colleagues. Likewise, during periods of negative growth shocks, senior technocrats needed to ensure that the formal banking system continued to channel cheap credit to state-directed investment drives, which maintained growth at respectable levels and provided funding to SOEs and local governments favored by senior politicians. Although senior technocrats have not been removed from power for failing to perform a given task, they have been forced to give up a policy portfolio for perceived failure. When former premier Zhu Rongji was forced to give up the SOE portfolio after fellow Politburo members charged that his SOE restructuring plan was creating too much unemployment, his prestige suffered a terrible blow (Fewsmith 2001, 213). The imperative to retain control during economic crises repeatedly frustrated interest rate liberalization, despite active lobbying and agenda setting by central bankers.

Interest rate liberalization was allowed to proceed when inflation was low and growth was relatively high. During these "Goldilocks" periods, central technocrats were not as vigilant against informal banks, which saw the bourgeoning of informal credit with freely floating interest rates in these periods. Moreover, especially after 2000, strong growth periods without inflation also allowed central bankers to push forward interest rate liberalization in the formal banking system.

In similar ways that Latin American and former Soviet Union technocrats introduced "political bias" to reform policies that resulted in "partial reform," Chinese technocrats selectively implemented reform to retain key levers over the economy (Murillo 2002; Kessler 1998; Hellman 1998). Victoria Murillo (2002) shows that even when economic reform is imposed by the IMF in the aftermath of financial crises, politicians and technocrats could still implement policies in a way that benefited their own support coalitions. It is therefore no surprise to see an incremental pace of reform in China, which faced much less external pressure to carry out economic reform. Like their counterparts in other countries, top Chinese officials were constrained by the need to minimize short-term economic pain and to provide financing to various politically powerful interests.

The discussion that follows is divided into three major parts. First, I describe the process of setting interest rates in China, shedding light on how interest rate changes affect macroeconomic trends and distribution of benefits to various political actors. I then fully describe the incentives facing relevant actors in interest rate policies and why they might support or oppose liberalization. And, finally, I describe the several liberalization cycles and closely examine the factors that led to eventual crackdowns on liberalization from Beijing.

A Passive Interest Rate

Theoretically, interest rate is the equilibrium price of money. It reflects the opportunity cost of spending or investing today rather than tomorrow and the reward that savers reap for forgoing current consumption. As an important market signal, it has a bearing on whether individuals spend or save money or hold cash or deposits, and on whether firms invest or not. In China, however, government decrees, instead of the market, set interest rates, which therefore do not convey the equilibrium price of money.

Until the mid-1990s, the flow of money was determined by the credit plan, which specified the amount of borrowing and lending that each sector, province, and bank could undertake in a given year. This system relegated the other monetary instruments to supplementary roles. Interest rate adjustments were seldom used as a way to affect money supply, and money supply seldom influenced the price of money. At various times, due to high inflation and slow government action, real interest rates in China were negative. The only exception was the adoption of inflation-indexed deposit rates in 1988 and in 1994 to prevent savings from flowing out of the banking system into either underground banks or abroad (Su 1992). Even in those instances, interest rate adjustments only had the limited goal of influencing depositor behavior. As seen in Figure 1, lending interest rates fluctuated only five times before the mid-1990s, while lending fluctuated wildly during the same period.

Into the mid-1990s, especially after the 1993 inflation, the Chinese government adjusted interest rates more frequently as part of its monetary policy. While rates still did not reflect the equilibrium price of money, it began to factor into the cost-benefit analysis of the various interest groups in China. In this way, interest rate became a way through which the central government provided subsidies to politically influential groups. Specifically, the PBOC quickly expanded the categories of interest rate beginning in the late 1980s and into the 1990s such that by the mid-1990s, different rates applied to different sectors, types of firms, and types of financial institutions. For example, SOEs enjoyed lower lending interest rates than collectives, which in turn benefited from lower rates than private enterprises (Bo, Zhao, and Liu 1996). Perversely, this allowed SOEs, which received preferential rates, to arbitrage their cheap capital in the underground financial market for a healthy profit.


Because interest rate began to matter to a host of governmental interest groups, they began to actively intervene in interest rate adjustments. According to a central bank researcher, setting interest rate involved the different ministries, the Big Four banks (Bank of China, the Construction Bank, the Agricultural Bank, and the Industrial and Commerce Bank), the Ministry of Finance, the State Council, and the PBOC (Luo 2001). This bargaining process was formalized with the formation of the Monetary Policy Committee (huobi zhengce weiyuanhui) in 1997. The members of this committee, all appointed by the premier, included the governor of PBOC, a State Council secretary, two vice-governors of the PBOC, the president of the China Banking Association, the head of the State Administration on Foreign Exchange (SAFE), the heads of the three financial regulators, and representatives from other economic agencies and the academy. Because this committee was an advisory body, members had no leverage over the premier, but they tried to persuade him that their preferred monetary policy was the fight one (People's Bank of China 2010). The ultimate decision to implement monetary policy lay in the hands of the premier or even the Politburo Standing Committee.

In this manner, a veteran PBOC researcher describes interest rate adjustment as "a bargaining process between the different interests that produces a political equilibrium, not an economic one" (Xie 1995b). The politicized nature of monetary policymaking meant that the PBOC at times set interest rates that were against the monetary target, such as lowering rates for SOEs even though the goal was to reduce money supply. Into the twenty-first century, money supply targets were achieved through administrative measures such as relending operations (zaidaikuan), reserve requirement adjustment, and credit ceilings (Ren 2000). When inflation accelerated in late 2007, the central government successively raised interest rates but soon discovered that a credit ceiling was necessary to control money supply (Jia 2007). The need to reimpose a credit ceiling to control inflation, however, continued to discredit interest rate as an effective tool of monetary policy.

In one area of the Chinese financial sector--unofficial banking--interest rates played a real role in money allocation. When there was high inflation and a credit ceiling in the official banking sector, borrowers who could not get credit from state banks were willing to pay high interest to underground banks to secure financing. This in turn motivated unofficial banks to offer higher interest to depositors who risked their savings in underground banks (Tsai 2002). This dynamic caused sizable withdrawal of funds from state banks during inflationary episodes, when fixed deposit rates produced negative real rates. As discussed in the next section, spontaneous interest rate liberalization through the shifting of funds from the state banks to underground banks was a constant worry to central technocrats. Instead of allowing spontaneous liberalization to take place, policymakers during high inflation periods sought to maintain financial repression in the official banks by shutting down the underground banks.

Main Interests for and Against Liberalization

Given the distributive consequences of interest policies, what were the bureaucratic entities that supported and opposed interest rate liberalization? In brief, large SOEs and the state banks opposed interest rate liberalization because it increased their cost of capital, decreased their profit margins, and--in the case of the SOEs--decreased their ability take advantage of the arbitrage. The Ministry of Finance also fought liberalization because existing interest rate policies decreased the explicit deficits of the central coffer in myriad ways. The main proponents of liberalization included a subset of technocrats within the PBOC and local governments, which preferred liberalization for professional reasons and for increased local development. Local officials, however, can be compensated by investment projects financed by the state banks. Thus, they were only weakly in favor of interest rate liberalization. Other beneficiaries of interest rate liberalization--the depositors and private enterprises--have played a small role in the policy process because they were actors outside the regime. Ultimately, interest rate liberalization in China has progressed slowly because the premier and other senior leaders in the State Council had a strong disincentive to promote its advancement, especially during periods of economic challenges.

Large SOEs

The large SOEs in China were against interest rate liberalization for the simple reason that they benefited from the inflexible interest rates. SOEs gained from the status quo in two ways. First, they received explicit subsidies through low or even subsidized lending interest rates. For example, the State Council implemented the policy of providing "closed-ended loans" (fengbi daikuan) to distressed SOEs with a potentially profitable production line. Banks were required to provide this loan with a specially low interest rate (Bureau of Economic Prediction 1999). As many SOEs had overdue loans and were supposed to pay a stiff penalty for them, the PBOC also drastically lowered the penalty interest rate for overdue loans to relieve their burdens (People's Bank of China 1999).

Implicitly, however, even without mandatory lending interest rates, the Big Four banks had an incentive to overlend to large SOEs, especially after 1998. In 1998, Premier Zhu Rongji implemented a system to hold bankers responsible for nonperforming loans, but he also demanded banks to lend sufficiently to maintain economic growth and to generate a profit. Within a few years, the China Banking Regulatory Commission was formed to monitor banks' nonperformance loan (NPL) ratios (Heilmann 2005). Under the crossed pressure to lend massively and to limit NPL ratios, banks fulfilled their lending quota by pouring money into firms that had minimal bureaucratic risk. In other words, banks sought out firms they knew were protected by government policies or would be bailed out by the government in the event of default.

Their favorite clients included SOEs that had received central government blessings, as well as SOEs and state corporations that had recently offered their shares publicly. Since most publicly traded state firms have also undergone debt-to-equity swaps, their asset-to-liability ratios were likely to be much lower. They were more likely to meet interest payments in the short run. Moreover, a publicly traded company also signaled to banks that the SOE enjoyed the protection of the government (Chen 2000). Besides publicly traded SOEs, banks also favored large SOEs, especially those that were on the list of "key point enterprises" (zhongdian qiye), because, again, lending to them entailed less bureaucratic risk for managers in the event of a default. (2) Rather than evaluating firms based on their commercial or liquidity risk profiles, bankers lent to firms based on the bureaucratic risk profile of these firms.

With cheap and easy access to capital, SOEs set up their own finance companies to lend out capital at the black market rate or to speculate in the real estate or stock markets. While some profit from this arbitrage benefited the SOEs, much of it also went into the pockets of SOE officials (Xie 1995b). In a liberalized financial system with real competition between banks, banks would lend to more profitable private enterprises, depriving SOEs access to cheap capital. While liberalization might force some SOEs to adjust to the new environment, the vast majority of SOEs, which had been kept alive through interest rate subsidies, would make even more losses. Central technocrats had little interest in this outcome.

State Banks

The Big Four banks opposed interest rate liberalization because they preferred the existing situation of guaranteed profits. First, the Big Four were strongly in favor of a mandatory interest rate on deposits because it prevented banks from engaging in "ruinous competition" with each other to attract deposits, which would increase interest payment to depositors and lower the banks' profitability (Xie et al. 2001, 31). (3) Until recently, PBOC set the rates for lending and deposits (Zhou 2002). As seen in Figure 2, the spread between mandatory loan and deposit rates before the mid-1990s guaranteed a modest profit for state banks. The exceptions were periods of high inflation, when deposit rates were boosted to prevent capital flight from the formal banking sector. During these periods, the state banks were under threat from unregulated banks, which paid depositors inflation-indexed, market-determined rates. To prevent the outflow of funds to these underground institutions, the government has had to repress these institutions while offering higher deposit rates to depositors. Banks thus clearly had an interest in quashing unregulated institutions.

As the Big Four state banks prepared for listings in the Hong Kong and mainland stock markets in the late 1990s, the central bank ensured that there was a healthy spread of at least 3.5 percent between deposit and loan rates to give banks billions of RMB in guaranteed profits (Dai 2002). Although the upper bound on loan rates was removed in 2005, banks still could not charge loan rates lower than the PBOC benchmark rate. Thus, with the continuation of control over deposit rates and a lower bound on loan rate, banks continued to enjoy a nice spread between deposit and loan rates. As long as banks were held to these bounds and few unofficial banks existed to compete with the official banks, they were still guaranteed a sizable profit.

The Big Four banks were especially weary of the prospect of competing for deposits because they were saddled with large number of NPLs, which required them to use profit to write them off (Shih 2005). If the cost of capital increased, they would be less able to write off these NPLs, which would necessitate a larger bailout of the banks by the treasury. In this respect, banks had an ally in the Ministry of Finance (MOF) and senior technocrats because both had an interest in banks handing in as much net "profit" as possible over to the government. (4) Moreover, senior technocrats wanted banks' cooperation in massive spending programs during economic downturns. Fixing deposit rates to guarantee a handsome profit to banks when they lend was a powerful motivator to encourage lending.

Instead of facilitating interest rate liberalization, the introduction of foreign banks after China joined the WTO actually strengthened domestic banks' preference for fixed deposit interest rates. Although all banks benefited from the interest spread, foreign banks were limited in the amount of lending they could conduct by restrictions against cross-border movement of capital and complex procedures on opening new branches to take in deposits (China Banking Regulatory Commission 2006). Thus, the interest spread disproportionately benefited Chinese banks, which already had a large deposit base. Because they could not compete in setting higher deposit rates, foreign banks mainly competed with Chinese banks in providing new services to depositors and investors (Luo 2007). Deposit rate liberalization would significantly decrease the interest spread profit enjoyed by domestic banks, thus making them less competitive vis-a-vis foreign banks.

Besides the fear of deposit competition, the Big Four banks have also acquired a large quantity of low-yield treasury bonds in recent years in an effort to diversify their portfolio and to lower the NPL ratio. Banks bought up bonds and still made a slight profit because PBOC rediscounting and bank deposit interest rates cost banks slightly less than what they made from interest paid by bonds. (5) By January of 2010, domestic banks held over 60 percent of the government bonds outstanding, as well as 80 percent of the bonds issued by the policy banks, which helped finance government projects ( 2011). Rather than trading these bonds actively in the repurchasing market, the state banks mostly sit on them and collect the slight profit paid by these papers (Areddy 2002). This situation further committed the banks and the central government to fixed deposit rates. Banks, which held large quantities of government bonds, would have faced large losses had interest rate liberalization led to much higher yields on new bonds due to the inverse relationship between the price of existing bonds and the yield of new bonds. The government would then have to engage in costly compensation to the banks and also pay higher yields on newly issued bonds.

Ministry of Finance

The Ministry of Finance also disapproved of interest rate liberalization because it increased the cost of financing the deficit, especially during economic downturns when the need to engage in deficit spending increased. Because a minister of finance was often evaluated by the size of the explicit deficit, the MOF constantly sought to reduce the short-term, explicit deficit. Former minister of finance Xiang Huaicheng told Western analysts that "China's leaders, especially the economic leaders, are very cautious with respect to debt. We shut the doors, and we discuss these issues every day" (Studwell 2002). Again, strict limitation on non-performing loans encouraged banks to lend to "safe" entities related to the state and to purchase low-yield assets such as treasury bonds (Monetary Policy Analysis Team of the PBOC 2002). A fixed deposit interest rate prevented "ruinous competition," thus guaranteeing banks a small profit even if it invested in low-yield treasuries. Interest rate liberalization would cause banks to compete for depositors by increasing deposit rates, thus enlarging the cost of capital. This would force banks to deploy capital toward higher-yield assets, such as loans and corporate bonds. In the primary market for bonds, the MOF would have to offer higher yields to attract buyers, which would further exacerbate the deficit. Although liberalization of deposit rates would also increase the pool of deposits in banks, China's already high savings rate meant that the marginal increase of deposits from liberalization was likely to be insignificant.


In economic downturns, low borrowing rates limited the cost of financing SOE losses at a manageable level, which also decreased the explicit budget deficit of the government. The low interest rate also gave banks and other financial institutions an incentive to invest in other low-yield instruments that lowered the deficit, such as bonds issued by the policy banks and corporate bonds issued by SOEs. Without mandatory, low-interest rates, banks and investors would demand higher yields for bonds issued by policy banks and would, in the case of IPOs for SOEs, offer less money for these loss-making entities. All this would increase the central treasury's cost of financing state construction projects and keeping SOEs afloat.

PBOC Technocrats

Despite the wide array of interests that opposed liberalization, a group of technocrats in the PBOC has consistently lobbied for liberalization since the mid-1990s. It is difficult to discern why they have so persistently advocated liberalization. Part of it doubtless stemmed from a genuine desire to conform the Chinese banking system to that in the West. These PBOC officials were also frustrated by the constant intervention by the State Council and other ministries in monetary policies. If interest rates liberalized and became strictly a tool for monetary policies rather than a channel for subsidies, PBOC officials hoped that administrative intervention from the other ministries, if not the State Council, would decline. (6)

According to these technocrats, the liberalization of interest rate would give banks, especially joint-stock banks, the incentive to lend to the vibrant private and joint venture sector, creating jobs and increasing the efficiency of the financial system (Xie et al. 2001, 29) The inability to change interest rate and the campaign against "financial risks" also compelled banks to put a large amount of excess reserve at the PBOC, which increased PBOC interest payments (He 1998).

In making their argument for liberalization, they were helped by the growing consensus in academia and in government think tanks in favor of interest rate liberalization. By 2001, there were hundreds of articles written by bankers, officials from various ministries, and academics advocating interest rate liberalization each year (Table 1). Of the articles listed in Table 1, the authors are identified in a minority of cases, and they included both government technocrats from various agencies and academics. The barrage of articles on the issue shows that the lack of intellectual support was hardly the main cause of the slow pace of interest rate reform.

Local Government and Local PBOC

Besides technocrats at the PBOC's headquarters, the other set of relevant actors in favor of interest rate liberalization was the local government and the local PBOC in prosperous regions. While local governments in poorer regions depended heavily on subsidies, the local governments along the prosperous east coast had an interest in ensuring an adequate flow of capital to the private and collective enterprises in their respective jurisdictions. Because their promotions depended on local growth, and local growth increasingly depended on the development of local private and collective enterprises, these officials wanted a free money market to supply adequate capital to these enterprises. As such, local governments have consistently been on the forefront of experimenting with interest rate liberalization and in sheltering underground financial institutions that ignored PBOC interest rate policies. For example, rural credit cooperatives (RCCs) in Wenzhou experimented with charging an interest rate that was 100 percent higher than the mandated rate as early as 1980 (Bo, Zhao, and Liu 1996). For the next two decades, RCCs and even branches of the Big Four banks in Wenzhou pushed the envelope with PBOC policies and were frequently the target of central crackdowns (Bo, Zhao, and Liu 1996). In a publicly circulated article, PBOC officials at the Wenzhou branch even boasted about their violation of official PBOC policies and their efforts to "experiment" with interest rate policies (Bo, Zhao, and Liu 1996). At the same time, unregulated financial institutions, which provided a substantial part of the financing to the private sector, have long charged market interest rates in these localities (Tsai 2002).

Local PBOC officials had another reason to support rate liberalization: to reduce the monitoring costs of maintaining interest rate policies. In 2002, the PBOC had to monitor over seventy types of interest for commercial banks, thirty-six types for policy banks, as well as an additional fourteen types of subsidized rates. Essentially, because the center manipulated the mandatory interest rate to allocate rent to regions, sectors, and policy areas, the PBOC had to ensure that the proper interest rate applied to every major loan (Xie et al. 2001, 28). This caused a regulatory nightmare at every level of the PBOC.

Senior State Council Technocrats

The most decisive actors were the senior State Council bureaucrats at the premier and vice-premier level. Their command potentially could override the individual wishes of all the previous interest groups. For the senior technocrats, firm control over deposit and loan rates constituted a powerful tool for the government's effort to boost short-term growth, contain the deficit, and fulfill a host of policy objectives. With the need to maintain growth through massive investment and the opposite need to constrain deficit at a reasonable level, control over interest rates became crucial in ensuring that both objectives could be achieved. During periods of high inflation, technocrats had to protect the state banking system by suppressing episodes of spontaneous interest rate liberalization. During economic downturns, when massive government spending became necessary, the state banking system and low fixed interest rates became handy tools of economic revival. Mandatory deposit rates provided domestic financial institutions a slight profit from buying low-yield government securities, thus decreasing the cost of financing deficit. With managed rates, high-level technocrats could also ensure a healthy profit for the banks. Interest rate policies also allowed the government to "rescue" SOEs and to engage in massive infrastructure spending at relatively low cost, which appeased special interests favored by senior politicians.

With strict control over China's vast financial resources, top technocrats could claim credit for "solving" China's myriad problems. In this way, the interests of the premier and other top-level technocrats were aligned with the interest of the pro--status quo groups. If the banks, the Ministry of Finance, and the large SOEs produced positive performance indicators due to interest rate policies, the premier would also be judged in a positive light. Even supposedly promarket policymakers decided to delay interest rate liberalization in order to achieve these policy objectives.

A Tortuous Path Toward Liberalization

Since the reform, spontaneous episodes of interest rate liberalization have taken place at the local level in periods when the local government had relative autonomy over economic policies. Nonetheless, the central economic bureaucracy, which had the option of endorsing and legitimizing liberalization, consistently brought its full might to quell illegal deposit taking and lending as part of anti-inflation drives. During economic downturns, official interest rate liberalization was stalled in order to provide cheap funds to countercyclical investment drives. Thus, time and again, top bureaucrats of various ideological stripes found mandatory interest rates too useful to let go. As a result, formal interest rate liberalization has proceeded in fits and starts, never quite reaching the point of full liberalization. To the extent meaningful liberalization occurred, it took place between economic shocks. The cases below describe four periods of de facto or de jure interest rate liberalization and show how they ended due to either high inflation or negative shocks to growth.

Grassroots Liberalization in the 1980s

The first and perhaps most far-reaching single step in interest rate liberalization took place in 1981, when the central government allowed banks to fluctuate the rate they charged SOEs for working capital loans to within 20 percent of the PBOC official rate (State Council 1983). Previously, banks had no right to deviate from the official rate set by the PBOC on any loans. At the same time, local-level financial institutions had begun to experiment with interest rate liberalization because state policy remained too rigid for the nascent private sector. In Wenzhou, where many of China's nascent private firms were located, rural credit cooperatives began charging an interest rate that was twice as high as the PBOC-mandated rate (Bo, Zhao, and Liu 1996). Meanwhile, underground banks, or associations (hui) with no ties to the states, began to attract deposits by promising illegally high interest rates (Tsai 2002). From the beginning, the local government and the local PBOC in some localities were supportive of or at least tolerant of these institutions. Rather than trying to extinguish them, they encouraged RCCs to compete with underground banks through further interest rate liberalization, such that by 1986, over 78 percent of the RCCs in Wenzhou charged an interest rate significantly higher than the PBOC-mandated rate (Bo, Zhao, and Liu 1996).

When inflation reached an alarming level in late 1985, the central authorities, then controlled by veteran planner Chen Yun, swooped in not only to reimpose financial order, but also to investigate cases of "chaos" (luan) among local financial institutions. During periods of high inflation, real interest rates paid by the state banks became negative, thus prompting depositors to withdraw large sums of money from the official banking system in favor of underground banks, which paid much higher rates to depositors (Zhou 2000; Huang 2000). The local branches of state banks in some cases responded by raising deposit rates against regulation. To combat such competition, the PBOC issued an edict that forbade all forms of competition for depositors and borrowers through "illegal means" (feifa shouduan)--namely, interest rate adjustments. It also forbade local governments from issuing "financial business licenses," which were used to sanction underground banks (People's Bank of China 1986).

To enforce these decrees, the party's anticorruption watchdog, the Central Discipline and Inspection Commission (CDIC), led teams of inspectors composed of the CDIC, Ministry of Finance, and National Audit Office officials to inspect local financial institutions (Central Discipline and Inspection Commission Team 1997). The year 1986 saw the bankruptcy and closure of a string of illegal financial institutions in Wenzhou that had engaged in speculation of various sorts (Zhang et al. 2002). Although the government pointed to fraudulent practices by underground banks as the main reason for closure, the main reason was in fact to prevent "ruinous competition" between underground banks and state banks (Huang 2000).

Despite this setback, local PBOC in Wenzhou continued to experiment with greater flexibility with both deposit and lending interest rate for both RCCs and branches of the Big Four banks (Bo, Zhao, and Liu 1996). Moreover, underground financial institutions soon reappeared in various coastal cities when inflation moderated in the 1986-1987 period. The high inflation in 1988 and 1989 once again imposed another round of crackdowns on local liberalization initiatives and on underground banks (People's Bank of China 1989). Rather than allowing interest rate liberalization to spread, as in the case of the household responsibility system, the central technocrats, this time led by Li Peng, chose to suppress all "illegal lending" (Shih 2008).

Liberalization After Deng's "Southern Tour"

A new round of liberalization began in 1992 after Deng's tour of south China, when he urged local officials, "Make a new path. Even if you make a mistake, it does not matter" (Tian 2004). Not only did it galvanize local developmental efforts, it also encouraged local governments to experiment with interest rate liberalization through underground financial institutions. In Wenzhou, rather than just credit associations, 1992 saw the formation of financial companies, leasing companies, agricultural cooperation societies, and stock ownership transfer consulting services companies (guquan zhuanrang zixun fuwu suo), all of which were underground banks implicitly sanctioned by the local authorities (Zhang et al. 2002). While some of these entities were fraudulent schemes, the fact that they consistently provided more capital to the private sector than the state banks indicated that they served an important function in prosperous localities. In a 2001 survey of Fujian farmers in Lianjiang County, legal financial institutions provided merely 10 percent of farmers' working capital needs, while underground institutions provided 40 percent. Another study in 2001 reveals that most lending needs in rural Zhejiang, Fujian, and Guangdong were filled by underground banks (Cui, Li, and Wu 2001). The informal banks' ability to charge market rates allowed them to allocate money much more efficiently than the state banks.

As inflation rose in 1993 to double digits, however, State Council technocrats, now led by executive vice-premier Zhu Rongji, once again sought to stop spontaneous interest rate liberalization by ordering a crackdown on underground banks (Central Discipline and Inspection Commission Team 1997). Although Zhu Rongji was unable to impose a credit ceiling on banks in 1993 due to Deng Xiaoping's preference for high growth, he was able to immediately shut down a weak interest group--the underground banks that had been only weakly defended by local officials in a few places (Chen 2005, 267).

Formal Liberalization in the Mid-1990s

As before, spontaneous liberalization came to a stop due to inflation in the early 1990s. However, a group of promarket technocrats in the PBOC had been promoted to positions to influence policies by the mid-1990s. While their efforts still did not bring about liberalization because of the leadership's opposition, their role as agenda setters for the regime's policies brought about some changes in China's interest rate policies, especially when inflation was low and growth was not under threat.

In 1995, Xie Ping, then a rising star in the PBOC, published two articles that provided a blueprint for interest rate liberalization (Xie 1995a, 1995b). According to Xie, the PBOC should first liberalize interbank rates, then allow banks some flexibility with loan rates. The government could then open up the rates for the bond market, which would create a market link between the bond market and the interbank market. Fourth, the PBOC should free up repurchasing rates and stop paying banks interest for reserves to encourage them to participate in the capital market. Fifth, the government should allow banks to float lending interest rates within a certain band. Finally, banks should be allowed to experiment with floating deposit rates within a certain band. Since the mid-1990s, interest rate liberalization has proceeded more or less according to Xie's plan because of the tireless lobbying efforts by him and others, but the pace of liberalization has been much slower that what these technocrats had hoped. (7) Attempts to commit to a strict schedule for liberalization were repeatedly frustrated, despite a growing consensus among bankers, academics, and government officials that interest rate liberalization would vastly improve the efficiency of capital allocation in China. (8)

Xie's timing in lobbying for interest rate liberalization was fortuitous. Figure 3 shows quarterly inflation in China since 1995, when Xie proposed liberalization. The bottom horizontal line is zero inflation, below which was unusually severe economic slowdown and deflation. The second horizontal line denotes the average inflation in the period between 1995 and the first quarter of 2011. Finally, the third horizontal line denotes inflation that was one standard deviation above the average in that period, above which were high inflationary episodes that alarmed policymakers. As seen on Figure 3, inflation dropped dramatically from 17 percent in 1995 to 7 percent by the end of 1996. Vice-Premier Zhu Rongji, then in charge of banking policies, allowed the PBOC to implement a series of reform measures in the capital market that laid the groundwork for full liberalization. In 1997, the PBOC liberalized rates in the interbank bond and note market, which allowed banks to borrow at market prices. However, the equilibrium prices at the interbank market, as well as the supply and demand for funds, were still distorted by the mandatory rates for lending and deposits.

With some progress already, the Zhu administration began with a hopeful note for those in favor of interest rate liberalization in 1998. The Asian financial crisis and the resulting slowing of growth, however, scuttled interest rate liberalization. In early 1998, the PBOC resumed open market operations, which gave the PBOC a powerful tool to control money supply that would one day replace strict interest rate policies. Later in the year, the primary market for policy bank bonds also liberalized, which gave both the PBOC and commercial banks an additional instrument to manage liquidity flow. In the meantime, the PBOC allowed commercial banks to increase deposit rates to 10 percent above the official rates and loan rates for small and medium-sized enterprises to 30 percent above the official rates (Bi 2000).


In 2000, the long-awaited interest rate liberalization finally seemed reachable. In July, PBOC governor Dai Xianglong announced a definite plan to liberalize interest rates in three years. Technocrats in the PBOC and others who supported liberalization went on a propaganda blitz in support of the timetable, arguing that the macroconditions for liberalization were finally ripe. Those in favor argued that liberalization could finally take place because the huge size of the banking system would mitigate any harmful effects of the liberalization. Any problem that arose was likely to be small relative to the size of the banking sector (Luo 2001; Zhou 2000). In September 2000, the PBOC further announced that rates on foreign currency deposits would be set by the China Bank Association, a newly formed government-directed association of bankers (Asian Wall Street Journal 2002). For foreign exchange deposits above US$3 million, the banks and the depositors could negotiate a rate directly, subject to PBOC approval (People's Bank of China 2000). Full interest rate liberalization seemed within grasp.

However, Premier Zhu Rongji was increasingly under pressure to generate growth in the aftermath of the Asian financial crisis. Growth in China fell below 8 percent in 1998 and 1999 and remained anemic in 2000. As Figure 3 shows, inflation slipped into negative territory in the second half of 1998 and remained so until the third quarter of 2000. Even afterward, China teetered on the edge of deflation for a couple of years more. In spring 2001, Zhu ordered Dai to abandon the three-year timetable and to change the time frame to a vague "five to ten years" (Gilley and Murphy 2001). While the Big Four banks lobbied for the delay, the ultimately decision was made by Premier Zhu. An informant who worked closely with Zhu on financial policies stated that Zhu intentionally delayed interest rate liberalization in order to deal with a host of other issues, including maintaining growth rate and rescuing SOEs. (9) In late 1999, the Politburo Standing Committee also decided to launch an enormously expensive infrastructure building program for western China (Zhu 2001). Ultimately, the state banks provided over 600 billion RMB in loans to finance this campaign (Research Team of the CASS Western Development Research Center 2003). Interest rate control, which minimized capital costs and guaranteed a healthy profit for banks, made banks eager participants in the state's investment drives. At a time when banks also needed a healthy profit margin to write off a massive amount of nonperforming loans, interest rate liberalization would have been inconvenient.

To be sure, Zhu's intervention did not put liberalization completely on hold, because agenda setters within the PBOC continued to propose new reform measures. For example, Dai Xianglong announced at the beginning of 2002 that banks could set interest rates for loans to small and medium-sized enterprises up to 50 percent higher than the PBOC rate. Previously, banks could set this rate at only 30 percent higher than the PBOC rate (People's Daily 2002). In a low-interest environment, however, the loosening of interest rate regulation translated into a mere 2 percent leeway for banks. Later on, the PBOC approved experiments that allowed lending interest rate for RCCs to increase to twice as high as the PBOC rate. Two decades after Wenzhou RCCs instituted the same measure, the PBOC finally gave its seal of approval to experiment with this interest rate. As one research report on this reform points out, however, even allowing interest rate to float to twice as high as the official rate still meant that lending and deposit rates were over 10 percent lower than unofficial market rates (Research Team of the PBOC Fuzhou Branch 2002).

Liberalization in the Wen Jiabao Administration

After China moved from the Asian financial crisis into a period of sustained growth in 2003, interest rate liberalization seemed finally within grasp. As before, enthusiasts within the PBOC published several reports in support of liberalization, while representatives from the Big Four banks also provided reasons for slowing down reform (Chan 2002). Also, China finally shook off the threat of deflation in 2003 and resumed relatively high-speed growth with only a moderate degree of inflation in 2004 (Figure 3). To the surprise of some, on October 29, 2004, the upper limit on lending interest rates was removed, allowing banks to in principle charge as high an interest rate as they wanted (People's Daily 2005). Moreover, banks could also give depositors rates below the benchmark deposit rates. Similar to Governor Dai Xianlong's timetable a few years ago, the PBOC issued a report laying out a concrete plan for full interest rate liberalization.

Despite this liberalization, the underlying logic in the financial system remained the same. On the deposit front, the removal of lower bounds on deposit rates was largely symbolic, as banks had few reasons to needlessly decrease rates below those offered by their competitors. Thus, few banks took advantage of the freedom to give less than benchmark deposit rates (Green 2006). On loan rate liberalization, the central bank reasoned that it would allow banks to "give different loans and rates on the basis of the different risk profiles of the clients" (Research Team on Monetary Policy at the PBOC 2005). While this sounds like a significant gain in efficiency, it was in reality a signal to banks to continue to provide cheap financing to state-sponsored projects and state-owned enterprises, which had lower bureaucratic risk profiles. In the meantime, "ruinous competition" between banks was still limited by strict upper bounds on deposit rates and lower bounds on loan rates. Thus, banks still could not compete with each other to offer higher deposit rates. Likewise, banks could not compete with each other to offer borrowers low interest because the lowest rate a bank could offer was 90 percent of benchmark rates. A PBOC report reveals that a full 27 percent of all loans made by the state banks were set at the lowest legal rates, suggesting that banks would have competed by offering borrowers low rates had they been allowed to do so (Research Team on Monetary Policy at the PBOC 2005). To give the PBOC credit, the liberalization of loan rates prompted city commercial banks and rural credit cooperatives to offer more loans at high rates to riskier borrowers in the private sector, thus providing financing to a segment previously frozen out of the formal banking system (Research Team on Monetary Policy at the PBOC 2005).

Into the 2008-2009 economic downturn, control over interest rates once again facilitated massive countercyclical investment drives. As seen in Figure 2, the PBOC continued to guarantee a healthy interest spread for banks in the global economic downturn. With the upper bound on loan rates removed, banks earned even more money by lending. Thus, when the central government called on banks to provide financing to the 4 trillion RMB stimulus package in November 2008, banks responded with great enthusiasm. Lending in China exploded upward in 2009, growing an astonishing 30 percent from the previous year. The PBOC had originally set credit quotas in 2009 at a little over 5 trillion RMB. By the end of the year, banks had made a historically large number of new loans totaling nearly 10 trillion RMB (Panckhurst, Zheng, and Wang 2011). With deposit rates held below benchmark and loan rates above benchmark, banks were actually reaping in healthy profits in the midst of an economic downturn (Han 2009).

Thus, the liberalization of the upper bound in lending interest rate benefited all the relevant political actors. Senior-level technocrats retained the ability to finance the largest countercyclical investment drive in China's history with relative ease. Banks were still protected from "ruinous competition" and continued to enjoy a healthy interest rate spread from lending. Because of banks' willingness to finance the stimulus program, the Ministry of Finance did not have to issue as much debt, thus limiting the size of the fiscal deficit. Although some large SOEs probably paid higher borrowing costs due to freed-up loan rates, banks were eager to provide massive amount of financing to them, which allowed them to earn profits by relending funds to other entities. As the world slowly emerged from the economic crisis, inflationary pressure built up very rapidly in China due to rapid credit expansion in the previous two years. By the beginning of 2011, inflation was heading back into dangerous territory. While the Chinese leadership was in crisis mode, any talk of further interest rate liberalization was put on hold. Another Goldilocks moment would have to present itself before the next round of liberalization could be seen.


Although China has not faced externally imposed reform policies, it has engaged in significant economic reform on its own. In the cities, many smaller state-owned enterprises were privatized or shuttered, while the private sector was allowed to grow freely (Naughton 1996). Prices of most goods and services have been liberalized (Wedeman 2003). Despite a giant sea change in the Chinese economy, the state continues to control crucial macroeconomic levers that allow it to affect economic outcomes in important ways. By having control over the flow of money and the direction of investment, central-level technocrats can ensure that inflation does not rise beyond control and that growth remains strong. At the same time, these levers also allow them to buy the support of interests patronized by other Politburo members, including local officials and SOE managers, especially during economic downturns. To maintain the effectiveness of these levers, they need to hold depositors in China hostage to the state financial system. If private banks emerge to offer depositors higher interest rates, state banks would have to match those higher rates, thus increasing the cost of financing massive stimulus programs. Despite these strong incentives for top technocrats to hold on to the status quo, interest rate liberalization has made some progress in China. Even in the 1980s, informal banks emerged to offer high deposit rates. Into the 1990s, central bankers influenced by Western thinking about monetary policy and weary of the politicized role of the PBOC began to push for interest rate liberalization in earnest. They made progress on liberalization when inflation was low and growth was robust.

Although convenient for policymakers' political goals, China's interest rate control continues to tax household depositors in China and some manufacturers outside China. As long as banks are barred from competing for deposits, hundreds of millions of depositors continue to earn artificially low deposit rates, which subsidize the profitability of state banks. The state's ability to mobilize large quantities of money at low cost also has negative implications for the world. Most remaining SOEs are concentrated in the heavy industrial and commodities sectors. Thus, as a Chinese government think tank notes, easy credit has allowed them to retain--and in some cases even expand--their capacity in the midst of a serious global downturn (International Financial Research Center 2009). This has exacerbated global overcapacity and led to the dumping of Chinese goods in certain sectors, especially steel, onto the world market. Thus, an important victim of the government's continuing effort to manipulate interest rate is global competitors of Chinese state firms.


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(1.) The term Goldilocks economy was coined by the financial community to describe an economic state that is neither too hot nor too cold (Stelzer 2005).

(2.) Author interviews in Beijing, November 27, 2000; in Shenyang, December 26, 2000; and in Dalian, May 23, 2001.

(3.) Author interview in Beijing, June 23, 2001.

(4.) Every year, the Big Four banks and the MOF fight over how much "bank profit" would be used toward writing off bad debt and how much would be remitted to the MOE Both entities, however, preferred a larger size of the "profit" (author interview in Beijing, May 14, 2001).

(5.) Interest paid by bonds can be slightly lower than deposit interest rates, especially for short-term bonds. Nonetheless, after subtracting the deposit tax from the deposit interest payment, the deposit rate is lower than the interest paid by bonds. While the Ministry of Finance is supposed to collect the deposit tax, it is unclear how much the banks give the Ministry of Finance and how frequently the tax is collected from the banks. Interview evidence confirms that banks are able to make a profit by buying bonds, which suggests that banks are benefiting from the deposit tax in some manner (author interviews in Beijing, May 14 and June 23, 2001). Also see Monetary Policy Analysis (2002)

(6.) Author interview in Beijing, May 14, 2001.

(7.) Ibid., January 3 and May 14, 2001.

(8.) Ibid., June 23 and 27, 2001.

(9.) Author interview in Cambridge, MA, May 2, 2002.

Victor Shih is associate professor of political science at Northwestern University specializing in China. An immigrant to the United States from Hong Kong, Shih received his doctorate in government from Harvard University. He is the author of a book published by Cambridge University Press, Factions and Finance in China: Elite Conflict and Inflation. He is also the author of numerous articles appearing in academic and business journals, including China Quarterly, Comparative Political Studies, Asian Wall Street Journal, and Far Eastern Economic Review, and is a frequent adviser to the private sector on the banking industry in China. His current research concerns elite political dynamics and local government debt in China.
Table 1 Number of Academic Articles on Interest Rate Liberalization

 Articles with Interest
Year Liberalization in Title

1994 35
1995 25
1996 60
1997 31
1998 24
1999 25
2000 122
2001 229
2002 280
2003 366
2004 280
2005 229
2006 217
2007 156

Source. The data come from a keyword search on the China Academic
Journal (CAJ) electronic database of Chinese journals. The search
counted the number of articles with titles that include Interest rate
and reform (lilu, gaige), interest rate and liberalization (lilu,
zis,-ouhua), or Interest rate and marketLation (lilu, shichanghua).
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Author:Shih, Victor
Publication:Journal of East Asian Studies
Geographic Code:9CHIN
Date:Sep 1, 2011
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