On 21st of June, the People’s Bank of China (PBoC) announced changes to commercial banks’ mechanism for setting the time deposit ceiling from a multiplier method to a basis points method. This represents  another, albeit retrograde, step in China’s 16-year interest rate liberalization process.  In our view, however, the change will likely have limited impact on commercial bank funding costs, investor returns and the financial markets.

Changing Methodology:

The PBoC’s official deposit rates stopped being legally binding in October 2015 when the central bank removed the floor and ceiling on borrowing and lending rates.  Nevertheless, commercial banks continue to implicitly reference these rates when setting their deposit rates by using a multiplier with large banks pricing at 1.4x and smaller banks pricing at 1.5x.  However, this methodology had several alleged flaws. It disproportionally magnified the impact on longer term deposits and encouraged aggressive competition.

To rectify these flaws and align deposit rate setting with lending rates, the PBoC, in consultation with commercial banks  introduced a new mechanism for setting the ceiling on deposits.  This basis points method requires a variety of different spreads to be added to the official deposit rates depending on their maturities.  The new basis point methodology will also maintain a gap between large (10bps and 50bps) and small (20bps and 75bps) banks to preserve competition.

Impact on term deposit yields:

Time deposits yield curve will be flatter using the new methodology. This is especially noticeable for longer tenor deposits.

Source: PBoC, Bloomberg, J.P. Morgan Asset Management, data as at 30 June 2021

Implications:

The new methodology will reduce bank funding costs, especially for longer tenor deposits. However, given margin pressures, it is unlikely that commercial banks will pass on these savings onto borrowers. The impact on household and corporate savings will be minimal – interest rate sensitive money has already switched to other and/or higher yielding products, while the percentage of cash in longer-term deposits is small.

The new methodology will also further reduce the attractiveness of deposits and may force smaller commercial banks to increase reliance on the interbank markets. Finally, a lower deposit rate curve could flatten the commercial bank bond yield curve.

Source: PBoC, Bloomberg, J.P. Morgan Asset Management, data as at 30 June 2021

Conclusion:

The changes to the deposit rate setting mechanism is potentially a slight reversal of China’s multi-decade interest rate liberalization process.  Nevertheless, for banks it will offer the benefits of lowering fund costs and fixing the spread between shorter and longer term deposits.  Meanwhile, for the PBoC it reaffirms its unchanged rates outlook.  However, for more interest rate sensitive money market fund investors, we believe the changes will have little impact.