News Analysis: China steps closer to full interest rate liberalization

China's new move to scrap the mandatory loan-to-deposit ratio (LDR) is set to help reduce the country's overall financing costs and bring it one step closer to full interest rate liberalization.

The State Council, or the cabinet, on Wednesday passed a draft amendment to China's Banking Law that gives banks more freedom to make loans by removing the 75 percent loan-to-deposit ratio.

The ratio will instead be seen as a liquidity-monitoring indicator, according to a statement released after an executive meeting chaired by Premier Li Keqiang.

The move will enable financial institutions to increase lending to agriculture and small businesses, the statement said.

Zeng Gang, with the Chinese Academy of Social Sciences, said the removal of the LDR requirement was an "inevitable result".

"As a banking liquidity indicator, mandatory LDR is falling behind the reality of banks' rising borrowing costs and cannot reflect the real liquidity conditions of the banking sector," Zeng said.

The rule has resulted in distortions in the financial market, as many banks had to rush to absorb more deposits at the end of each month to meet the requirement, he said.

The draft amendment will be tabled to the top legislature, the National People's Congress Standing Committee, for review.

China has kept the 75 percent ratio unchanged for years. Last year, the central bank expanded the definition of what constitutes a bank's deposits in a bid to release more capital for lending.

At the end of the first quarter this year, the overall LDR was 65.67 percent, much lower than the 75 percent red line set by the banking regulator.

But some small and medium-sized banks have LDR levels nearing or even higher than the line.

Zhong Hua, researcher with the Hong Kong-based Hang Seng Bank Limited, said the new move will give small and medium-sized banks more room to make loans.

"Since those banks lend mostly to small and medium-sized enterprises [SMEs], the move will help lower the financing cost of SMEs and promote their development," Zhong said.

Lian Ping, chief economist with the Bank of Communications, agreed, saying that the measure is conducive to reducing lending rates and thus the overall social financing costs.

"In terms of immediate impact, we do not think the removal of the LDR will have a material impact on loan growth," a research note from the HSBC reads.

The real constraint on bank lending is risk aversion, which meant that the willingness to lend has diminished faster relative to the demand from borrowers. Therefore more aggressive monetary policy easing is still the most effective antidote to the slowdown in lending growth, HSBC said.

"The move is another step on the path of financial reform and interest rate liberalization," it said.

Zhou Xiaochuan, governor of China's central bank, said earlier this year that there is a high likelihood that interest rate liberalization reforms will be completed by the end of this year.

With the removal of LDR reducing deposit rate competition, and hence lowering upward pressure on interest rates, HSBC said it expects an announcement removing the deposit rate cap before the year's end. Endi