beyondbrics

India’s economy has finally leapfrogged China’s. No, not in growth – that will have to wait another couple of years. But with a key economic reform, Delhi has stolen a march on Beijing.

By deregulating interest rates on savings accounts last week, India introduced a change that China has long talked about as a way of taming asset bubbles and stimulating domestic consumption, but has ultimately shied away from implementing.

China rarely looks to India as a paragon of good economic management. After all, in dollar terms, Chinese GDP per capita has gone from about the same as India’s two decades ago to being more than three-times as large today.

So it was provocative when Peng Wensheng, chief economist at China International Capital Corp, a leading domestic investment bank, wrote a note (in Chinese) this week titled “India frees its deposit rate — is it worth learning from this?”

Before India swells with pride, though, it would appear that the main lessons are negative: what to avoid rather than what to do.

“Controlling interest rates in India had led to an outflow of savings from banks, sparking a rise in direct financing and off-balance-sheet activity that aggravated asset bubbles and the unfair distribution of wealth. Although India’s liberalisation of savings rates appears sudden, in fact it was the result of a long-standing contradiction between high inflation, negative real rates and fixed deposit rates.”

India had held rates on savings accounts at 3.5 per cent for eight years until May, even as inflation ran near double digits.

China too has seen savings rates periodically fall into negative territory. At present, one-year deposits earn 3.5 per cent and consumer price inflation is 6.1 per cent. But through a bevy of administrative controls, China has been able to rein in price pressures in a way that India has not, and inflation is now on track to slow.

There are also plenty of differences between the financial systems that make the liberalisation of rates trickier in China.

As Peng points out, bank deposits are 92 per cent of the total value of the stock and bond markets in India, but in China they are 140 per cent. Additionally, the savings rates that India liberalised apply to about one-fifth of the deposits in the banking system; household savings are more than two-fifths in China.

Most importantly, Peng argues that the benefits of rate liberalisation must be balanced against the risks.

“If banks cannot effectively judge customer credit risk and regulators cannot appropriately supervise banks, then the risks of marketisation are quite big.”

China has taken a series of small steps towards liberalising rates. It has introduced an interbank lending rate that has become an important benchmark in recent years. It has allowed banks to experiment with competition on deposit rates in the field of wealth-management products. And it has expanded the scope for them to compete on lending rates.

Peng was too diplomatic to say so, but his verdict seems clear.

India reformed rates from a position of weakness. China is trying to attain a position of strength before pulling the trigger.

Related reading:
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India: outpacing China by 2013?, beyondbrics
Guest post: China’s disappearing bank deposits, Victor Shih on beyondbrics