How high will the rate wall get? That's from the FT on the central bank's push to keep money market rates up as it seeks to delever the financial system without, hopefully, bringing the whole thing down. In order to do just that, the PBoC apparently tightened again just before the end of 2013. On December 31 in fact. Cheery. As the FT's Rabinovitch said, the PBoC has been about as clear as possible in stating what it hopes to achieve by nudging rates higher. "Banks must strengthen their liquidity management," it has said in repeated statements. Anyway at the risk of boring everyone with more China rate stuff this week, here's how UBS's Wang Tao sees China's ongoing attempt at liberalisation going in 2014. Tao, it should be said, seems far more sanguine about the process than many and since we have no idea how this will play out, it's worth a read. On if, and by how much, rates will move up, with our emphasis: A recent study done by researchers at the Hong Kong Institute of Monetary Research (Dong He et al 2013) suggests that China's real "equilibrium" interest rate could be about 4-4.5% after liberalization. This implies that the average real rates will rise by 200-250 bps in the process of liberalization, as the current real rate (average of lending and deposit rates) is about 2%. The HKIMR paper used three empirical methods to calibrate the "natural interest rate" (equilibrium rate) for China, one of which was by estimating (and eliminating) the impact of financial repression on China's interest rate using cross-country data and the IMF's index on financial repression (Abiad 2008). The authors acknowledged many problems with various estimates, including relying on models with assumptions not-applicable for China, but such issues are likely to exist with any estimates of "natural interest rate." An important issue is that existing estimates do not take into account how high savings may affect the "natural interest rate" post financial liberalization. Experience from East Asian economies showed that real interest rates in Japan, Korea and Taiwan did move higher as they liberalized interest rates and financial market in the early to late 1980s, but subsequently fell and stabilized<. It is notable that as Japan and Korea developed, the growth-interest rate differential narrowed and turned positive, fitting the "golden rule" [that a country's nominal interest rate should be at or above its nominal GDP growth rate, and which probably doesn't count for much in DMs] in the early 1990s and the past few years, respectively (Figure 11) ... We think real average rates will go up by less than 200 bps in the next 2 years as can be inferred from the above research. First, high saving and ample funds for credit expansion help. Second, we think interest rate liberalization will be pursued gradually over the next 2-3 years. Last but not the least, the low level of global rates and increased financial integration will limit rate increase at home. As capital controls are gradually eased, we expect the large interest rate differentials and stable RMB exchange rate to attract more FX inflows, including in the form of much higher foreign borrowing by domestic companies. Already in Q1-Q3 2013, we estimate that non-FDI capital inflows reached around USD 35 billion, helped by a relaxation in foreign borrowing, low external rates, and a steadily appreciating exchange rate... In 2014, we expect the 7-day repo rate, the most representative rate in the money market, to average 4-4.5%, and expect the 10-year government bond yields to stabilize slightly below 5%. Meanwhile corporate bond yields and shadow banking rates may go up further. On how the rate movement might affect the economy: In principle, higher interest rates will negatively affect the economy in the following ways: (1) higher rates lead to a drop in credit demand, which will lead to slower investment and GDP growth; (2) Higher rates increase borrower's debt burden and reduce their cash flows and ability to invest; and (3) higher rates worsen the asset quality of existing debt, leading to more non-performing loans, which could force de-leverage in the financial system and in the economy. However, one also needs to look at the quantity of credit in the course of financial liberalization. The experience of most other countries following financial liberalization show that credit typically expanded more rapidly soon after than before. There are typically two reasons: Higher lending rates and narrowing of interest margins drive banks to lend more; Development of financial markets, including shadow credit market, following the liberalization creates more channels for credit expansion. Figures 13-16 show that credit as a share of GDP increased markedly following financial liberalization in the US, Japan, Korea, and Taiwan. In the case of the US, non-bank credit (including shadow banking) developed even more rapidly. More extensive empirical research (for example, Kaminsky and Schmukler 2003) also showed that most countries have seen a financial market boom soon after financial liberalization. And why they are not very concerned that rising rates will lead to a big drop in credit growth: In the case of China, the increase in money market rates and bond yields so far is not yet that significant for the economy. Banks" funding costs are still anchored by controlled deposit rate, though that will be eroded down the road. The rising bond yields and money market rates have not and will unlikely transmit to a large extent to the loan market in the near future. The amount of credit affected by the rising rates is relatively small, constituting mainly of corporate and LGFV bonds and off-balance sheet credit, accounting for about less than a quarter of the overall credit... Changes in interest rates have never been and are still not the main channels through which credit growth is affected.With extensive financial repression and non-binding interest rates, the government has typically relied on base money supply, credit quota, and sector-specific credit policies to manage credit growth and achieve desired road money growth target. The current interest rate level is still below the market-clearing level or the returns to capital in the economy. As such, the ongoing rise will unlikely lead to credit demand dropping to below what the government is willing to supply, which we think could be another 17 trillion in TSF and at least another 9 trillion in RMB loans for 2014. In the meantime, banks still want to expand their balance sheet to gain more revenue and regulatory protection, as margins are still largely protected. Higher rates will mean higher debt burden for the borrowers that rely on the bond and shadow banking market, including LGFVs, some SOEs, property developers and some SMEs. The overall impact of higher rates will depend on the speed at which budget constraints are hardened in the economy - we deem that to be relatively slow. If the borrowers all faced hard budget constraints, their spending and borrowing would be quite negatively affected. However, many of the borrowers which face rising rates have relatively soft budget constraints, and are insensitive to rate rises. Even as the government vows to control local government debt, other means of financing are contemplated, including special agency and/or instruments for infrastructure financing. The latter can help to reduce the debt burdens and cash flow pressures in the process of interest rate liberalization while supporting continued increase in debt and growth. Of course, not all borrowers that face higher interest rate can rely on the government's help. Companies that are likely to be hurt more by the rising rate are SMEs, some property developers, and some heavy industry borrowers. Non-performing loans will likely rise. However, to the extent the impact of higher rates on overall credit (and therefore GDP growth) is limited, and to the extent that some of the borrowers with worse asset quality are protected by the government, the impact on banks" balance sheet will also be limited. Interest rate liberalization, accompanied by more general financial liberalization, will lead to an erosion of banks" dominance in the financial system, the development of shadow banking market, and likely increased volatility in financial markets in the next few years. These are conclusions drawn from empirical evidence from other countries, including from the US and East Asian economies (for example, Figure 17 below, and Kaminsky 2003).