Excerpts from My Essay on “Chinese Interest Rate Liberalization” Why would a nation want to liberalize interest rates? There are both positive and negative consequences to discuss here. Positively, looking at the effects on monetary policy, “liberalization enhances the effectiveness of indirect policy and interest rates as price signals,” (Feyzioglu, 11). Historical examples have shown that monetary policy becomes “highly effective after interest rate liberalization,” (11). Also, liberalizing the deposit rate, “allows banks an additional channel to compete for deposits, and therefore fund their lending operations,” (8). By this, consumers are more inclined to hold accounts with banks that have higher deposit rates. This liberalization increases the account value for the customer, and gives the bank additional capital to use in lending. For banks, lending is obviously used to generate more profits. In theory, liberalizing the lending rates would produce a very similar result. With a lower rate that banks are required to pay to lend, also known as “loose monetary policy”, we should expect the volume of loans outstanding to increase.
On the other hand, interest rate liberalization comes with its draw backs as well. Many studies have shown that almost all banking crises have been associated with financial liberalization, (Kaminsky, 1998). Even further, financial liberalization has been known to expose the risk and poor performance of portfolios prior to liberalization, (Caprio and Klingebiel, 1996). Another possible cost is strengthened price competition and reduced profitability in the banking sector without direct regulation of credit. However, it’s reasonable to argue that increased competition contributes to greater efficiency and discipline on banks. Thus, as there are no conclusive relationships between liberalization and crises or reduced profits, further analysis of China’s economy is needed to develop an argument.
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