The People's Bank of China removed commercial banks' lending rate floor last Friday, allowing them to set their lending rates freely. Before the announcement, banks were not allowed to lend money at a discount over 30% of the benchmark set by the PBoC.

The move is largely hailed as symbolic as the more important ceiling on deposit rates was left unchanged. Market watchers and analysts say this was the result of China's conservatives offering concession on the removal of the lending rate floor in exchange for tightening their grip on the deposit rate ceiling.

It is generally accepted that the impact of removing the lending rate floor woould be limited in the short term.

UBS said that removing lending rate restrictions signals the government's resolve to liberalize interest rates, and over time, this should help lead to more market-oriented allocation of capital.

At least in principle, banks will be free to differentiate pricing strategies and lower financing costs for corporate and household clients. This may lead to more competition, and overall rates could drop as competition stirs up in the banking sector, UBS noted. The margin squeeze could improve efficiency of banks and better services.

In the short term, removing the lending rate floor may not lead to a meaningful decline of financing costs. According to the PBoC, 65% of bank loans were made above the benchmark lending rate in Q1 2013, 24% at the benchmark rate and only 11% below benchmark rate.

The proportion of loans made above the benchmark rate was higher in Q1 2013 than a quarter earlier. So it is estimated that the effective 1-year lending rate actually went up by 0.16 percentage points to 7.16% as of the end of March 2013 from a quarter earlier, and may have continued ticking up in Q2 2013.

As a result, the removal of the lending rate floor, without an increase in the relative supply of lending, will probably have no practical effect on the cost of money in China in the near term, UBS argued.

Deutsche Bank said the reform could potentially reduce average lending rates if the central bank injects more liquidity into the interbank market or reduces the reserve requirements, but it could marginally reduce banks' net interest margin at the same time.

Last Friday the PBoC also scrapped the rate controls on discounting commercial bills and the lending rate caps on rural credit cooperatives in move to slightly help increase funding availability for small firms. The floor on mortgage rates was left unchanged.

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