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Last week, the People's Bank of China (PBoC) announced that it was removing the floor on lending rates.

At the time we pointed out that if policymakers were serious about interest rate liberalization they needed to remove the ceiling on deposit rates and reward Chinese households.

In a new note, Societe Generale's Wei Yao points out that removing the ceiling on deposit rates is complicated and could take a few years, for three key reasons:

  1. "If the cap on deposit rates were to be removed now, banks could feel pressure to raise deposit rates to compete for funding, which  may be only partially passed on to borrowers due to the economic slowdown. Subsequently, interest rate margin compression would be likely to occur during the period that non-performing loans  would be likely to continue to rise."

  2. "A deposit insurance scheme is perceived as a necessary condition for deposit rate liberalization, but the implication of such a programme is again that not every interest-bearing financial product will be backed by the central government and even banks can go under within the legal structure.

  3.  There isn't an adequate alternate to the benchmark deposit rate at the moment, and if the PBoC doesn't manage this carefully it could lose control of monetary policy.

This move is expected to cause near-term pain. But in the longer term, it's a crucial reform that will reward the Chinese household sector and help rebalance the economy away from exports and towards consumption.