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China moves closer to 'riskiest' step with removal of loans cap

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China took one of its biggest steps in banking reform, moving to end a two-decade-old rule that has capped lending relative to deposits as Premier Li Keqiang seeks to usher in market-based economics.

[SHANGHAI] China took one of its biggest steps in banking reform, moving to end a two-decade-old rule that has capped lending relative to deposits as Premier Li Keqiang seeks to usher in market-based economics.

An amendment to the banking law will remove the 75 per cent limit, the State Council said on its website Wednesday. The Standing Committee of the National People's Congress needs to give approval at its meeting in March.

While the change has the potential to boost credit growth, a bigger constraint may be limited demand for funds in a faltering economy. Looming now is what the central bank has called one of the "riskiest" parts of financial reform, ditching a ceiling on the interest rates that lenders pay on deposits, a move that may come in the second half of this year.

"Banks' credit lending growth is expected to accelerate with the help of the move," said Xu Gao, chief economist at Everbright Securities Co in Beijing. "But we need to bear in mind that there is a bigger obstacle, which is sluggish financing demand from the real economy." The State Council plans for the loan-to-deposit ratio of banks to be monitored by authorities.

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Over the past two years, China's government has removed a floor on lending rates, allowed banks to pay up to 50 per cent more than benchmark deposit rates and established a deposit insurance system. Premier Li aims to boost the role of markets in a state-run banking industry that has US$29 trillion of assets, almost twice the amount of its US counterpart.

The central bank has indicated that a cap on deposit rates is likely to be scrapped this year. The risk: excessive competition for deposits could flow through to higher borrowing costs for companies and instability in the financial system.

The loan-to-deposit and reserve-requirement ratios "are the two most outdated and distorted regulatory measures in China's financial system," Larry Hu, head of China economics at Macquarie Securities Ltd in Hong Kong, wrote in a note. "Taking a long term perspective, it marks another key step in China's financial deregulation, a major market theme now and in the coming years."

The shake-up is five years after the nation completed the stock market listings of the last of its dominant big four banks, which include Industrial & Commercial Bank of China Ltd. The law limiting lending to 75 per cent of deposits has been in place since 1995.

Removal of the cap will be good for bank earnings and valuations, easing competition for deposits, according to Sanford C. Bernstein & Co analysts led by Hou Wei. They estimated that a 1 per cent increase in the ratio would lead to a 1 to 2 basis-point improvement in net interest margins and up to a 1.2 per cent increase in banks' 2016 earnings.

While the loan-to-deposit level for the industry was 66 per cent in March, and the China Banking Regulatory Commission eased the requirement last year by changing the method of calculation, it has remained a constraint for some listed lenders. Bank of Communications Co's ratio was about 74 per cent in March, while China Construction Bank Corp.'s was 72 per cent.

Wu Xiaoling, a former central bank deputy governor, has argued that the ratio and state-imposed quotas for lending have undermined banks' abilities to manage their assets and liabilities, and led to distortions such as the use of illegally obtained deposits to boost lending.

The government may rely on indicators such as a Basel III liquidity coverage ratio, which measures the amounts of easy-to- sell assets that banks have available in times of stress, according to China International Capital Corp.

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