OREANDA-NEWS. China's introduction of bank deposit insurance, set for 1 May, is an important precursor to further reforms to the banking system which include full deposit-rate liberalisation, says Fitch Ratings. An ongoing commitment to pushing through key reforms is indicated by the government proceeding with deposit insurance at this time. Chinese banks are facing rising operational headwinds from slowing growth, margin pressures and weakening asset quality. The reforms could have significant implications for both the sector and wider economy.

Most notably, deposit insurance is a pre-requisite for full interest-rate liberalisation which Fitch views as a powerful driver of macroeconomic rebalancing. By allowing banks to raise deposit rates, this could act to transfer wealth away from more leveraged corporates to net savers, namely households. Rebalancing to a less credit-intensive and more consumption-oriented (as opposed to investment-oriented) economy is key for China to avoid any further build-up of structural vulnerabilities, and for establishing a more sustainable growth path.

For the time being, however, the deposit rate ceiling at 1.3x the benchmark rate - together with earlier asymmetrical rate cuts - leads Fitch to believe there is limited room for banks to hike deposit rates further over the short term, even if the deposit ceiling is removed altogether.

Critically, the introduction of deposit insurance may be a step toward Chinese banks being allowed to default, and more domestic creditors being exposed to some form of losses. This would especially be the case if deposit insurance also sets the stage for a formal bank resolution framework which may lead to reduced government support for some financial institutions. Fitch does not expect any imminent changes to our current support ratings as a result of the deposit insurance plan. A greater tolerance for defaults in the broader corporate sector would need to occur before we would expect support for banks to decline.

A key question is whether the formal deposit insurance scheme will change depositors' perception over the implicit state guarantee for banks. If retail depositors still expect the state to bail them out in the event of stress, then having a deposit insurance scheme will not make a significant difference to deposit patterns.

If depositor perceptions shift, however, this could then prompt the diversification of larger deposits among different institutions and a flight to quality to the strongest banks. Smaller banks would see their liquidity risks and funding costs rise in the event of more intense competition for deposits. This could in turn prompt an increase in funding sourced through the inter-bank market and/or through off-balance-sheet channels such as the issuance of wealth management products.

Alternatively, the authorities may need to introduce additional measures to improve system liquidity. Overall, a tougher operating environment could also act as a catalyst to expedite consolidation.

The deposit insurance scheme will provide coverage up to CNY500,000 per deposit holder per bank, including local- and foreign-currency deposits and accrued interest. All commercial banks (including wholly foreign-owned or Sino-foreign owned banks), rural credit cooperatives and cooperative banks must participate in the plan, but foreign bank branches and overseas branches of Chinese banks are excluded.

The insurance to be paid by the banks will include a risk premium based on the credit profile of the individual bank in addition to the standard rate, and are subject to changes upon approval from the State Council. Beyond these broad guidelines, there are few details as to how the plan will work in practice.