China's interest rate liberalization process has yet to be completed. Despite removal of deposit interest rate ceilings on 23 October 2015, controls like window guidance are still imposed to prevent commercial banks from setting interest rates freely. This paper estimates implicit interest rates in China (i.e., the additional yield to official interest rates that banks must pay to attract deposits) using headquarter-level data of 88 commercial banks from BankScope and branch-level data of 317 branches in 90 counties and 14 provinces for the period 2005–13. The econometric methods allow for both heterogeneity and spatial correlation in banks’ behavior to better capture the characteristics of the Chinese banking industry. Three main findings emerge from this study. First, the estimated mean implicit interest rate is between 70 percent and 78 percent of the explicit interest rate—ignoring implicit interest rates results in underestimation of funding costs. Second, a 1 percent increase in deposit interest rates is estimated to decrease implicit interest rates by 0.44 percent, implying that the cost of interest rate liberalization will be smaller than the increase in deposit interest rates. Third, small share-holding banks, city commercial banks and rural commercial banks pay higher implicit interest rates than large state-owned banks. To promote efficient resource allocation, therefore, interest rate liberalization needs to be firmly pursued but its impact on different types of banks needs to be closely monitored to minimize disruptions to the real economy.

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