Interest rate liberalization is of great importance for the establishment of a more market-oriented economy as well as a more functioning financial market in China.

Administratively regulated interest rate twists the demand/supply balance of the banking market, distorting the banking behavior of both lenders and households.

Generally speaking, with regulated interest rates, households are not appropriately compensated for their deposits and hence do not have the motivation to deposit as warranted by market conditions. Meanwhile, banks are not appropriately priced for their deposit-taking and lending business and thus do not have incentives to make efficient use of the deposits as warranted under market prices.

In the case of China at the present stage, this has resulted in two critical and troublesome issues.One is a negative real interest rate in the context of increasing inflation, and the other is the fact that bank funds are always channelled to larger and better-connected enterprises, but away from smaller-sized or private enterprises.

The liberalization of interest rates, that is not to administratively regulate but allow the market to determine interest rates, is therefore necessary. Market-determined deposit rates will allow households to be compensated for their deposits according to market conditions, which will eliminate or at least improve negative interest rates, increase the financial income of households and give households more motivation to deposit. The role of market-oriented lending rates is also important in the sense that it will improve the allocation and efficiency of investment considerably by channelling funds to sectors and enterprises that are more in need. As a result, more funds would go to smaller and private enterprises, instead of larger or better-connected enterprises.

In fact, China has taken important steps in liberalizing its interest rates over the past 15 years. Inter-bank interest rates were first liberalized in 1996, soon followed by market-determined yields of financial and treasury bonds. In 2004, an important development took place as the ceiling for lending rates and the floor for deposit rates were lifted.

Then short and medium-term corporate bonds and notes with market-determined interest rates were introduced in 2005 and 2008 respectively. Meanwhile, a major advancement of rate liberalization was the launch of the Shanghai Interbank Offering Rate benchmark rate system in 2007.

Despites these steps, two regulatory restrictions remain - that the People's Bank of China (PBoC) maintains a floor on lending rates expressed as a fraction of 0.9 percent of the PBoC's benchmark rates, and a ceiling on deposit rates for all tenors. These two restrictions are devastating because they prevent banks and households/enterprises from dealing at market prices.

That is, banks are not able to make deposits-taking and lending decisions based on their opportunity and risk assessments, nor can households/enterprises make deposit/borrowing decisions based on their cost/benefit considerations in view of market conditions. Consequently, negative real interest rates and biased lending to larger and better-connected enterprises remain.

Admittedly, the floor on lending rates and the ceiling on deposit rates have played important roles in protecting China's banking system from excessive competition for funds and the resultant instability of the banking market. And indeed, overall fund demand still exceeds fund supply in China as the banking system is not yet sound enough to withstand severe competition at the present stage. Therefore, immediate and complete removal of the deposit rate ceiling and lending rate floor is not justifiable.

But this should not prevent us from making progress in the liberalization of interest rates. Negative real interest rates and biased lending towards large and well-connected enterprises have severely hurt economic and social developments as well as reforms.

The gradual removal of the lending rate floor and deposit rate ceilings are thus called for. First the floor for the lending rate should be lowered, and then the ceiling of the deposit rate increased in an incremental manner. Eventually both should be lifted. In line with this development, more banks, particularly small to medium-sized ones which focus on serving small- to medium-sized and private enterprises, should be established. This is in order to ease the market demand/supply tension for funds and in turn facilitate a market-determined interest rate environment.

Zhou Xiaochuan, governor of the PBoC, said recently that China would make marked progress in interest rate liberalization during the 12th Five-Year Plan period. It means that the central government is to embrace a faster pace of interest rate liberalization in the coming five years. Practical and effective measures, however, need to be developed to facilitate the process. They will make a significant contribution to the country's further economic reforms and development over the next five years.

The author is senior vice-president, chief economist / strategist for China Banking at CITIC Bank International. The opinions expressed here are entirely his own.

(HK Edition 06/01/2011 page2)