ISSUES ON INTEREST RATE MARKETIZATION

Major achievements in interest rate marketization reform in the past three years

The formation mechanism of discount and rediscount interest rate was restructured in March 1998, liberalizing discount interest rate.

The interest rate of financial bonds issued by policy banks was liberalized in September 1998.

Government bonds began to be issued in the form of interbank bond market bidding in September 1999.

Consultative interest rate was introduced into the CDs of insurance companies in October 1999.

The loan rate floating amplitude of financial institutions has been expanded, varieties of loan rate have been simplified, and the approach of loan rate restructuring has been explored.

Interest rate instruments have been used flexibly, while the interest rate has been adjusted downward seven times successively, which promotes the sustainable rapid development of national economy.

Interest rate of loans in foreign currency was liberalized on September 21, 2000. The financial institutions are allowed to have negotiated interest rate for forex deposits above 3 million US dollars, which should be reported to the Central Bank afterwards.

The Central Bank has adopted flexible open-market operation to adjust the interest rate of money market. In the process of interest rate restructuring, the Central Bank has always paid attention to the adaptation of the reform process to the self-restriction ability of commercial banks and the macro adjustment ability of interest rate of the Central Bank.

The necessity and urgency of stable interest rate marketization

The aim of the restructuring is to raise the efficiency of capital allocation through financial market and accelerate the economic growth. After the reform of over twenty years, most of the commodity and service prices have been determined by market, and the efficiency of resources allocation by market has been improved greatly. However, the formation mechanism of the price of capital,i.e.,the interest rate is not as competitive as the price of commodity and service in general. Therefore, the efficiency of capital-concerned resources allocation is still restricted considerably. At the same time, the efficiency of capital utilization still needs improving.

Objectives and outline of interest rate marketization

The ultimate target of interest rate marketization is to valige market determined interest rate. Concretely speaking, commercial banks and financial institutions will have the right to decide the price of financial products, meaning that they can decide their deposit and loan rates on their own judges. Meanwhile, the Central Bank will indirectly influence the interest rate of banks by adjusting the interest rate of money market.

Interest rate of foreign currency goes first in the reform process. In order to keep the balance of capital account and guarantee break-even of foreign currency businesses of Chinese commercial banks, domestic deposit interest rate of foreign currency should keep up with that of the international financial market.

It is also understandable that the marketization of loan rate goes before deposit rate. The most difficult part of interest rate marketization is the reform of deposit rate. If commercial banks lack self-restriction and use abnormal interest rate to attract deposits, vicious competition without considering cost would occur, which would result in the huge loss of commercial banks and many other bad consequences.

Why do we insist in restructuring long-term before short-term interest rate? Because if otherwise, the capital resources of commercial banks and enterprises would tend to be short-term oriented, which would weaken capital stability and increase the liquidity risk.

Risk of interest rate marketization

The liberalization of capital price, i.e., the interest rate marketization, will be facing greater risks than commodity price restructuring. Risks can be classified into two aspects: on the micro level, commercial banks are impacted most. Because once commercial banks have the absolute power over interest rate, the competition in credit market would be fiercer. The competition in financial areas would be fiercer than that in industrial areas because due to the homogeneity of capital, capital can transfer easily among different banks.

On the macro level, the macro adjustment of finance will face a more unstable environment. In the booming period of economy, commercial banks may increase the loan according to the increasing demand of the market; while in the recession period, the loan may decrease greatly. After the liberalization of interest rate, the Central Bank can only adjust the interest rate through the indirect adjustment of interest rate of money market, which means the control ability on the macro finance fluctuation might be weakened. On the other hand, the great increase of financial derivatives makes the financial transaction more isolated from the real economy, which increases the macro financial risk at the same time. According to the experience of various countries, financial trading volume usually soared up after the liberalization of finance especially the liberation of interest rate.

Macro economic conditions for interest rate marketization

Is deflation a good time opportunity to implement interest rate reform? Generally speaking, interest rate reform will not cause a common increase of interest rate when there is insufficient demand in loan and high proportion of resident savings. From this point, it is good for the economy to implement interest rate reform in deflation period. On the other hand, considering the capital deficiency reality interest rate reform will increase the general interest rate level in a period of inflation, which will then have some effects of curbing inflation.

From the angle of macro economy performance, the interest rate marketization requires the general balance of total demand and supply. Under this circumstance, the adjustment of monetary policy may be more initiative and flexible. On the other hand, interest rate marketization optimizes the allocation of resources through the transfer of resources among different departments, industries, enterprises, and regions.

Micro economic conditions for interest rate marketization

From the angle of commercial banks as a whole, the spread between loan and deposit interest rate is the most important of all factors affecting the benefits. The direct control on loan and deposit rates by the Central Bank is to maintain the interest of commercial banks as a whole and is the necessity of the financial system stability while commercial banks lack self-restriction. This kind of protection will lead to the indolence of commercial banks and go against the general financial efficiency. Therefore, we must carry out interest rate marketization, reduce protection from the Central Bank gradually and ensure the reasonable interest rate spread of commercial banks at the same time. The key issue here is whether commercial banks are capable of controlling the deposit and loan rate themselves, in order to realize the effective control on the operating cost and revenue.

Interest rate marketization and development of money market

China’s interest rate marketization began with money market.

The marketized interest rate is the result of trading on money market. Money market is the place where many trading parities exchange their financial products. Competitive trading in money market forms the trading prices of financial products.

The interest rate marketization emphasizes money market as the basis, because commercial banks determine the loan and deposit rates based on that of money market. Money market interest rates actually determines the deposit and loan rate of commercial banks, which reflects their average financing cost and average capital revenue.

Interest rate marketization and development of capital market

The purpose of interest rate marketization is to raise the efficiency of capital allocation in financial market, including both money market and capital market. Money market affects the real economy mainly through the assets business of commercial banks, firstly, taking credit as intermediary while capital market does it more directly.

Capital market has always had a strong relationship with the interest rate policy of the Central Bank and the Central Bank has also put a huge concern on capital market including stock price. After the interest rate marketization, the capital flow speed between capital market and money market would be accelerated. We should sufficiently estimate the interaction between the interest rate and the capital market.

Coordination of interest rate marketization and other macro economic policies

The first is the relationship with fiscal policy. Sound fiscal situation is the basis of solid performance of macro economy. Sustained surplus and deficits go against the stability of macro economy, and cannot provide macro economic conditions for interest rate marketization.

The second is the relationship with employment policy, industry policy and regional development policy. In the process of industrialization, medium/small-sized enterprises are facing increasingly unfavorable situation in competition, but most of the employment opportunities are created by them. In order to increase employment, governments of all countries provide policy support to medium/small-sized enterprises, for example, certain credit quota requirment and appropriate preferential interest rate.

Management of interest rate marketization by the Central Bank

After interest rate marketization, the management of market interest rate by Central Bank should focus on the general level of interest rate and the supervision on the order of market rate.

Interest rate, as an important monetary policy instrument, is also the operational goal and intermediate goal of monetary policy. In recent years, many economic scholars from developed countries emphasize the importance of real interest rate, which is more suitable for the situation in the market-oriented developed countries. However, the cost and revenue management of commercial banks and enterprises in China has not reached required level, and the adjustment of money market interest rate by the Central Bank cannot effectively influence deposit/loan interest rate level of financial institutions. The transmission of interest rate is blocked in many ways, so real interest rate is not paramount important. But real interest rate becomes more and more important judging from the tendency of development. In the future, the Central Bank will use open market operation, re-loan, rediscount and other policy instruments to influence the demand-supply situation and interest rate level in the market, through which realizes its target of inflation and economic growth.

(by Dai Genyou, Director, Monetary Policy Department, People's Bank of China)