Monetary Policy Analysis Group of

the People’s Bank of China

 

January 2005
Executive Summary

 

The market-based interest rate reform is an important element of China ’s efforts to develop the socialist market economy and enhance the role of the market in resource allocation. It is also a key step to strengthen the indirect financial management and a prerequisite for improving the operating mechanism and increasing the competitiveness of the financial institutions.

 

In 1993, a blueprint for carrying out the market-based interest rate reform was drawn up in the Decision on Issues concerning Establishing the Socialist Market Economic System adopted by the 3^rd plenum of the 14^th CPC National Congress and the State Council’s Decision on the Reform of the Financial System. In 2002, it was decided in the report of the 16^th CPC National Congress to “steadily advance the market-based interest rate reform and improve the allocation of financial resources”. In 2003, the Decision on Issues concerning Improving the Socialist Market Economic System adopted by the 3^rd plenum of the 16^th CPC National Congress further pointed out that steps would be taken to “steadily advance the market-based interest rate reform and improve the interest rate formation mechanism based on market supply and demand”. The Decision also required that “the central bank guide the movement of market interest rates by applying various monetary policy instruments”.

 

The above important decisions adopted by the Central Party Committee and the State Council clearly pointed out the way forward for the market-based interest rate reform. In terms of the sequence of the reform, interest rate in money market and bond market will be liberalized first, followed by gradual liberalization of the interest rates of loans and deposits. In liberalizing the loan and deposit rates, reform measures will be introduced on foreign currencies before domestic currency, on loans before deposits, and on long-term and large-value loans and deposits before short-term and small-value instruments.

 

In recent years, steady progress has been achieved in China ’s market-based interest rate reform. Since 1996, interest rate in the inter-bank borrowing market and bond market and the issuing rate of the treasury bond and policy financial bond were liberalized; controls on the interest rate on foreign currency loans and large-value foreign currency deposits was removed; long-term large-value RMB negotiated deposit was introduced on a pilot basis; and the band of interest rate of RMB loans was gradually widened. In particular, important steps were taken in 2004 to further advance the market-based interest rate reform. The band of lending rate of the financial institutions was further widened on January 1, 2004 . The system of allowing the central bank some discretion to add surcharge on its lending rate was introduced on March 25, 2004 . On October 29, 2004 , the upper limit on the interest rate of loans of the commercial banks was removed and that of the rural and urban credit cooperatives was raised to 2.3 times the benchmark rate. Lower limit was no longer applied to the interest rate of RMB deposits.  

 

In the course of market-based interest rate reform, efforts have been made to develop the interest rate system of the central bank. The formation mechanism of rediscount rate was reformed and the central bank was given some discretion to add surcharge on its lending rate, leading to improved interest rate structure of the reserves of the financial institutions. The central bank has also flexibly adjusted the benchmark interest rate of loans and deposits of the financial institutions and coordinated the interest rate policies for domestic and foreign currencies in line with macroeconomic developments. With these measures, the central bank has gradually improved the regulation mechanism and strengthened its macroeconomic management capability. In 2005, continued efforts will be made to promote the market-based interest rate reform. The financial institutions will be encouraged to further enhance their development potentials and strengthen asset/liability management and credit risk pricing. Sound interest rate pricing mechanisms will be set up based on the symmetric risk-return principles. Meanwhile, the interest rate management system of the central bank will be further improved.   

Part One  The Process of Market-based Interest Rate Reform

 

Steadily advancing market-based interest rate reform is of utmost importance in China ’s financial reform. In the early years of reform, emphasis was placed on ironing goods prices. Starting from late 1990s, priority has been given to rationalization and market-based reform of production factors price. Market-based reform of interest rate, which is the price charged on credit fund, one of the important production factors, constitutes a vital integral part of the liberalization process of production factors price. The reform was launched and advanced based on worldwide experiences and the strategy mapped out by the CPC Central Committee and the State Council. The broad guiding principles are to liberalize interest rates of the money market and bond market before those charged for deposits and loans.

 

I. Liberalization of inter-bank lending rates

Inter-bank lending rate is the foundation of the overall financial market interest rate, and thus is targeted as the breakthrough point of the whole interest rate reform process.

 

1.      Pilot liberalization of inter-bank lending rate

On January 7, 1986 , the State Council promulgated the Provisional Regulations of the People’s Republic of China on Banks that explicitly stipulated specialized banks may lend to each other, with the maturity and interest rate of the lending set based on negotiations of the concerned parties. From then on, inter-bank lending business spread quickly throughout the country. In allusion to the problems as market participants lacking risk awareness during the early stage of inter-bank market development, the Provisional Rules on Administration of Inter-bank Lending Business was released in March 1990, which for the first time formulated operational rules for the inter-bank market and set the principles of imposing upper limits on inter-bank lending rate. This document has played an active role in the regulation of inter-bank market development and in risk prevention.

 

2.      Official liberalization of inter-bank lending rate

On November 30, 1995 , in accordance with the instructions of the State Council about development of financial market, the People’s Bank of China (Hereinafter referred to as the PBC) dismantled all the inter-bank intermediaries such as the financing centers established by the commercial banks. Starting from January 1, 1996 , all inter-bank lending business has been reorganized through the nationwide unified inter-bank market network, leading to the formation of CHIBOR. Thus, the institutional and technical conditions have so far been basically prepared for the liberalization of inter-bank lending rate.

 

On June 1, 1996 , the PBC issued the Notice of Abolishing Upper Limits on Inter-bank Lending Rate that clearly stipulated the inter-bank lending rate should be decided independently by both sides of the transactions according to the market supply and demand of credit fund. The liberalization of inter-bank lending rate marked an important pioneering stride forward and created a solid foundation for the subsequent market-based interest rate reform.

 

II. Liberalization of bond market interest rate

Bond market is an important component of the financial market and the liberalization of bond market rate has constituted an important step in advancing the overall market-based interest rate reform.

 

1.      Issue of government bonds on pilot market basis

In 1991, government bonds issuance started to take the form of market underwriting. In 1996, the Ministry of Finance introduced the market-based issuance of government bonds through the platform of stock exchanges, helping improve the efficiency and lower the cost of government bond issuance. Annual issue of government bonds in that year reached RMB195.2 billion yuan, which was affected in various forms like interest rate bidding, yield bidding and date of fund transfer-based bidding. In the mean time, a single price or multi-price bidding was adopted according to the demand and supply in the market and the issue volume. This represented the starting point to liberalize interest rates of bond issue in China and gained experience for the introduction of market-based reform of bond interest rates later on.

 

2.      Interest rates liberalization of bond repo and outright cash transactions in the inter-bank bond market

On June 5, 1997 , the PBC issued the Notice on Issues Concerning Inter-bank Bond Repo Transactions, and decided to utilize the nationwide inter-bank lending market to deal in inter-bank bond repo transactions. Based on the experiences attained in the liberalization of the inter-bank lending rate, the PBC decided to proceed with a liberalization of the bond repo interest rate and the outright cash transaction price in the inter-bank bond market and leave the rates to be negotiated by the involved parties.

 

Such a measure not only increased the capital utilization efficiency of financial institutions, but also enhanced their incentives to adjust the assets and liabilities structure. With the persistent increase of the turnover of bond repo and outright cash transactions in the inter-bank bond market, their characteristics as a short-term position financing instrument became increasingly evident. Short-term repo rate was an important indicator for central bank in reviewing the positions of the depository financial institutions, and thus laid the foundation for its open market operations. The liberalization of interest rates for inter-bank bond repo and outright cash transactions strengthened the market capability in finding the proper price and prepared good conditions for further liberalization of the issuance rate of government bond and policy financial bond in the inter-bank market.

 

3.      Liberalization of the issuance rate of policy financial bond and government bond in the inter-bank bond market

Before 1998, policy financial bond was issued at administered interest rates, discouraging subscription from the commercial banks as the set price could not meet the expectations of the bond issuers and investors at the same time in terms of interests protection. By 1998, as interest rates of the inter-bank lending, bond repo and outright cash transactions have already been left to be decided by the market, the conditions to introduce market-based issuance of financial bonds by the policy banks turned mature. In September of 1998, China Development Bank issued financial bonds based on public bidding through the bond issuance system of the PBC for the first time, followed by the issuance of financial bonds by the China Import and Export Bank in the same way. In 1999, for the first time, the Ministry of Finance issued government bonds by the way of interest rate bidding in the inter-bank bond market.

 

Liberalization of the inter-bank bond market rates has effectively promoted the development of the inter-bank bond market in that it provided an important reference for the pricing by the financial institutions of their products, started the gradual formation of a long-term interest rate and market yield curve, and built the market foundation for the implementation of monetary policy based on indirect instrument. First, financial institutions have more incentives to adjust their asset structure, resulting in a steady increase of their bond investment, a decline of excess reserve ratio (See Figure 1) and an improved sensibility to the central bank’s open market operations. Second, open market operation instruments were diversified, lending to increased flexibility and intensity of the operations.

 

Figure 1. Securities investment and excess reserve ratio of financial institutions

Source: Monthly Report of the People’s Bank of China on Sources and Uses of Renminbi Credit Funds of Financial Institutions.

 

Box 1  Development of the Inter-bank Market and Market-based Interest Rate Reform

 

In light of international practice, development of the financial market is vital to the market-based interest rate reform. First of all, the development of financial market increases the role of interest rate in resource allocation; second, the development of financial market provides favorable conditions for the innovation of financial products, which is key to the market-based interest rate reform; third, the development of financial market makes it possible to foster a parallel improvement of the central bank’s ability to manage interest rate and the ability of the financial institutions to price financial products and to control interest rate risks, and therefore is important to improve central bank’s macro-financial management system and operational capability of the financial institutions.

 

To steadily advance the market-based interest rate reform, the PBC earnestly followed guidance of the central government, put emphasis on inter-bank market construction, improved market regulation system and provided institutional support for the reform process. In recent years, regulations and rules on management of inter-bank lending business, assets and liabilities ratio of the commercial banks and inter-bank bond transactions were successively promulgated establishing fundamental rules for the inter-bank market operations.

 

Recently, inter-bank market participants have kept expanding. In particular, inter-bank lending market participants have been increased to include most financial institutions, such as depository financial institutions, some non-bank financial institutions and policy banks issuing bonds based on market principles, with the number of participants escalating from 96 at end-1997 to 656 at end-2004. Inter-bank bond market participants have been widened to include various financial institutions and non-financial institutions as legal entities, such as city commercial banks, insurance companies, foreign banks engaging in RMB business, securities companies, fund management companies, financing companies and leasing companies, with the number of participants increasing from 16 in 1997 to 3983 at end-2004.

 

While participants of inter-bank market kept increasing, instruments and transaction methods also diversified. Take the inter-bank bond market as an example, after the introduction of market-based issuance of policy financial bonds in 1998 and government bonds in 1999, instruments traded in the inter-bank bonds market were greatly diversified, with new products such as discount bond, coupon bond, strip bond, and optional bond etc successively launched. In terms of the bidding methods, quantity bidding and interest rate bidding were both adopted. On April 12, 2004 , the PBC promulgated the Administrative Rules on “Sell-buy Back” Repo Transactions in Nationwide Inter-bank Bond Market, which further diversified the bond repo transactions and improved the pricing and risk preventing functions of the market.

Turnover of inter-bank market transactions kept growing, consistent with the increasing market participants and growing diversity of financial products. Statistics show that, inter-bank lending totaled RMB1.46 trillion yuan in 2004, augmenting by 6 times of that in 1998; outright cash transactions in inter-bank bond market totaled RMB2.52 trillion yuan, increasing by 758 times of that recorded in 1998; turnover of bond repo transactions increased by 90 times from 1998 to RMB9.31 trillion yuan in 2004.

The recent development of the inter-bank market is of great importance to China ’s financial reform. First, inter-bank market development helped build the foundation for the formation of completely market-based benchmark yield curve. At present, inter-bank lending rate and repo rate have served as important references for the pricing of short-term financial products, and the issuance rate of bond in inter-bank bond market and yields in the secondary market also provided references for the pricing of medium and long-term products. Second, inter-bank market has become an important platform for the conduct of monetary policy based on indirect instruments. Since 1998, open market operations have become the most important instrument for the central bank in its conduct of monetary policy. The sensibility of market participants to monetary policy signals was continuously enhanced and the monetary policy transmission became more fluent, leading to increased flexibility and effectiveness of monetary policy conduct.

 

III. Market-based reform of lending and deposit rate

Deposits and loans of commercial banks are currently still the main channels for the accumulation and supply of social fund in China , and they also constitute the major business of the commercial banks. Therefore, introduction of a market-based deposit and lending rate holds the key to the success of the overall interest rate reform. The guiding principles are to liberalize interest rate of foreign currency before that of domestic currency; lending rate before deposit rate; and rate of long-term, large-value funds before that of short-term, small-value funds.

 

1.      Progress in domestic advancing market-based reform of foreign currency rate.

Since 1996, with the introduction of foreign currency business in the commercial banks, a pricing system for foreign currencies was widely established across the banking sector. Besides, supply and demand for foreign exchange in domestic market is both relatively adequate, which creates a good opportunity for introducing market-based reform of foreign currency rate. On September 21, 2000 , with the approval of the State Council, the PBC started reform of its administration on interest rates of foreign currencies in the domestic market. First, foreign currency lending rates were liberalized, with financial institutions granted the discretion to set foreign currency lending rates as well as the calculation and payment of interests on the basis of international market change and other factors as the financing costs and risk profiles etc. Second, large-value foreign currency deposit rate was liberalized, with the interest rates of large-value foreign currency deposits above the value of USD3 million (inclusive) left to be negotiated and agreed between the financial institutions and their customers.

 

In March 2002, the PBC applied interest rate management policy on small-value foreign currency deposits of the domestic residents in foreign financial institutions. In July 2003, the interest rate of small-value deposit in pound sterling, Swiss Franc and Canadian dollar was liberalized, allowing the commercial banks to quote and publish interest rate of their own discretion, while the quotation and publication of interest rate of small-value deposit in the US dollar, Euro, Hongkong dollar and Japanese Yen remained in the hands of the central bank.

 

In November 2003, the lower limit of the interest rate of small-value foreign currency deposits was removed, enabling commercial banks to set their own interest rates below the upper limit set by the PBC according to changes in international financial market. This decision was a positive step forward in advancing the market-based deposit rate reform.

 

In November 2004, the PBC liberalized the interest rate of small-value foreign currency deposit with the maturity above one year, endowing commercial banks with greater discretion in the decision of foreign currency rate.

 

With the steady liberalization of interest rate for foreign currency deposits and loans, related rules governing interest rate management of foreign currency deposits and loans as well as the pricing mechanism for foreign currency liabilities and assets were successively established by the Chinese commercial banks. Each bank also enhanced its authorization management over the branch offices in charging foreign currency lending rates. For instance, the headquarters would stipulate a minimum surcharge and authority for the branch offices in setting foreign currency lending rate based on interest rate level in the international market. These measures have increased the awareness and capability of the commercial banks in managing interest rate risks.

 

2.      Steadily advancing market-based reform of RMB lending rate

(1) Initial progress in market-based reform of RMB lending rate

In January 1987, the PBC made its first attempt to liberalize RMB lending rate on a pilot basis. It was stipulated in the Notice on Deregulation of RMB Lending Interest Rate that, abiding by national economic policies, a commercial bank can put a surcharge on its lending rate not exceeding 20 percent of the benchmark interest rate of working capital loans.

 

In May 1996, the band of lending rate applied to working capital loans was narrowed to ±10 percent around the benchmark rate as an effort to reduce interest payment burdens of the enterprises. However, against the background of persistent interest rate cut, the narrowed loan interest rate band led to a decline of banks’ incentives in granting loans to the small and medium-sized enterprises (SMEs). To strike a balance between return and risks and encourage credit support to the development of SMEs, the PBC raised the upper limit of interest rate charged on loans granted by financial institutions (excluding Rural Credit Cooperatives (RCCs)) to small enterprises from 110 percent to 120 percent of the benchmark rate on October 31, 1998; and that charged by the RCCs from 140 percent to 150 percent of the benchmark rate.

 

To stimulate loan extension by the commercial banks and improve financial services, effective from April 1, 1999 , the band of lending rate was further widened, with the upper limit being set at 130 percent of the benchmark rate for financial institutions in the rural areas. Starting from September1, 1999, the upper limit of lending rate charged by commercial banks on the SMEs was also raised to 130 percent of the benchmark rate, while the interest rate band of loans granted to large enterprises remained at ±10 percent of the benchmark rate. RCCs were not included in this policy adjustment.

 

With the liberalization of lending rate, the PBC required commercial banks to learn from the experiences of the China Construction Bank and Shanghai Bank to formulate respective rules on lending rate management, build relevant models and risk measurement software and delegate proper authority to their branch offices in deciding loan interest rate. In 2003, the PBC emphasized further that, all commercial banks, Urban Credit Cooperatives (UCCs) and RCCs should improve their internal system to manage the pricing and adjustment of lending rate. After years of efforts, all commercial banks and some of the UCCs and RCCs have generally established an interest rate management system based on distinct factors as costs and risks etc.

 

(2) Important strides in the process of market-based reform of the RMB lending rate

Since 2003, the PBC has made three vital steps forward in advancing the market-based reform of RMB lending rate:

 

First, in August 2003, when introducing pilot reform to the RCCs, the PBC allowed RCCs in the pilot reform areas to adjust lending rate upward to 200 percent of the benchmark rate.

 

Second, the PBC expanded the band of loans interest rate charged by financial institutions on January 1, 2004 . The upper limit of lending rate charged by commercial banks and UCCs was raised to 170 percent of the benchmark rate, and that by RCCs to 200 percent of the benchmark rate. The lower limit of lending rate charged by financial institutions was maintained being at 90 percent of the benchmark rate. At the same time, the PBC decided not to set interest rate band for lending based on the ownership and size of the borrowers.

 

Third, on October 29, 2004 , the PBC decided to remove the upper limit of RMB lending rate of financial institutions (excluding the UCCs and RCCs) after securing approval of the State Council. Taking into consideration the fact that the UCCs and RCCS had yet to improve their competitiveness and business management capability to adapt to the policy change, the upper limit was maintained on the lending rate of these credit institutions, but the ceiling was increased to 2.3 times of the benchmark rate. Lower limit for RMB lending rate of all financial institutions remained unchanged, being at 0.9 times of the benchmark rate. By then, the management of RMB lending rate of China ’s financial institutions has basically been transformed into a system without an imposed upper limit but only with a lower limit set to prevent disorderly competition.

 

At the same time, a lending rate adjustment reporting system was initially established, enabling commercial banks as well as the UCCs and RCCs regularly report to the PBC their adjustment of the lending rate. The reporting system benefited not only the authorities by providing them a mechanism to monitor loan interest rate movement throughout the country in a timely manner so as to improve decision-making, but also the financial institutions by providing them incentives to set up an integrated data collection and analysis system based on which they could make loan interest rate management an integral part of the broad business development strategy.

 

Since 2003, the PBC took three steps in a row to widen loan interest rate band of the financial institutions, which have made a positive contribution to pushing forward the market-based interest rate reform, promoting healthy development of the financial institutions and improving macro economic management.

 

First, lending rate was set to better cover risk premium. A proper measurement of risk premium was vital to solve the borrowing difficulties faced by the SMEs. At present, business operation of some small enterprises was shaky, and the social credit culture was underdeveloped, which has exposed financial institutions to increased lending risks to the SMEs. The gradual liberalization of the lending rate provided incentives for financial institutions to better cover risk premiums, strengthened financial services for the SMEs and privately-owned enterprises.

 

Second, with a steady improvement of the financial environment, financial institutions were able to cover loan losses with interest income, the macro financial environment comprises many micro systems, such as the legal framework, social credit system, accounting and auditing standards, intermediary service system, progress in enterprises reform and the relationship between banks and enterprises etc. The overall financial environment has a direct impact on lending risks and the proportion of newly increased non-performing loans. Improvement of the financial environment in China cannot be accomplished overnight, but rather will take a relatively long period of time to effect a fundamental change. Therefore, there exists a long-time requirement for the financial institutions to set its lending rate at a level sufficient to cover risk premium and to compensate loan losses with interest income.

 

Third, financial institutions were equipped with enhanced capability in pricing their products. After the entry into WTO, especially after the transitional period ended in 2006, competition in the financial industry will become intensified. With the complete liberalization of RMB business for the foreign financial institutions, domestic commercial banks will face a variety of challenges, in particular from how to effectively improve their asset and liability management. As China has long practiced administered interest rate, commercial banks thus tended to have a weak capability in pricing their products and did not establish a systematic data-base to track down and categorize risk factors such as the ratios and reasons of defaults by various enterprises. Widening interest rate band could help to improve the capability of the commercial banks in managing their assets and liabilities and develop into internationally competitive financial institutions.

 

Fourth, realizing the principle of “differentiated treatment in macroeconomic management”. Resource allocation is required to be improved in the building of socialist market economy, which demands financial institutions to price loans in line with the financial situation and risks of the borrowing enterprises. After the widening of the lending rate band, financial institutions could differentiate their credit policies to and charge different prices on various categories of customers based on analysis of their risk profiles, which could help to improve resource allocation and speed up the market-based interest rate reform.

 

Box 2：The Adjustment of Lending Rate in the Fourth Quarter of 2004

On October 29, 2004 , the PBC decided to remove the upper limit of RMB lending rate of financial institutions (excluding RCCs). Upper limit of RMB lending rate for the UCCs and RCCs was widened to 2.3 times of the benchmark rate. The floor for RMB lending rate of all financial institutions remained unchanged, with the lower limit being at 0.9 times of the benchmark rate.

 

In January 2005, a survey was carried out with respect to the adjustment of lending rate by financial institutions in the fourth quarter of 2004. Statistics show that, among the loans provided by financial institutions in the surveyed period, those extended at downward-adjusted rate accounted for 23.23 percent, up by 2.43 percentage points from the third quarter of 2004; those issued at benchmark rate accounted for 24.56 percent, down by 4.54 percentage points from the third quarter of 2004; and those offered at upward-adjusted rate accounted for 52.21 percent, up by 2.11 percentage points from the third quarter of 2004. There were also loans extended at a rate that fell into the newly expanded interest rate band, among which, those within twice of the benchmark rate accounted for 2.68 percent, indicating that lending rate have a better coverage of risk premium.

 

Of the loans provided by state-owned commercial banks, those charging downward-adjusted rates accounted for 27.13 percent, up by 2.83 percentage points from the third quarter of 2004; those issued at benchmark rate accounted for 28.54 percent, down by 11.46 percentage points from the third quarter of 2004; and those charging upward-adjusted rates accounted for 44.33 percent, up by 8.63 percentage points compared with the third quarter of 2004. Loans granted by joint-stock commercial banks at upward-adjusted rates accounted for 36 percent, up by 2.7 percentage points from the third quarter of 2004, remaining the lowest share among all financial institutions; those at downward-adjusted rates accounted for 32.93 percent, up slightly by 0.93 percentage points from the third quarter of 2004, standing the largest share among all financial institutions. Compared with the third quarter, loans extended by regional commercial banks at downward-adjusted rates increased by 5.49 percentage points, and those at upward-adjusted rates fell by 6.07 percentage points. Loans by RCCs issued at upward-adjusted rates saw slight increase, still within the band of (1.5, 2.0], those at downward-adjusted rates and benchmark rate witness small decline. (See Table 1)

 

Table 1：Proportion of Loans Issued at Various Interest Rate Bands in the Forth Quarter of 2004 (By Financial Institutions)

   Unit：percent

Note: Band of lending rate applied to the UCCs and RCCs is (2, 2.3].

Source: Reports of Lending Rates by Commercial Banks

 

Large enterprises saw their largest share of loans issued at downward-adjusted rates, being at 64.17 percent, down by 6.33 percentage points from the third quarter; their share of loans issued at benchmark rate accounted for 53.58 percent, up by 0.48 percentage points; and those issued at upward-adjusted rates accounted for 27.58 percent, down by 6.92 percentage points. Among the loans extended to medium-sized enterprises, those issued at downward-adjusted rates and upward-adjusted rates accounted for 22.50 percent and 36.72 percent respectively, up by 1.60 and 4.32 percentage points from the third quarter; those charging benchmark rate accounted for 26.01 percent, down by 3.19 percentage points. Out of the loans offered to small enterprises, those issued at downward-adjusted rates increased by 4.73 percentage points from the third quarter; those issued at benchmark rate and upward-adjusted rates accounted for 20.41 percent and 35.70 percent respectively, up by 2.81 and 2.60 percentage points from the third quarter of 2004. (See Table 2)

 

Table 2：Proportion of Loans Issued at Various Interest Rate Bands in the Forth Quarter of 2004 (By Borrowers)

                                                          Unit：percent

	Downward -adjustment	1.0	Upward-adjustment
			subtotal	（1.0, 1.1］	（1.1, 1.3］	（1.3, 1.5］	（1.5, 2.0］	2.0+
	[0.9,1.0)
Large Enterprises	64.17	53.58	27.58	29.45	26.48	24.22	20.80	0.00
Medium-sized Enterprises	22.50	26.01	36.72	37.03	36.38	37.14	34.96	34.66
Small Enterprises	13.33	20.41	35.70	33.53	37.14	38.64	44.25	65.34
Sum	100.00	100.00	100.00	100.00	100.00	100.00	100.00	100.00

Source: Reports of Lending Rates by Commercial Banks

 

In general, removal of the ceiling on lending rate of the financial institutions (excluding UCCs and RCCs) and expansion of the interest rate band for the UCCs and RCCs has started to gradually bear fruits, as reflected in the increased willingness of the financial institutions to set lending rate in line with credit risks and to improve financial services.

First, it encourages financial institutions to charge different interest rates on the borrowers on the basis of credit risk and cost. Financial institutions, especially the state-owned commercial banks and the joint-stock commercial banks have the incentives to continuously improve their product pricing system and interest rate risk management and further strengthen proactive price setting, leading to increased adoption of pricing loans based on credit risks and costs.

Second, it encourages financial institutions to increase credit support to the SMEs and improve financial service. According to the survey, loans granted to small enterprises within the band of (1.5, 2] and above 2 recorded the highest proportion among the loans issued at upward-adjusted rates, and among the loans issued at downward-adjusted rates, the proportion of loans extended to small enterprises grew by 4.7 percentage points over the third quarter of 2004, and that extended to medium-sized enterprises also increased. Therefore, financial institutions were proved to be capable of implementing the lending rate adjustment policy issued on October 29, 2004 and determining adjustment coefficients on the basis of borrowers’ credibility and associated risks. The expansion of interest rate band helps to complement the relatively high risks and costs undertaken by the small and medium-sized enterprises (SMEs) and encourages financial institutions to increase their credit support to the SMEs and private sectors.

 

Third, it helps to fully serve the expected monetary policy target. In the fourth quarter of 2004, macroeconomic management measures continued to play important roles, as especially reflected on the lending rate structure of the commercial financial institutions. The interest rate of fixed-rate loans, accounting for a relatively high proportion in short and medium-term loans, increased, in particular, fixed interest rate for 1 to 3-year loans rose by 0.8 percentage points over the third quarter. On the contrary, the interest rate of loans with adjusted rates that account for a high proportion in long-term loans decreased. Meanwhile, among the loans falling into the downward adjusted rate band, the proportion of loans issued to the SMEs increased while that issued to large enterprises decreased, indicating that macroeconomic management has different effects on lending rates. Giving further leeway to the management of lending rates will improve the transmission mechanism of macroeconomic policies, enhance the effectiveness of monetary policy transmission, and contribute to macroeconomic management to “ differentiate financial support to different sectors”.

 

3. The market-based reform of RMB deposit rates made significant progress

At the early stage of China ’s economic reform, trust investment companies and RCCs had liberalized deposit rates on a pilot basis. While useful experience was gained from the reform, problems also emerged. For instance, due to the lack of financial disciplines, financial institutions with poor performance set higher rates to attract deposits, leading to massive transfer of deposits and interest rate management irregularities. The pilot floatation of deposit rates was hence abolished in 1990. This experience proved that market-based interest rate reform should be started with large-value deposits and steadily advanced by allowing deposit rates to be adjusted downward under an imposed upper limit.

 

To make further research on market-based deposit rate reform and meet the needs of financial institutions on managing assets and liabilities, in October 1999, the PBC approved China’s commercial banks to provide long-term large-value negotiated deposit business with a maturity over 5 years and an amount of no less than RMB30 million yuan to China’s insurance companies and the interest rate would be determined upon consultation by both parties involved in the deposit agreement, marking a pioneering step forward in the advancement of the market-based deposit rate reform.

 

In February and December of 2002, the National Council of Social Security Fund and the social insurance agencies at provincial level that had established individual accounts for pension contributions were included in the above deposit scheme. In November 2003, China Postal Savings and Remittance Bureau was authorized to reach deposit agreement with the commercial banks and RCCs on negotiated terms. Liberalization of the interest rate on long-term large-value negotiated deposits attained experiences for introducing profound market-based deposit rate reform while at the same time enhanced pricing capability of the commercial banks and improved deposit rate administration system. The reform action further clarified the sequence of market-based deposit rate reform that liberalized interest rates of long-term large-value deposits before that of the short-term small value.

 

The PBC, with the approval of the State Council, allowed interest rate on deposits to adjust downward on October 29, 2004. Depositary financial institutions were since allowed to take deposits offering interest rates below (but not above) the announced benchmark rate. Hence, the PBC achieved the target of “allowing deposit rates to adjust downward below the imposed upper limit”.

 

Allowing financial institutions to lower deposit rates is an important step forward promoting the market-based interest rate reform. It improves the management skills of financial institutions and facilitates the development of capital market.

 

First, it has provided incentives for financial institutions to strengthen liability management, boost capital adequacy, and prevent risks of excessive business growth. In recent years, the assets of commercial banks have grown rapidly, with annual growth averaged at around 20 percent. The excessive growth of assets may cause problems such as the deterioration of asset quality and the decline of capital adequacy ratio. Allowing deposit rate to adjust downward will encourage financial institutions to actively control liability size and exercise self-discipline, which stands as one of the targets of this round of macro financial management.

 

Second, it has helped rationalize the balance sheet of the commercial banks. At present, the maturity mismatch of assets and liabilities in commercial banks (shorter-term deposits relative to longer-term loans) has posed a serious problem. On the asset side, lending rates of medium and long-term loans for investment should be increased while that of short-term loans should be kept at a low level, so as to maintain an appropriate relationship between investment and consumption, which could be achieved by allowing commercial banks some discretion to adjust lending rates. On the liability side, the rates of medium and long-term deposits should be higher than short-term ones so as to promote the growth of long-term liabilities of the commercial banks. Allowing commercial banks to lower deposit rates could encourage them to actively adjust the liability yield curve by offering higher interest rate for long-term liability products, and engage more in medium and long-term liability business.

 

Third, it has facilitated a coordinated relationship between direct financing and indirect financing. The Chinese enterprises rely heavily on bank loans, leading to a relatively high financial leverage and a concentration of loan risks in the banking sector. Allowing deposit rate to adjust downward is conducive for commercial banks to develop various financial products, especially fund products to improve the financing structure and foster the development of capital market.

 

The removal of lending rate ceilings for financial institutions (excluding UCCs and RCCs) and allowing for downward adjustment of deposit rates effective from October 29, 2004 was a historical milestone in the process of market-based interest rate reform that marks the achievement of the preliminary reform target of “imposing only ceilings on deposit rates and lower limits on lending rates”. This policy action put in place a general framework for market-based interest rate reform in the current period. In the coming periods, the reform will progress by focusing on the implementation of this guiding policy, improving the governance and internal control of financial institutions to enhance their pricing capability and risk management, and further developing the central bank’s monetary policy conduct.

 

In general, the market-based interest rate reform represents a gradual deregulation of interest rate control. Since 1996, 118 administered interest rate products in both domestic and foreign currencies have been liberalized, consolidated or abolished currently, there are 30 administered interest rates subjected to management by the PBC. With steady progress in the market-based interest rate reform and improvement of pricing capability of financial institutions, the PBC will continue to enlarge the discretion of financial institutions in interest rate pricing, and guide the interest rate to improve its role in the allocation of financial resources and macro-economic management.
Part Two   The Construction of Central Bank Interest Rate System and Interest Rate Administration

 

Interest rate is an important transmission channel of monetary policy. With the abolishment of credit quota control in January 1998, the central bank has gradually transformed its monetary policy conduct from based on direct control to indirect management. The Third Plenary Session of the Sixteenth National Congress of CPC has clarified the target of market-based interest rate reform, which is to “establish an interest rate formation mechanism based on market supply and demand that can be managed by the central bank through the application of monetary policy instruments”. This guiding principle contains three interrelated aspects: first, interest rate should be determined by demand and supply in the market; second, the central bank should guide and exercise management over the market rate; third, monetary policy instruments should be applied to guide and adjust market rate. To achieve this target, central bank interest rate system should be improved and the transmission mechanism of monetary policy be rationalized to gradually make interest rate as one of the important economic leverages applied in macroeconomic management.

 

I. Advancing the construction of central bank interest rate system and improving monetary policy transmission

 

Advancing the construction of central bank interest rate system, improving the formation mechanism of central bank interest rate and strengthening the guidance of central bank interest rate to market rate are preconditions for the central bank to effectively conduct interest rate management policy, and constitute important integral parts of the whole process of market-based interest rate reform.

 

1.      Reform of rediscount rate and its formation mechanism

China officially started rediscount business for commercial banks in 1986 when the bills market was on its initial stage of development and relatively small in size. The rediscount rate was then made at a level downward adjusted by 5 to 10 percent of the various tranches of lending rate of the same term. Since May 1996, rediscount rate was determined based on 5-10 percent downward adjustment of the central bank lending rate at the same tranches.

 

On March 21, 1998, the PBC reformed the formation mechanism of discount and rediscount rates, stipulating that rediscount rate should be determined by the central bank as an independent tranch of interest rate, while discount rate was made by adding 0.9 percentage points to the rediscount rate. On July 1, 1998, the PBC lowered rediscount rate to 4.32 percent from 6.03, and widened the maximum increase on discount rate to 2 percentage points, bringing the discount rate to a level slightly lower than the 6-month lending rate. In December of the same year, the ceiling of discount rate was set to equal the lending rate of the same term (including the adjustment).

 

Reforming the formation mechanism of discount rate has rationalized the transmission of central bank monetary policy, encouraged financial institutions and enterprises to actively engage in bills discounting business, and promoted the overall development of the bills market. Meanwhile, making rediscount rate as the floor of discount rate has helped prevent fluctuations of market rates, thus providing a security value for market development. Rediscount rate has become an important instrument of the central bank for the conduct of monetary policy.

                                                                                                                                                      

2. Discretion for the central bank to determine its lending (rediscount) rate

As one of the monetary policy instruments, central bank lending is mainly used to adjust short positions of financial institutions. Allowing the central bank some discretion to adjust its lending rate mainly refers to the arrangement under which, with the authorization of the State Council, and in line with the macroeconomic situation and on the basis of central bank lending (rediscount) benchmark rate, the PBC can decide and publish timely the increase of interest rates charged for its loans (discounts) to the financial institutions.

 

On January 1, 2004, with the consent of the State Council, the PBC expanded the band of lending rates for financial institutions, marking a great progress in the market-based interest rate reform. However, the central bank lending rate is still not flexible to meet the needs called for by the preemptive or fine tuning of monetary policy and bring the combined effects of monetary policy instruments into full play. The most serious problem caused by the inflexibility of central bank lending rate lies in the fact that it fails to react timely to the changes of market rate, and hence makes it possible for financial institutions to arbitrage. Also, the release of base money caused by the lower than market rates of central bank lending rate can lead to distortion and failure of the intended monetary policy measures.

 

With the approval of the State Council, the PBC was granted discretion to add a surcharge on its central bank lending rate, starting from March 25, 2004. Considering the economic and financial situations at that time and the required credit support to the SMEs, the PBC decided to raise the interest rates charged on central bank lendings used for position adjustment and short-term liquidity support of financial institutions by 0.63 percentage points, and the rediscount interest rate by 0.27 percentage points.

 

Allowing the central bank some discretion to adjust its lending rate is another significant step forward along the line of market-based interest rate reform. It has helped improve the central bank interest rate formation mechanism, rationalize the financing relationship between the central bank and the borrowing institutions, and promote the scientific, efficient and transparent approach to central bank lending management.

 

3.      Improving the interest rate structure of the reserves

In March 1988, the PBC carried out reform on the reserve requirement system, with the excess reserve account and required reserve account consolidated, the interest rates unified and the reserve requirement ratio lowered from 13 percent to 8 percent. In November 1999, the PBC further lowered the reserve requirement ratio from 8 percent to 6 percent. These policy actions have played important roles in accelerating the supply of base money, promoting loan issuance of the commercial banks and supporting the economic development. To prevent an excessive growth of deposits by the commercial banks in the central bank due to higher interest rate paid on the reserves and a decrease of their loan business, the interest rate on the reserves has been kept at a level lower than the financing cost of commercial banks since 1998.

 

With the consent of the State Council, the PBC further reformed the interest rate system of the reserve deposits on December 21, 2003, and applied different interest rates to the excess reserves and the required reserves of the financial institutions kept in the consolidated account with the central bank. The PBC lowered the interest rate of the excess reserves of the financial institutions from 1.89 percent to 1.62 percent while the interest rate of the required reserves remained unchanged at 1.89 percent.

 

The moderate reduction of interest rate of the excess reserves has created a favorable mechanism for the financial institutions to improve funds utilization, contributed to the stable operation of money market and capital market, brought the combined effects of macroeconomic policy actions into full play, rationalized the interest rate system of the central bank and improved the interest rate structure of the reserve deposits.

 

4.         Reform of the interest rate of postal savings deposits in the central bank

Interest rate of postal savings deposits in the central bank is a historical product left in the development process of China ’s postal savings business. Since the inception of postal savings business in 1986, all deposits taken by postal savings institutions have been re-deposited in the PBC. As the interest rate paid on postal savings deposits in the central bank is higher than that offered by the postal savings institutions to the depositors, postal savings deposits have increased rapidly, leading to considerable outflow of financial resources in the rural areas.

 

On August 1, 2003, with the approval of the State Council, the PBC decided to reform the interest rate of postal savings deposits in the central bank. Interest rates of new deposits in the central bank would be subject to the interest rate applied to the reserves of the financial institutions in the central bank (annualized rate of 1.89 percent). Interest rate of the existing deposits in the central bank would remain unchanged at an annualized rate of 4.131 percent. Meanwhile, postal savings institutions would be allowed to use their newly absorbed deposits to participate in bond transactions in the inter-bank market, reach large-value deposit agreement with the Chinese commercial banks and RCCs, engage in business cooperation with policy banks, conduct some specified intermediate business, and underwrite treasury bills and policy financial bonds.

 

The implementation of this policy has been conducive to resolving the long-existing problems caused by the excessively high postal savings deposits rate paid by the central bank such as the unfair competition between the financial institutions, the irrational interest rate structure of the PBC, and the outflow of financial resources from the rural areas, etc. It has also provided incentives for the postal savings institutions to use funds independently according to market rules, enhance business performance, and bring postal savings business development up to a healthy track.

 

II. Improving central bank’s macro financial management through interest rate policies

 

Since 1998, the PBC has applied a broad range of monetary policy instruments to achieve the monetary policy target. In terms of the employment of interest rate policy, efforts were made primarily on two fronts. First, level and structure adjustment of interest rates, i.e., the central bank flexibly adjusted the deposit and lending rates for financial institutions according to the needs of monetary policy implementation or changes in the macroeconomic and financial situations; also, the central bank adjusted small-value foreign currency deposit rates according to interest rate movements in the international market to coordinate domestic and foreign currency interest rate policies. Second, open market operations were conducted to guide market interest rate development.

 

The adjustment of interest rate in China has been conducted based on the monitoring and analysis of price movement, investment, consumption and BOPs, with adequate attention paid to the general price level, macroeconomic policies, supply and demand of funds in the market as well as the interests of the government, banks, enterprises and the individuals, so as to make the adjustment forward-looking, timely and scientific. At the same time, equilibrium between the domestic and external sectors has been emphasized to improve local and foreign currency interest rate policy coordination. Open market operations have been focused on controlling the supply of base money, and adjust the liquidity of commercial banks to ensure a broad stability of the money market rate and improve the yield curve.

 

1.      Flexible adjustment of the deposit and lending rates

In view of the overheated economy and persistent increase of price level, the PBC twice raised the lending rate respectively in May and July of 1993. The interest rate adjustment, together with other profound economic reform policies, had played a significant role in reining in the fixed asset investment, containing the rise of inflation, and hence contributed to the soft landing of the economy.

 

By 1996, the macroeconomic control had achieved evident effects with the price level falling markedly. However, business performance of the enterprises was still lackluster as they continued struggling with many difficulties such as the declining sales-to-output ratio, increased losses both in terms of the absolute value and the industrial coverage, and heavy interest repayment burdens, etc. To reflect the price changes and relieve the enterprises’ interest repayment burden, the central bank three times lowered the deposit and lending rates of the financial institutions respectively in May and August of 1996, and in October of 1997. The central bank at the same time also cut its deposit and lending rates to the financial institutions accordingly.

 

With the outbreak of the Asian financial crisis in the second half of 1997, great changes took place in the international economic situation. China ’s economic development also met difficulties such as sluggish growth of consumption, persistent negative increase of price, decline of export and foreign investment, and the rise of financial risks, etc., calling for large-scale economic restructuring. The central government had therefore taken a series of effective measures to stimulate domestic demand, with implementation of the proactive fiscal policy and sound monetary policy. The PBC also flexibly applied the interest rate leverage to support the economic development, and lowered the RMB deposit and lending rates of the financial institutions five times in a row, respectively in March, July and December of 1998, June of 1999 and February of 2002.

 

After the eight cuts of deposit and lending rates, the deposit rate was lowered accumulatively by 5.98 percentage points, and the lending rate accumulatively by 6.92 percentage points, which had reduced the enterprises’ interest repayment burden by nearly 300 billion yuan. In particular, the interest rates of one-year deposit and loan were lowered from 10.98 percent to 1.98 percent, and from 12.06 percent to 5.31 percent respectively, both representing a record low in a period of more than two decades. The low interest rate had played an important role in boosting domestic demand, relieving enterprises’ debt burden, and achieving the macroeconomic control target of low inflation and high economic growth.

 

Table 3: Average Adjustment of deposit and lending rates since 1993

                                            (in percentage point)

Date	Average adjustment of deposit rate	Average adjustment of lending rate	Change in interest spread
1993.05.15	1.19	0.82	-0.37
1993.07.11	1.35	1.38	0.03
1995.01.01	0	0.72	0.72
1995.07.01	0	0.95	0.95
1996.05.01	-0.98	-0.75	0.23
1996.08.23	-1.50	-1.20	0.30
1997.10.23	-1.10	-1.50	-0.40
1998.03.25	-0.16	-0.60	-0.44
1998.07.01	-0.49	-1.12	-0.63
1998.12.07	-0.50	-0.50	0
1999.06.10	-1.00	-0.75	0.25
2002.02.21	-0.25	-0.50	-0.25
2004.10.29	0.27	0.27	0

Notes: 1. “-“ denotes a cut of interest rate or a shrinkage of the interest spread

2.      The 2004 figure indicates an average adjustment of the one-year deposit and lending rates

 

At the beginning of 2004, some acute problems emerged in the process of China ’s rapid economic development such as overinvestment and heightened pressures on inflation. Under these circumstances, the government has applied a combination of economic, legal and certain administrative measures to exercise macroeconomic control, which produced positive outcome. On October 29, 2004, to build upon the attained preliminary achievements in macroeconomic control, the PBC, with the consent of the State Council, raised the benchmark interest rates of RMB deposit and lending. The one-year benchmark lending rate was raised by 0.27 percentage points from 5.31 percent to 5.58 percent, while that of one-year deposit by 0.27 percentage points from 1.98 percent to 2.25 percent. Interest rates of deposit and lending at other different tranches were adjusted accordingly with the interest rates of medium and long term maturities gaining a larger increase over that of the short-term ones.

 

This policy action marked the first interest rate hike in nine years, and was widely applauded both at home and abroad. Its significance lies in the fact that the central bank has attached greater importance to economic measures and market instruments in macro economic control and more focused on taking a pre-emptive and fine-tuning approach to ensure the conduct of monetary policy more forward-looking, scientific and effective.

 

The increase of the benchmark interest rates will help to contain inflationary pressures and prevent investment rebound, relieve liquidity pressures of certain enterprises and reduce the capital recycling outside the banking system. It is also conducive to optimizing economic structure, improving efficiency, and maintaining the good momentum of sustained, rapid, coordinated and healthy development of the economy.

 

Box 3 :  Quantitative instruments vs. price instruments

 

Monetary policy instruments may be divided into two main categories as quantitative instruments and price instruments according to their effects on economic operation. Quantitative instruments include required reserve ratio, open market operation, central bank lending, and rediscount, etc., which are mainly applied to adjust the quantity of base money supply, while price instruments mainly refer to interest rate and foreign exchange rate which are used to adjust prices. Generally, the central bank applies monetary policy instruments mainly to affect economy in aggregate. The central bank adjusts money supply with quantitative instruments such as open market operations and reserve requirement ratio to affect major economic variables. Price instruments are mainly applied to affect financial cost and income expectation so as to send macroeconomic policy signals for market participants to adjust behavior at the micro level, and hence to reduce the side effects of macroeconomic control measures to the minimum. Meanwhile, as the market determined interest rate in itself contains risk premium that reflects structural deficiencies, it helps to establish a competitive mechanism enabling the fittest to survive, improve resource allocation and promote economic restructuring.  The employment of interest rate and other price leverages to exercise macroeconomic management on the one hand helps to avoid the negative effects brought by the administrative measures such as “one-size-fits-all” actions or an abrupt step on the brake pedal, and on the other hand imposes impact on the banking system and the real economy in a gradual way, thus preventing occurrence of new non-performing loans.

 

From the practice of western countries, with the expansion of financial market, the increase of market participants and the improvement of market equilibrium, price instruments are more preferable to quantitative instruments in the course of monetary policy implementation, especially when the financial market is wide and deep enough.

 

Since 1998, to prevent deflation and financial risks, the PBC has adopted a mix of policy actions along with the proactive fiscal policy to stimulate domestic demand, making effectively support to the economic growth. However, China ’s economy is still in transition, the interest rate has yet to be fully liberalized based on market principles, and the monetary policy transmission has to be made more effective. Compared with the proactive of central banks in the mature economies which mainly rely on the interest rate leverage to conduct monetary policy, the PBC has long resorted to quantitative instruments in its monetary policy implementation.

 

With the improvement of the central bank’s indirect control system and monetary policy transmission, the increase of commercial banks’ capability and power in product pricing, and the growth of sensibility to monetary policy signals at the micro level, price instruments begin to play more important roles in the conduct of monetary policy. At the beginning of 2004, in view of the heightened inflationary pressures, the PBC timely adjusted its central bank lending rate and rediscount rate. To prevent investment rebound and further build upon the positive outcomes of previous macroeconomic control measures, on October 29, 2004, the PBC raised the RMB benchmark deposit and lending rates. The central bank’s flexible application of interest rate leverage in financial resource allocation has indicated a growing reliance of China on market instruments in macroeconomic management.

 

2. Open market operation and central bank interest rate management

Since the PBC abolished its credit quota control in January 1998, open market operation has gradually become the prominent instrument in monetary policy implementation. With steady increase of financial products and market participants, the role of open market operation as an important transmission channel for monetary policy has become even distinct as it guides the development of the money market interest rate and conveys the monetary policy stance.

 

At present, with M2 as the intermediate target of monetary policy, the PBC is confined to focus on quantitative targets in its open market operations. Since the PBC resumed open market operations on May 26, 1998, it has primarily looked to base money (the excessive reserve of financial institutions) as the operational target. Due to the close relationship between the quantity and price (money market interest rate) of base money, the PBC has also take money market interest rate as an important indicator in monitoring the supply of base money. As the deposit and lending rates of financial institutions are not fully liberalized and the interest rate transmission mechanism has yet to be improved, money market interest rate has only limited impact on financial institutions’ deposit and lending rates, leading to high dependence of open market operations on quantity bidding.

 

As the market-based interest rate reform deepened, the PBC actively created favorable conditions to encourage the OMOs’ operational target to focus on money market interest rate. Staring from April 2003, the PBC introduced central bank bills as a new instrument for base money adjustment, and issued 3-month, 6-month and1-year central bank bills on rolling basis in the market. By end-2003, 63 issues of central bank bills worth 722.68 billion yuan had been released, with the outstanding balance amounting to 337.68 billion yuan. From the start of 2004, in response to the rapid growth in foreign exchange reserve and equivalent increase of base money supply, and taking into consideration changes in market interest rate and needs of monetary policy implementation, the PBC adopted either quantity bidding or interest rate bidding (including price bidding) in the central bank bills issuance to flexibly adjust the liquidity in the financial system. Central bank bills totaling 1507.15 billion yuan were issued in the whole year. Furthermore, the PBC issued the central bank bills more based on interest rate bidding so as to locate the level of market interest rate and the commercial banks’ expectation of interest rate movement. Correlation between the yield of central bank bills and money market interest rate became increasingly evident. These measures have created favorable conditions for the development of benchmark interest rate, the building of central bank’s indirect control system, and the deepening of market-based interest rate reform. As the reform steadily progresses, open market operations will play an increasingly important role in interest rate management.

    

3. Coordination between domestic and foreign currency interest rate policy

An important step in the course of formulating and implementing monetary policy lies in the coordination of the RMB exchange rate policy and interest rate policy, in particular in the coordination of the interest rate policy of domestic and foreign currencies.

 

In 2000 when foreign currency interest rate liberalization barely started, the interest rates of RMB deposits and loans were brought down to their historical lows after the PBC lowered interest rates seven times in a row. For instance, the rate of 1-year deposit was 2.25 percent. The interest rate of US dollar in the international market, however, kept on increasing as a result of Fed’s in interest rate hike for six times consecutively between 1999 and 2000. In May 2000, the 1-year US dollar LIBOR rose to its peak level at 7.5 percent, pushing the interest rates of domestic US dollar deposits and loans to a level much higher than that of the RMB interest rates. Interest rate spread between domestic and foreign currencies continued to widen, adding to the complexity of policy coordination: (1) the interest rate of RMB was lower than that of domestic foreign currencies, leading to a rapid growth in foreign currency deposits, while the demand of domestic enterprises for foreign currency loans was insufficient; (2) the interest rate of foreign currency deposits offered by Chinese banks was lower than that offered by foreign-funded banks, resulting in a massive transfer of corporate foreign currency deposits from the Chinese banks to their foreign counterparts; (3) the interest rate of foreign currencies in domestic market was lower than that in the international market, providing incentives for the Chinese enterprises to maintain their foreign exchange earnings abroad.

 

Between 2001 and 2002, in order to better coordinate the interest rate policies of domestic and foreign currencies, and in response to the substantial fall of interest rate in the international market after “9.11”, the PBC flexibly adjusted the interest rate of domestic small-value foreign currency deposits ten times. At end-2002, 1-year interest rate of small-value US dollar deposits stood at 0.8125 percent, lower than the corresponding RMB deposit rate of 1.98 percent. The interest rate spread between 1-year deposits of domestic and foreign currencies gradually changed from -3.75 percentage points to 1.17 percentage points. In the second half of 2002, the 1-year US dollar LIBOR stayed around 1.6-2 percent, reversing the lopsided lending rate difference between the domestic and international markets. The interest rate of domestic foreign currency loans stayed around 3-3.5 percent, lower than that of RMB loans (5.31 percent), creating favorable conditions for the commercial banks to expand foreign exchange credit business. Meanwhile, the PBC unified foreign currency interest rate policies of the domestic and foreign-funded banks on March 1, 2002, creating a platform for competition on equal footing (See Table 4).

 

Table4: The Spread Between RMB Nominal Interest Rate and US Dollar Interest Rate

Unit：％

Year	Interest rate of RMB Deposits	Interest Rate of Domestic US Dollar Deposits	Spread Between RMB and Domestic Foreign Currency Deposits	Interest Rate of Deposits in the US	International Spread Between RMB and Foreign Currency Deposits
	（1）	（2）	（1）－（2）	（3）	（1）－（3）
1996	7.47	4.78	2.69	5.78	1.69
1997	5.67	5.00	0.67	5.88	-0.21
1998	3.78	3.75	0.03	5.08	-1.30
1999	2.25	4.44	-2.19	6.51	-4.26
2000	2.25	5.00	-2.75	5.91	-3.66
2001	2.25	1.25	1.00	2.28	-0.03
2002	1.98	0.81	1.17	1.28	0.70
2003	1.98	0.56	1.42	1.32	0.67
2004	2.25	0.88	1.38	3.02	-0.77

Sources：the PBC website, Bloomberg

Note：RMB deposit interest rate refers to 1-year rate; the interest rate of domestic US dollar deposits refers to that of 1-year small-value deposits; the interest rate of international US dollar deposits refers to the rate of 1-year CDs in the US.

 

From the beginning of 2003, the world economy has gradually recovered. In early April of 2004, US dollar interest rate in the international market started to rise as supported by increased market expectation of the Fed’s interest rate hike. After the Fed raised the interest rate consecutively for five times in the second half of the year, the dollar rate in the international market continued to rise.

 

In response to such a situation, the PBC raised the ceiling of interest rate for domestic small-value US dollar deposits in November 2004. Interest rate of 1-year small-value US dollar deposits increased from 0.5625 percent to 0.875 percent. Such a policy action helped control the interest spread between domestic and international markets within a reasonable scope, which was conducive to easing the revaluation pressure on RMB as it helped to stabilize the domestic foreign currency deposits in the context of an increased RMB interest rate benchmark.

 

Box 4 : Foreign Currency interest Rate Adjustment and Interest Spread Risks

 

The interest rate level of financial products is mainly determined by their underlying risks. Generally speaking, long-term interest rate is higher than short-term rate because it involves more uncertain factors. In an economic expansion period, however, the relationship between the short-term and long-term interest rates may become lopsided as a result of the tightening of monetary policy; in a period of financial panic, such a phenomenon may often surface as well. Apart from being affected by the yields, interest rate level in international market is also influenced by expectations of future economic and financial development. If the interest rate is expected to move downward, the long-term interest rate will fall and short-term rate tends to rise, and vice versa.

 

With the global economic slowdown, in the second half of 2000, the market widely expected the Fed would loose its monetary policy, leading the short-tem LIBOR rise above the long-term interest rate in the international market. For instance, on February 21, 2001 the overnight US dollar LIBOR stood at 5.63 percent, 0.44 percentage points higher than the 1-year interest rate of 5.19 percent.  But in China , as the interest rates of foreign currency deposits at various terms pegged to the corresponding term structure of RMB deposits, plus other factors such as the time lag of interest rate adjustment, the long-term foreign currencies deposit rate was as a result much higher than the short-term rate. For instance, the interest rate of 1-year small-value US dollar deposit was 3.8125 percent, 2.312 percentage points higher than that of the demand deposit (1.5 percent). If the Chinese commercial banks lend in the international market with domestically raised fund, they will incur losses as a result of the large interest rate spread between the domestic and international market.

 

After 2001, the PBC made fine-tuning adjustments on a continuous basis of the interest rates of small-value foreign currency deposits at various terms, leading to a gradual contraction of the interest spread among deposits at different terms. For instance, when the interest rates of domestic foreign currency deposits were adjusted on July 2,2003, the interest spread between demand deposit (0.075 percent) and 1-year deposit (0.5625 percent) reduced to 0.49 percentage points. At the same time, due to changed market expectations of the economy, interest rate spread in the international market was reversed in that long-term (1-year) rate rose to a level 0.1 percentage points higher than the overnight rate. As a result, the interest rate level of domestic small-value foreign currency deposits at various terms was more rationalised, and brought closer to the international market rate, which has to a large extent helped resolve the long-existing problem of interest spread risk (See Figure 2).

 

Figure 2: US Dollar Interest Rate Spread between Domestic and International Market in 1999-2003

 

Source: the PBC, Bloomberg

 

Before 2003, due to insufficient domestic demand for foreign currency loans, the Chinese commercial banks had to lend in the international market using the excess balance of foreign currency deposits. At end-December, 2002, outstanding balance of international lending reached USD58.2 billion, equivalent to 40 percent of the balance of foreign currency deposits. The commercial banks absorbed foreign currency deposits in domestic market, and lent abroad, thus objectively demanding a reasonable interest spread between domestic deposit and overseas lending business.

 

At the early stage of foreign currency interest rate liberalization, all commercial banks resorted to price strategy to attract clients as an effort to expand market share, leading to a rise of the interest rate of large-value foreign currency deposits. On the one hand, narrowed interest margins between deposits and loans have intensified pressures on the small and medium- sized commercial banks; on the other hand, the Fed’s persistent interest cut has dampened international interest rate level, posing a sharp contrast to the rising interest rate of large-value deposits in the domestic market. At end-2000, the interest rate of large-value foreign currency deposits reached as high as 6.08 percent, the average interest spread between foreign currency deposits and loans was merely 1.07 percentage points, and that between domestic deposits and foreign lending was only 0.6 percentage points, a fall of 1.4 percentage points from August 2000, displaying a growing interest risk. By then, the Chinese commercial banks strengthened interest rate pricing management and risk control, and supported by continuous fall of international interest rate, brought the interest rate of 1-year large-value deposits down to 2.02 percent in December 2001, compared with the lending rate of the same maturity at 3.74 percent. Average interest spread between domestic deposit and loan business rose to 2.33 percentage points, while that between domestic deposits and foreign lending rose to 0.79 percentage points, providing a rational platform for the commercial banks to grow their foreign exchange business. The interest spread between foreign currency deposits and loans maintained roughly at 2 percentage points in 2002 and 2003, showing that with an increasingly market-based mechanism put in place, commercial banks have tended to make sensible pricing decisions despite fierce competition.

 

Table 5: Changes of Interest Spread between Domestic Deposits and Loans, and between Domestic Deposits and Foreign Lending

Unit: %

Time	Deposit Interest Rate （1）	Loan Interest Rate （2）	Spread between Deposits and Loans （2）-（1）	LIBOR （4）	Spread between Domestic Deposits and Foreign Lending （4）-（1）
Aug,2000	5	7.625	2.625	6.98	1.98
Dec,2000	5.621	6.69	1.07	6.23	0.6
Dec,2001	1.41	3.74	2.33	2.42	0.79
Dec,2002	0.949	3.11	2.16	1.59	0.64
Dec,2003	0.61	2.56	1.95	1.32	0.71

Source: Foreign Currency Interest Rate Report, Bloomberg

Note: All figures are monthly- weighted average interest rates; figures in column (2) only cover the interest rates of the Industrial and Commercial Bank of China , Bank of China and China Construction Bank.

Part Three  Outlook of Market-based Interest Rate Reform, and the Institutional Building

 

Market-based interest rate reform is a step-by-step process. It has to be proceeded along with other improvement such as in corporate governance and internal control of financial institutions, the central bank’s monetary policy implementation system and the financial supervisory capability. Preliminary reform plan for the coming period contains the following aspects: unifying loan interest rate adjustment policy to all financial institutions; revising relevant rules and regulations; improving the pricing system of financial institutions for deposits and loans, and enhancing their pricing capability; increasing the diversity of financial products as well as the width and depth of the financial market; gradually establishing and improving the central bank’s interest rate management system to strengthen the role of the market in resource allocation.

 

I. Continuously pushing ahead market-based interest rate reform

1. Unifying loan interest rate adjustment policy to all financial institutions

The large number of UCCs and RCCs, though different each in its business environment and management skills, share on feature in common that is low efficiency and lack of a sound loan pricing system. There are two concerns associated with removing the ceiling of lending rate for the UCCs and RCCs. On the one hand, due to their underdeveloped product pricing system, the UCCs and RCCs will likely take a monopolistic approach to set loan interest rate at an excessively high level; on the other hand, this can lead to an increase of underground banking in certain areas and a growth of capital cycling out of the banking system, dampening the effects of macro economic control. To address these concerns, along with the development of pricing system, measures should be taken to improve loan pricing capability of the UCCs and RCCs and gradually remove the upper limit of lending rate, so that they will be able to charge different lending rates to the borrowers taking into account of the risks and costs, and to better respond to monetary policy stance and support the rural economy. At the same time, the PBC will further streamline its management of interest rate, and gradually give more discretion to the financial institutions in terms of loan pricing.

 

2. Exploring appropriate ways for deposit rate liberalization

Liberalization of deposit rate constitutes an important component of the whole process of market-based interest rate reform as well as the precondition for financial institutions to engage in active asset-liability management. To advance this reform process, research should be conducted to set standard for negotiated deposit certificates and improve their liquidity, and at the same time, gradually lift the minimum value requirement for such deposit certificates, so as to promote deposit rate liberalization steadily.

 

3. Gradually shaping a complete and reasonable yield curve

Yield curve is an important reference for the price setting of medium and long-term loans, especially for the pricing of the fixed rate loans. Shaping a complete and reasonable yield curve requires that on the one hand, maturity structure of treasury bonds should be optimized, and balance management and rolling issuance of treasury bonds be gradually adopted; on the other hand, efforts should be taken to diversify financial products, encourage the development of direct financing, especially financing through the securities investment fund and corporate bond market, and allow commercial banks to issue long-term debt instruments and launch securities investment fund, so that the width and depth of the financial market can be improved.

 

4. Improving the central bank’s interest rate management system

As the market-based interest rate reform progresses, the central bank’s interest rate management system should be further improved. The central bank will increasingly apply various monetary policy instruments to influence the market interest rates and further guide the movement of the financial institutions’ deposit and lending rates. Efforts should also be taken to establish and improve the related institutional arrangement to smoother the transmission of monetary policy and enhance its effectiveness.

 

5. Streamlining interest rate management of small-value foreign currency deposits

Currently, foreign currency interest rate management is limited to the ceiling imposed on interest rate paid on deposits below USD3 million or equivalent value in euro, HK dollar and the Japanese Yen. Efforts should be taken to streamline interest rate management of small-value foreign currency deposits by improving term structure of small-value foreign currency deposits and lowering the threshold of large-value foreign currency deposits. To ensure the independence and effectiveness of China ’s monetary policy, it is necessary to maintain the current interest rate management on small-value foreign currency deposits for a certain period of time.

 

II. Construction of interest rate pricing system in financial institutions

Along with the market-based interest rate reform, all financial institutions should further deepen property right reform, improve interest rate pricing capability, strengthen internal control, and consolidate the micro-level foundation for interest rate liberalization.

 

1.      Risk premium should be scientifically determined based on risk profile

A symmetry of risk and return is the fundamental principle for asset pricing. In theory, lending rate equals to non-risk yield plus risk premium and target rate of return. Pricing loans based on symmetric risk and return requires that lending rate must cover the incurred cost and fees, risk losses and target return, while taking into account of competition strategy, so that competition among the financial institutions could be based on rational pricing. However, constrained by the existing institutional deficiencies associated with unsatisfactory financial environment, internal cost accounting and performance evaluation, pricing capability possessed by the financial institutions has yet to satisfy the requirement of interest rate liberalization, and is likely to encourage financial institutions to engage in disorderly price competition and extend inefficient loans, leading to a decline of their asset quality and competitiveness as well as the sound and sustainable development of the financial sector.

 

2. Pricing system and the pricing capability of the financial institutions should be improved

The development of a scientific pricing system requires that financial institutions continuously improve their management, and put in place infrastructures and supporting technologies needed for interest rate pricing.

 

First, improving corporate governance. Strengthening corporate governance of financial institutions means that the relationship among the shareholders, board of directors, board of supervisors and senior managers in terms of their respective rights, responsibilities and interests should be clearly defined, and intervention from government or a particular shareholder be avoided, so that financial institutions can target profit maximization under the constraint of capital adequacy requirement in real sense.

 

Second, establishing interest rate pricing management and risk control systems. Professional criteria for loan pricing, risk control and performance evaluation should be detailed. Management accounting system that focuses on cost accounting and performance assessment of each category of products, clients and business units should be set up to provide basic data for loan pricing.

 

Third, putting in place a risk premium assessment system. Business in management information system should be established and improved, through which probability and extent of loss from each kind of risks can be calculated on the basis of available data and the IRB approach, so as to establish the reference value of risk premium for each business transaction, and the solutions for risk control.

 

Fourth, setting up internal price transfer system and positive incentives mechanism. Internal division and flow of business should be clarified, and positive incentives mechanism be cultivated by setting up an effective interest reallocation system based on internal price transfer arrangement.

 

Fifth, building an internal capital constraint system. Internal capital accounting and allocation system should be established. To discipline business expansion and structural adjustment of the assets, liabilities and off-balance-sheet business by either the line departments or branch offices, thus keeping a balance between profit incentives and risk control.

 

Based on a symmetry of risk and return, and taking into consideration of each business development, financial condition and technology strength, financial institutions should gradually enhance their capability of interest rate pricing by following the internal pricing and management accounting procedures (See Figure 3).

 

Figure 3：Micro Foundation for Asset Pricing of Financial Institutions

                     

                    Property Right System、

                    Positive Incentives Mechanism

 

profit maximization

 

Credit                                                Management

       

                          Pricing based on                      Accounting

Risk    expected losses     Symmetry of Risk and Return   cost and fees

       unexpected losses              performance assessment    System

Assessment                    

 

System

 

risk premium       

                                                                       

                          

Economic capital

allocation system                     

                                                                              

           

Box 5 : Interest Rate Risk Control of Financial Institutions

 

As the market-based interest rate reform deepens, it becomes increasingly urgent for financial institutions to improve their interest rate pricing and risk control systems, which in turn determine the pace of interest rate liberalization. According to the Principles for the Management of Interest Rate Risk formulated by the Basle Committee, the primary forms of interest rate risk to which commercial banks are typically exposed include repricing risk, yield curve risk, basis risk and optionality, all of which can be found in China ’s commercial banks to some degree.

 

Repricing risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet positions. While such repricing mismatches are fundamental to the business of banking, if devoid of calculations and management, they can expose a bank's income and underlying economic value to unanticipated fluctuations as interest rates vary.

 

Yield curve risk exposes a bank to unanticipated shifts in the slope and shape of the curve. When such shifts affect a bank's income on the assets side and expenditure on the liabilities side in adverse directions, the bank suffers from a loss.

 

Basis risk arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. For instance, a strategy of funding a loan with a deposit, both of which reprice on a monthly basis but refer to different benchmark rates, exposes the institution to the risk that the spread between the two index rates may change unexpectedly.

 

Optionality occurs when a depositor withdraws or a borrower repays ahead of the scheduled date. Constraint by both institutional factors and micro-level mechanisms, optionality pose an acute risk in China since the financial institutions have limited options to impose penalties on premature withdrawal or loan repayment.

 

A survey carried out by the PBC in late 2002 and early 2003 found that despite some certain progresses, commercial banks face the following challenges in their establishment of interest rate risk control system:

 

First, awareness of interest rate risk needs to be promoted. Since interest rate has long been under administration, both the senior mangers and ordinary staff engaged in interest rate management business in the commercial banks are not adequately exposed to quantitative analysis of interest rate risk and relevant risk control system; only limited human resources are allocated to manage interest rate pricing and risk control; and the interest rate management information system is yet to be built up. With regard to interest rate management perceptions, many commercial banks have not yet developed a balanced effort on interest rate pricing and risk control.

 

Second, interest rate risk management information system is to be improved. Existing disintegrated business data need to be logically consolidated to ensure real-time measurement of the interest rate risk, and improve the effectiveness of risk analysis and management.

 

Third, effective credit rating system and scientific pricing system need to be developed. Currently, neither an effective credit rating system nor a business management accounting system targeting each category of products, units and clients, nor a scientific pricing system focusing on internal fund transfer price have been set up in commercial banks.

 

Fourth, financial institutions are short of effective financial instruments to control interest rate risk. Financial instruments such as FRA, interest rate futures, interest rate option and interest rate swap have been extensively used by commercial banks in western countries to control interest rate risk. However, these instruments are not yet available in China ’s RMB market, restricting commercial banks’ capability to effectively control RMB interest rate risk through market operations.

 

In recent years, as the market-based interest rate reform deepens, financial institutions have gradually shifted to take initiatives in interest rate pricing and risk management instead of passively accepting the imposed interest rate administration policy. With the band of lending rate further liberated on October 29, 2004, the financial institutions should seize the opportunity to speed up their institutional and technological building for interest rate risk management and improve their capability in risk control.  

 

III. Institutional building of the central bank in terms of interest rate management

With improved business management of the financial institutions at the micro-level, the PBC will take actions to strengthen the monitoring and analysis of interest rate movement as well.

 

1. Improving the existing two-tier interest rate monitoring system composing the PBC headquarters and its branches or central sub-branches in the provincial capitals. As the market-based interest rate reform deepens, reporting systems targeting loan interest rates, negotiated deposits rates and foreign currency rates have been built successively. To meet the requirement of the reform, the two-tier interest rate monitoring system will be further improved. In particular, monitoring, analysis and reporting of the market interest rate will be conducted on a regular basis, with guidance to the development of market rate and the interest rates of deposits and loans in financial institutions strengthened, so as to establish key reference for the interest rate policy making.

 

2. Establishing a system that records and evaluates progresses of the financial institutions in preparing the institutional arrangement for interest rate liberalization. In line with the defined interest rate policy, the PBC headquarters, its branches and central sub-branches in the provincial capitals should build up relevant recording systems to monitor and conduct periodical review of progresses made by financial institutions in their jurisdictions in the construction of interest rate pricing system, information management system and interest rate risk control system so as to offer timely policy advice for the market-based interest rate reform.

 

3. Building a disclosure system to regularly publish market interest rate level. In order to enhance the transparency of market-based interest rate reform, the PBC headquarters, its branches and the central sub-branches in provincial capitals have a mandate to publish the level and changes of interest rates on a quarterly basis to guide rational product pricing by the financial institutions and maintain orderly market competition.

 

4. Establishing monitoring and research systems on movement of private lending interest rates. The interest rate of private lending signals the intensity of capital recycling out of the banking system and reflects the fund supply and demand status in the private lending market. Therefore the central bank should include this important indicator when deciding on interest rate adjustment. As private lending has been a long existing phenomenon, it is necessary for the PBC branches to build a monitoring and information feedback system to track private lending activities, so as to strengthen the central bank’s macro economic management, safeguard financial market stability and improve interest rate management system.

 

5. Intensifying training on interest rate pricing and risk control. Training on interest rate pricing and risk control will be offered by the PBC headquarters, its branches and central sub-branches in the provincial capitals to financial institutions, especially the UCCs and RCCs. Technology support will also be provided to enhance financial institutions’ capability in interest rate pricing and risk prevention and to promote their self-sustained development.