In 1994, a series of policy measures in relation to China’s financial reforms were successfully implemented. The most important of these were the unification of the exchange rate, the transformation of the functioning of the People’s Bank of China (PBC), and the establishment of policy banks.1 However, the existing interest rate system was not modified. In contrast with the experience of most developing countries, interest rate liberalization in China will be the last item on the reform agenda, after the liberalization of the exchange rate and the opening of a securities market, reflecting the Chinese pattern of gradual financial reform. The reasons for delaying interest rate liberalization are not only some technical difficulties, but also different views on its sequencing and on the risks involved.

In 1994, a series of policy measures in relation to China’s financial reforms were successfully implemented. The most important of these were the unification of the exchange rate, the transformation of the functioning of the People’s Bank of China (PBC), and the establishment of policy banks.1 However, the existing interest rate system was not modified. In contrast with the experience of most developing countries, interest rate liberalization in China will be the last item on the reform agenda, after the liberalization of the exchange rate and the opening of a securities market, reflecting the Chinese pattern of gradual financial reform. The reasons for delaying interest rate liberalization are not only some technical difficulties, but also different views on its sequencing and on the risks involved.

The liberalization of interest rates is a widely discussed problem in China today and will be the most difficult aspect of China’s financial reform. The limited scope for interest rate reforms was defined in November 1993 in the “Decision on the Issues Related to the Establishment of a Socialist Market Economic System” of the Third Plenum of the 14th Congress of the Chinese Communist Party. It was stated that the central bank should adjust the basic interest rate in a timely fashion according to the demand and supply of funds in the market, and allow the deposit and lending rates of commercial banks to float within a limited margin. In December 1993, the “Decision of the State Council on Financial System Reform” stipulated that the PBC should set a ceiling for deposit rates and a floor for lending rates; streamline the relationship of deposit rates, lending rates, and interest rates for securities; set different interest rates according to maturity, cost, and risk, and maintain reasonable differentials between these rates; and try to establish a market-oriented interest rate system based on the central bank rate. Since the second half of 1994, the International Monetary Fund and the World Bank have also suggested that interest rate liberalization be sped up.

In this paper, some of the theoretical issues in relation to the reform of the interest rate system in China are discussed.

Interest Rate Elasticity of Savings

The interest rate elasticity of savings is a very relevant issue for China’s interest rate policymaking. According to economic theory, when countries maintain financial repression, the liberalization of interest rates may help increase the mobilization of savings, which would result in a higher level of investment and of economic growth. However, China’s situation differs from that of other countries. After about 15 years of economic reforms in China, deposit and lending interest rates have not yet been liberalized and are not set according to a market mechanism, but are still closely administered by the monetary authorities. However, financial institutions and instruments have become diversified and the financial market is now well developed. Interest rates in real terms for deposits with a maturity of one year, which play a major role in China’s economy, were at times negative. However, individuals have rapidly increased their savings, and the ratio of savings to GDP has remained high. Thus, some people question the impact of interest rates, whether market-determined or not, on Chinese individual saving.

One is hesitant to agree with this opinion. The axiom that savings are elastic to interest rates is undoubtedly correct. The above-mentioned phenomenon of reduced elasticity of interest rates on savings in China may only reflect the impact of other factors on savings, since the increase in savings is not determined only by the level of interest rates. Savings are a function of interest rates, all other things being equal. We should not deny the necessity of liberalizing interest rates simply because other factors also influence saving.

What is happening in China is due to the following specific factors.

1. Before 1980, the monetary income per capita was very low. Then per capita income increased rapidly, which accelerated the growth of savings. In other words, the impact of the increase in income on the growth of savings was greater than the impact of interest rates.

2. With the low savings per capita, interest earnings accounted for a small proportion of total incomes. As a consequence, the desire to earn interest income was not the main goal for the depositors. Before 1991, individual savings in rural areas averaged Y 2,200 per capita, and individual savings in rural areas averaged Y 277 per capita. Thus, income generated by interest earnings was very low, as was depositors’ sensitivity to the level of interest rates. However, in recent years, individual savings per capita have increased substantially. Moreover, holders of large deposits now represent a larger share of total deposits.

The fluctuation of interest rates is now becoming of more interest since it influences the expected interest income of some depositors. As the share of interest in total income increases, depositors pay more attention to the level of interest rates when making a choice between consumption and saving, at a given price level. Indeed, the relatively high level of real interest rates in 1990 and 1991 encouraged households to increase their savings. According to available information, total interest proceeds in China in 1994 reached Y200 billion, that is, about 4 percent of GDP. The increase in interest proceeds stimulates the growth of savings, which in turn reflects the stronger elasticity of savings to interest rates. For instance, the demand for three-year registered government bonds issued in March and April 1995 was high because their interest rate was 1.76 percentage points higher than that for bank deposits with similar maturity. As a result, in March 1995 the growth of savings remained constant, and purchases of these bonds amounted to Y 90 billion during March and April.

3. During the transition period, household savings tended to increase. This may have a greater impact on total savings than does the level of interest rates. The social security and welfare systems have changed due to the implementation of reforms in other sectors of the economy. Reforms in medical services, employment, and housing and pension funds, in particular, have increased uncertainty for households and stimulated the motivation for saving.

A survey on the motivations for saving, conducted in November 1991 in 20 cities, showed that 19 percent of total savings was intended for children’s education, 12 percent for retirement, and 13 percent for the purchase or construction of a house, for a total of 44 percent for these three motivations. Over time, the motivation for saving has shifted from saving for the purchase of durable consumption goods or for children’s weddings, to profit making or protection against risk.

4. The operating funds of enterprises are partially held in savings accounts. Indeed, a common practice in China is for individual businessmen and some enterprises to hold settlement funds in accounts that, for statistical purposes, are included in the category of savings. Owing to the lack of individual checks in China, some individual businessmen do not open a settlement account in a bank and most of the transactions have to be settled in cash. In addition, some enterprises also need cash to pay for intercity transactions. To reduce the risk involved in carrying cash, traveler’s checks—which can be used to withdraw cash in any of a bank’s branches—and out-of-city demand withdrawals are widely used. These funds, which are also included in the savings in monetary statistics, continue to increase too.

Interest Rate Elasticity of Investment

The interest rate elasticity of investment raises two issues: first, whether the state-owned enterprises (SOEs) as a group take into account the level of interest rates when they decide to invest; and second, whether, under the present circumstances, the liberalization of interest rates can be conducive to channeling financial resources to the most productive projects. The prevalent view is that SOEs’ demand for funds does not depend on the level of interest rates because of the “soft budget constraint.” Thus, the liberalization of interest rates may neither enhance the optimization of the investment structure nor improve the aggregate control of investment. In other words, from the perspective of the SOEs, the time to liberalize interest rates has not yet come.

This is partly supported by the conclusions of an objective analysis. A few years ago, when local governments and some SOEs became responsible for deciding on their investments, they were still not made responsible for potential losses that would arise from their decisions. Managers may decide to contract a loan, but once they are no longer in charge nobody knows who should be responsible for its repayment. It is a kind of “overlapping generations” model: the decision to invest can be inherited, but the obligation to repay debts is not considered a part of the legacy. In China, even the repayment of a loan can be rescheduled, not to mention interest payments. In fact, the repayment of interest is rare, especially when the creditor is one of the state commercial banks (SCBs). This is an illustration of the “soft budget constraint” mentioned above.

When the borrower is a local government or an SOE, and the lender is one of the SCBs, the repayment obligations for interest and principal become weaker on both sides. Thus, the elasticity of investment borrowing to interest rates is relatively low. Moreover, most of the loans in support of state key projects for agriculture and procurement of agricultural products are less sensitive to interest rates.

However, I would like to stress that these realities do not negate the necessity of liberalizing interest rates. Interest payments, as a cost constraint, do play a role in economic performance. First, some of the investors and borrowers take into account the level of interest rates, especially the non-SOEs as well as certain SOEs. Because investors and borrowers operate in a competitive environment, the interest rate level directly affects their efficiency and profitability. For these enterprises, the liberalization of interest rates will put external and domestic financing on an equal footing and will optimize the structure of both investment and the allocation of resources.

Second, the nonliberalization of interest rates, especially negative real interest rates, increases the dependency of SOEs on subsidized bank lending, which in turn increases the difficulty of liberalizing interest rates. This is the so-called “SOEs fund pitfall,” that is, a situation in which most SOEs are loss making under the market-based system and their inventories are increasing so that to avoid layoffs or relatively low wages the government has to force SCBs to provide these enterprises with subsidized loans. However, under soft budgetary constraints, subsidized loans cannot help these enterprises to become profit making. Rather, loan subsidization stimulates the demand for credit because some of the enterprises use funds obtained on credit to speculate on financial markets. Thus, the SOEs as a group force the SCBs to provide more subsidized loans. Moreover, loans are used by the SOEs for speculative purposes, which ultimately creates an inflationary “fund trap.” The liberalization of interest rates cannot fundamentally solve the problem of the SOEs’ soft-budget constraints, but low interest rates may stimulate unlimited demand for bank credit, which is not beneficial to economic reform in China.

Third, the insensitivity of the SOEs to interest rates does not constrain the liberalization of interest rates. In the transition process, the liberalization of interest rates need not wait until the enterprise reform is finalized. A strong debt constraint between banks and enterprises can be built up through legislation. The recently issued “Company Law,” “PBC Law,” “Economic Contract Law,” and “Commercial Bank Law” will all be helpful in this regard. Moreover, like the liberalization of prices, the liberalization of interest rates is not meant to solve the specific problems faced by SOEs. However, it will provide enterprises with an external pricing system that will introduce discipline in the financial system. We should not expect the liberalization of interest rates to solve all the problems of the SOEs. However, it is an important element that is needed for enterprise reform to proceed.

Liberalization of Interest Rates and Monetary Policy

In the transition to a market-based system, credit ceilings and central bank refinancing are the main instruments of monetary policy. Interest rates have not played an important role in monetary policy because the PBC has rarely adjusted deposit and lending rates. However, the frequent upward adjustments of deposit and lending rates in 1988 and 1993, respectively, helped reduce inflationary pressures.

Currently, the PBC sets deposit and lending rates charged by banks to their customers. Under the current circumstances, this administrative interest rate policy seems to be efficient, because it takes into account the interests of the different categories of borrowers dealing with the SCBs. However, it is difficult to determine a level for interest rates that both meets the monetary policy objectives and satisfies all the borrowers. As a matter of fact, the PBC (or sometimes the State Council), when adjusting interest rates, has to take into account conflicting interests of various groups.

There are four macroeconomic variables that have to be taken into consideration by the PBC: the total supply and demand for social credit; the costs of enterprises; the profitability of the SCBs and the impact on the budget of the central government; and the general level of market prices. Since the impact of interest rate adjustments on these four variables is sometimes conflicting, the PBC needs to focus on one or two variables according to the priority at the time. The PBC normally uses a trial and error approach to determine such priorities.

The crucial point at present is that, as an instrument of monetary policy, the level of interest rates links the interests of various parties and is not decided solely by the PBC. Each time the PBC wants to adjust interest rates, it has to consult with relevant ministries or government agencies in order to reach a consensus. If an agreement cannot be reached, the State Council will make the decision. Sometimes the decision on interest rate adjustments is not in harmony with a desirable monetary policy stance, but results from “games” among different parties. The decision-making process is very complex and takes a long time. Moreover, information is not shared equally among the parties, which prevents interest rate policy from playing an appropriate role in macro-economic control. Thus, interest rate policy is not an instrument at the PBC’s disposal, but rather, a kind of economic policy instrument in the hands of the State Council.

One debate is whether the liberalization of interest rates will facilitate control over inflation. This is a very pragmatic issue. Some think that if interest rates are fully determined by the market, they will increase substantially, which in turn will increase costs for enterprises and thus inflation. Another view is that interest rate liberalization is a prerequisite for an overall reform of monetary policy that would be conducive to anti-inflation policies. Experience with foreign exchange system reforms indicates that there will be higher volatility once interest rates are fully liberalized. It is still uncertain whether China’s monetary policy could be adjusted accordingly in response to these changes.

In fact, whether interest rates are liberalized or not, there is a risk for monetary policy. In the case of administered interest rates and liberalized prices in other sectors of the economy, the enforcement of interest rate controls is difficult. When inflation is high and interest rates low, it is difficult for the central bank to enforce interest rate controls. In addition, monetary policy relies on direct instruments such as the credit plan rather than on indirect and market instruments. Since interest rates are administered, the use of market-based instruments is not possible. For instance, the PBC would like to start monitoring banks’ reserves through open market operations using government securities, as a means to control money supply. However, since interest rates are not flexible, changes in banks’ excess reserves do not effectively constrain their profit margin or their liquidity. For instance, banks with excess reserves will not necessarily invest these funds in government securities. Thus, the preconditions for open market operations do not yet exist. Since interbank market rates are not yet liberalized, there is no link between the price of securities in the secondary market and the interbank rate. Because the market signals are distorted, open market operations cannot be used to signal the stance of monetary policy.

In Western countries, the boundaries between banking and other financial activities have blurred as a result of financial innovation, making it difficult to identify an intermediate target in terms of a stable monetary aggregate. As a consequence, there was a shift to intermediate targets of monetary policy in terms of a market interest rate. This illustrates the difficulty of implementing monetary policy without a reference market rate that reflects the demand and supply for funds.

For all these reasons, there is no doubt that liberalization of interest rates will take place in China. The question is how to initiate the process.

Dual Track of Interest Rates

The two-track system of interest rates has existed for a long time in China. One track is official interest rates, which are priced by the SCBs. The SCBs have branches all over China and can attract low-interest-bearing demand deposits and non-interest-bearing settlement deposits. The other track of interest rates is composed of interest rates priced by the nonbank financial institutions (NBFIs) and urban credit cooperatives that are adjusted according to demand and supply. The dual track of interest rates, that is, the coexistence of regulated interest rates and black market interest rates, is a feature of the Chinese economy. With the abolishment of a dual track for prices and the exchange rate, the only dual track left is that for interest rates.

The drawbacks associated with a dual track of interest rates are obvious. It allows such arbitrage operations as the relending at the market rate of funds borrowed at official interest rates, for speculation purposes. Lobbying and corruption in China are mostly due to this dual track of interest rates: loans intended to finance productive investments may be invested in real estate or the securities markets, which in turn accelerate the “bubble economy.” The parallel market is also active and monetary authorities have not been successful in their attempts to regulate it. On the other hand, most NBFIs are surviving thanks to the dual track. Some enterprises that are not entitled to get loans from the SCBs but can pay market interest rates borrow from the NBFIs, as well as some individuals and enterprises, are willing to deposit funds in the NBFIs in order to obtain higher remuneration.

The unification of interest rates in China is possible, as evidenced by the reforms of prices and the exchange rate. Some have suggested that the parallel market could be legalized, and interest rates priced by NBFIs and urban credit cooperatives; that borrowers should decide from which institution to borrow; and that NBFIs should not be subject to credit ceilings. However, the view is that SCBs should continue to charge official interest rates and be constrained by credit ceilings. The experience of Taiwan in the 1960s is presented as a model for such an approach. The current PBC interest rate policy follows this pattern. For instance, the urban credit cooperatives are allowed to adjust the interest rate charged for one-year loans to up to 30 percent over the official rate; the margin is 60 percent for the rural credit cooperatives, and 20 percent for the NBFIs. However, the legalization of the parallel market rate would not be beneficial. The dual track of the interest rate system, which is unavoidable in the transition period, should remain only for a short time. The liberalization of interest rates is the only sustainable solution.

Some are concerned that the level of interest rates will be very high after they are liberalized. For instance, the current one-year bank lending rate is 10.98 percent, compared with a market rate of 18 percent. After the unification of interest rates, the market rate might reach levels that would be unbearable for the economy. Although this seems reasonable, more analysis is required.

First, parallel market rates do not represent the equilibrium price. At present, the Chinese money market is segmented, so the parallel market interest rates differ from region to region; they could be 18 percent in Hainan and Guangdong, but 15 percent in southwest China. The liberalization of interest rates will be conducive to a unification of the money market, and the market equilibrium price will not be as high as the current parallel market rates.

Second, current parallel market interest rates include commissions (for brokerage, transfers, or evasion of supervision at different levels), which will automatically disappear once interest rates are liberalized.

Third, the major difference between the dual track of interest rates and that of prices and exchange rates is that the size of the black market for interest rates is very small, while it represented more than 50 percent of the foreign exchange market. The level of the unified exchange rate was therefore close to black market prices, but for the above reasons, this should not be the case insofar as interest rates are concerned-

Sequencing of Interest Rate Liberalization

China’s financial situation favors a gradualist approach to liberalizing interest rates over an overnight approach whereby all interest rate controls are removed and the market is left to decide their new levels. Such a sudden liberalization of interest rates would result in chaos.

In my opinion, an appropriate sequence for liberalizing interest rates in China could be the following. The first step would be to liberalize interest rates in the interbank market. This would not be disruptive and would allow for the formation of a reference rate. This would not only be good for the integration of the money market in China, but would also pave the way for the reform of monetary policy. As a matter of fact, the interbank rate, which results from transactions among financial institutions, perfectly reflects the demand and supply of funds in the market so that it is not necessary to set a ceiling for it.

The next step is to adjust bank lending rates to industrial and commercial enterprises frequently, reflecting changes in the reference rate. These rates might be a little higher than the interbank rate. In this case, bank lending rates would still be administered by the government or the PBC, but they would be much closer to market equilibrium interest rates. The cost of funds for enterprises would be almost liberalized, which might stimulate sensitivity to interest rates and strengthen enterprises’ capability to bear the pressure of market interest rates. At that point, deposit rates would still be controlled.

The third step is to liberalize government bond interest rates in the primary market, that is, to issue government bonds by tender or by auction. In other words, the buyer of government bonds can decide the issuing price based on the interbank rate. In this case, the price of government bonds in the secondary market would be linked to the level of interest rates in the interbank market. The government bond market would expand, and the number of investors and transactions would increase accordingly.

The fourth step is to voluntarily adjust the central bank refinancing rate and make it a reference point for the money market. At the same time, required and excess reserves should be lifted to give commercial banks an incentive to participate in the money and government securities markets. Liquidity management would be conducted mainly through PBC operations in the money market, and government securities would be the main collateral for these operations. At this stage, the central bank refinancing rate, the interbank rate, and the price of government securities in the secondary market would be interrelated. This would frame a system of interest rates that would provide a market environment for open market operations.

The fifth step is to allow commercial banks to adjust their lending rates according to the credit rating of their customers (the floating margin could be 30 percent). The PBC would only set the basic lending rate for one-year loans. Banks would set their interest rates for loans with different maturities on the basis of the one-year basic lending rate. One point we must bear in mind at this stage is that the PBC should set the one-year basic lending rate based on the prevailing interbank rate. It should not take into consideration other economic variables, nor should the PBC have to consult with other government agencies.

Some in the PBC think that an “appropriate” interest rate, which would serve as a reference for the basic lending rate, could be estimated based on calculations that take into account some economic and financial indicators (such as cost, asset structure, profit, and liability structure) for a sample of enterprises and sectors. I cannot agree with this suggestion. The equilibrium interest rate can only be determined by the demand and supply in the market; it cannot be calculated. The appropriateness of a calculated equilibrium price is still debated in the academic field. Now that we have agreed that the equilibrium interest rate should result from demand and supply, we should not reinstall an approach based on a “calculation.”

The sixth step is to allow deposit rates to float within a certain margin or set a ceiling, as proposed for lending rates in the fifth step. Since different types of financial institutions are competing for deposits, commercial banks cannot survive unless deposit rates are deregulated. In order to prevent the market from too fierce competition, the PBC could set a ceiling for the deposit rate, with periodic adjustments.

The seventh step is to fully liberalize bank lending and deposit rates. At this time, the liberalization of the interest rate would be finalized, and a market-based system would be established.


Policy banks are meant to assume responsibility for lending undertaken at the state’s behest in support of specific policies, notably for state projects, agricultural procurement and development, and trade financing, Eds.