The Standing Committee of the National People's Congress hold a meeting at the Great Hall of People in Beijing June 28, 2007. [Xinhua]

China's top legislature Friday gave the State Council the power to reduce or cancel tax on interest accrued from bank deposits and approved a massive sale of special T-bonds.

The Standing Committee of the National People's Congress voted in favor of an income tax law revision that gave the State Council the power to adjust the interest tax.

"The imposition, suspension or reduction of interest tax on bank savings, as well as specific methods thereon, are subject to the decision of the State Council," said the amended law.

Lawmakers also gave the go-ahead for the Ministry of Finance to issue 1.55 trillion yuan of special treasury bonds to finance the purchase of foreign exchange reserves for the yet-to-be-established State Forex Investment Company.

Interest tax

Analysts expect the State Council to initially halve the current interest tax rate to 10 percent. Should inflation continue to grow, then the cabinet could cancel the tax completely. However, there are also calls for the abolition of the tax altogether.

A pedestrian wallks past a Bank of China branch in Shanghai May 21, 2007. [newsphoto]

The tax adjustment will be the authorities' latest attempt to make the real interest rate positive and discourage the diversion of bank deposits to the stock market.

Currently, the benchmark one-year deposits carry an interest rate of 3.06 percent. However, given the 20 percent interest tax, the actual yield is just 2.45 percent.

That return is well below the inflation rate as measured by the consumer price index, which hit a two-year high of 3.4 percent after rising 3.0 percent in April and 3.3 percent in March.

If the real interest rate remains negative for a long time, it will do no good to the economy, said assistant central bank governor Yi Gang last weekend.

The negative interest rate is encouraging a massive diversion of bank deposits to the equity market, which has soared 50 percent so far this year after a 130 rally in 2006.

China's household deposits posted the largest monthly drop in May, decreasing by 278.4 billion yuan, according to central bank statistics.

The central bank has raised interest rates twice this year and is widely expected to announce two more hikes before the end of year.

China started to collect interest tax in November 1999 in the wake of the 1997 Asia financial crisis in a bid to boost domestic consumption. But that aim has largely failed due to the lack of an eligible social security network in the country.

Bond sales

It is still unknown who will buy the special treasury bonds, a key point in determining the impact of such a large issuance on the domestic economy.

The ministry could sell the bonds to the central bank in exchange for the foreign exchange reserves now held on its balance sheet, with few implications for the economy.

But if the bonds are sold to the inter-bank market, it will take much longer to raise the funds and will have bigger economic implications.

The latter case is more likely to happen, China Business News quoted sources as saying.

Also unknown is the timing of the bond offer. Some predict that it will kick off in July as the State Forex Investment Company will complete registration in August and start operations the next month, according to the newspaper.

On whether the bonds will be sold in one time or in several batches, the sources expect issuing the bonds in phases, which will have much smaller impact on the financial market.

In a briefing to the lawmakers on Wednesday, finance minister Jin Renqing said the special bonds will be tradable and have maturities of at least 10 years. The market will decide the coupon rate.

Finance professor Zhong Wei of Beijing Normal University foresaw a major fluctuation of the financial market caused by the sale, according to the China Business News report.

The excess reserve rate in the country's banks stands at just one percent after the central bank ordered the lenders to set aside more money as reserves, five times so far in 2007, he explained.

Earlier this year, China decided to set up the State Forex Investment Company to make more profitable use of its huge forex reserves which hit US$1.2 trillion by the end of March.

Stock market

News on the possible interest tax adjustment and the bond sale has affected the stock market for several days.

The benchmark Shanghai Composite Index fell 2.39 percent on Friday to close at 3,820.70 points, extending a four percent loss on the previous session. The declines followed a 3.68 percent fall on Monday and a 3.29 percent drop on last Friday.

Analysts expected the market to remain weak for several days as the bond sales might soak up money that would otherwise have gone into stocks. Bank deposits will also become more attractive after the interest tax is reduced or cancelled.

However, given the widening trade surplus and inflow of foreign direct investment, the market would continue to experience excess liquidity.

In addition, even after the cancellation of the interest tax, the real interest rate is still in negative territory and far below the return from stocks and mutual funds. Thus the exodus of deposits is unlikely to stop, analysts said.