A market-oriented way of financial reform

Interest rate liberalization provides the foundation stones for transforming monetary policy

It has been more than 20 years since China started reform aimed at liberalizing interest rates. That is one of the most important elements of the nation's economic restructuring reforms, started in 1996 when the central bank freed the Shanghai Interbank Offered Rate.

It made major progress from 2003 to 2004 but then slowed as monetary policy had to focus on curbing excessive liquidity from the fast-booming foreign exchange reserves. Since 2012, interest rate liberalization has accelerated again, and now the central bank's control has been almost removed.

The key to raising the efficiency of resource allocation is to let the market decide the price of production factors, including the price of financing or capital. The price mechanism will allocate social funds to the most effective sectors of the national economy, which will benefit the country's overall economic development and help improve people's living standards.

Interest rate liberalization is an important way to diversify financial products. As the economy develops, demand for financial resources has become highly diversified. Differentiating the prices of financial products through reform is necessary to satisfy various demands.

Interest rate liberalization will provide the basic conditions for monetary policy transformation from a quantitative model to a price model. It means that interest rates will reflect the real market and be an effective tool to affect monetary policy, as well as the economy.

As long as the administrative control on interest rates is removed, commercial banks will satisfy their customers' demands and deal with the pressure of competition in a more independent and market-oriented way.

In the initial stage of reform, the commercial banks may lack awareness of how to set the rates, and they may rely on the central bank. However, as reform has been a long process, commercial banks are prepared for that.

But incomplete market-oriented reform may lead to a double-track pricing system or price distortion. For example, when the government first allowed commercial banks to provide financial products with diversified interest rates, the products usually had higher rates than the traditional deposits.

So the market may worry that all deposit rates will increase toward higher levels after they are liberalized. Such a worry is unnecessary, as the deposit rates will finally be decided by supply and demand.

In addition, the obvious reductions in commercial banks' information costs require more flexible interest rates. Deposits and a part of lending products depend highly on data processing costs. The growth of information technology has changed the costs of the financing business. Commercial banks' pricing on deposits and lending should reflect these costs.

Some clients have higher expectations of deposit rates, especially when third-party payment and Internet companies pose challenges through financial innovations with lower costs. In future, the competitive structure in the financial sector will be influenced by the financial institutions' technological levels and their different cost levels.

However, interest rate liberalization does not mean the government will give up managing interest rates. Interest rates are the result of market-oriented resource allocation and, at the same time, are an important part of macroeconomic management.

It is necessary to manage rates according to the nation's development strategies at different stages, and according to the different cycles of inflation.

The central bank is required to improve the whole management system for interest rates and launch an advanced interest rate transmission mechanism for the financial market.

Meanwhile, supervision and self-regulation are needed to prevent abnormal interest rates. For instance, when the global financial crisis erupted, the US Federal Reserve lowered the policy rates close to zero, and started the first round of quantitative easing. Some banks then on the verge of bankruptcy, such as the Washington Mutual Bank, still raised deposits rates to as high as 10 percent, in order to attract more deposits to sustain the business. Those kinds of moves are damaging and can threaten financial stability.

Interest rate liberalization stresses a market-oriented way of reform, and is also a tool of macroeconomic management.

The author is vice-governor of the People's Bank of China.