In recent years, interest rate liberalization has become a hot topic amidst China's financial reforms. The People's Bank of China (PBC) expanded the floating range of deposit and loan interest rates in 2012, and eliminated the floor on lending rates on July 20, 2013, a clear indication of the government's intention to liberalize interest rates in future financial reforms. Jia Kang, Director of the Research Institute of Fiscal Science under the Ministry of Finance, and Meng Yan, an associate researcher at the Research Institute of Fiscal Science, believe that the interest rate liberalization is vital to China's financial reforms. Excerpts of their thoughts follow:

Why is the interest rate liberalization so vital to China's financial reforms? For years, China has adopted a policy of "financial repression." Since deposit and loan interest rates were artificially depressed, they failed to reflect the real status of monetary supply and demand. Under such circumstances, the demand for bank credit funds has far exceeded supply, and a lack of transparency has led to an imbalance in the allocation of credit.

As banks account for a large part of social financial assets, the bond market has been dispirited. As of May 2013, loans issued by financial institutions had reached 67 trillion yuan ($10.95 trillion), while the total assets of commercials banks had surpassed 139 trillion yuan ($22.71 trillion), according to statistics from the PBC.

In contrast, the total assets of China's insurance industry were a mere 7.7 trillion yuan ($1.26 trillion), deposits in the bond market were 25 trillion yuan ($4.08 trillion), and the total value of the stock market at 24.7 trillion yuan ($4.04 trillion). Counting the 8 trillion yuan ($1.31 trillion) of trust products, the size of the non-bank financial markets is equivalent to the balance of commercial bank credit. However, the 8 trillion yuan of trust products mostly came from commercial bank loans, and the 10 trillion yuan ($1.63 trillion) bank financial products should also be categorized as bank credit.

Apparently, bank credit makes up the lion's share of China's social financing, behind which is the government's regulation of the bond and stock markets, as well as the suppression of interest rates.

The control of deposit and loan rates should be blamed for the structural imbalance of bank credit assets. When the supply of social funds falls short of demand, a polarization also takes place in the allocation of commercial bank credit.

On the one hand, financial institutions tend to lend money to three groups - credible, large state-owned enterprises (SOEs), local governments and well-known private enterprises. On the other hand, cash-strapped small and medium-sized enterprises find it tough to get credit. They can only seek loans from informal financial institutions.

As of June 2013, small and micro-sized enterprises received 12.25 trillion yuan ($2 trillion) in loans from financial institutions, accounting for 28.5 percent of the total loans granted to enterprises. Even so, regulators like the PBC and China Banking Regulatory Commission have repeatedly required financial institutions to strengthen financial support for small enterprises and projects related to agriculture and the needs of farmers and rural areas.

A vital step

With "repressed" interest rates, commercial banks inevitably fall into a laggard operating and management state. Before the change in July, China used to impose both an upper limit on deposit rates and a lower limit on loan rates, which secured a stable and profitable interest margin for commercial banks.

As long as commercial banks run in an organized way and have basic credit risk prevention measures in place, they will generate stable revenue and won't bother innovating and becoming competitive.

Easy access to bank loans makes SOEs inefficient. In addition to management factors, low-cost loans are a major culprit behind their inefficiency. As many SOEs struggle with asset-liability ratios of more than 50 percent, interest payments account for a large share of their operating cost. As interest rates are lower than the cost of social funds, SOEs are not pushed to improve management and reduce overhead costs. In this sense, they lag far behind private or small and micro-sized businesses, which can only resort to high-cost private lending.

Low bank rates also undermine wealth growth. Large amounts of household deposits, hitherto, have been a major source of profits for commercial banks. To cope with economic volatility and uncertainty, Chinese residents, who are not used to taking risks, tend to deposit their savings in low interest bank accounts.

Therefore, liberalizing interest rates seems inevitable, which becomes an important link in China's financial system reform.

Liberalizing interest rates will give an impetus to China's capital market. The pricing system of social capital will be restructured, bank interest rates will return to market levels, and the bond and stock market will become more attractive to fund raisers. CA