THE moderate rise in the lending rate to banks implemented by the People's Bank of China over the New Year weekend was stronger in symbol than substance. By raising the discount rate for loans to state banks by an average of 0.24 percentage points, the central bank deviated for the first time from its practice of increasing interest rates on bank deposits. The move augurs well for the state banks, which generally have to pay higher interest on deposits but charge lower rates for loans. Short-term loans carry similar interest rates as short-term deposits, while long-term loans are charged less than the rate banks pay to depositors. That explains why state banks have extremely thin profit margins, if they are profitable at all. But the latest rise is too insignificant to produce a dramatic impact on banks' profitability, though it should still be welcomed. The long-term significance of the interest rate rise lies in the signal it gives on the central bank's intention to develop interest rates as a tool to control money supply, and thus the direction of the economy. This is long overdue. 'It will be some time yet before the central bank can turn to interest rates as an effective tool, but the move is a step in the right direction,' said Ma Guonan, senior economist at Peregrine Brokerage. Beijing has identified indiscriminate fixed-asset investments, especially by state enterprises, as a major culprit in the inexorable rise in inflation. And it has a point. Fixed-asset investments by the state sector grew about 37 per cent last year, compared with the national level of 28 per cent. Put simply, the austerity drive has had a bigger impact on the non-state sector than the state sector. By raising the interest rate for long-term loans, the central bank is hoping to force a cutback on fixed-asset investments by the state sector. To achieve that goal, the upward shift will have to be much bolder than any we have seen so far. Long-term loans for fixed-asset investments generally account for about 20 per cent of the total lending of state banks. These loans are unprofitable because they are made on political directives rather than on a commercial basis and the interest they bear is way out of line with true lending costs. With inflation running at about 24 per cent and interest on loans a little more than 10 per cent, there is every incentive to borrow, and the 0.72 per cent rise in rates on loans for fixed-asset investments which will follow the latest shift is little more than a flea bite. Analysts reckon that unless inflation is suppressed to below 20 per cent and interest rates on loans rise by several percentage points, state enterprises will barely feel it. Unfortunately, bank lending in China is hardly sensitive to interest rate changes. Qu Hongbin, China economist at Smith New Court Far East, said: 'Everyone knows that loans are made on the basis of directives and so are not sensitive to interest rates. This will have to change significantly if interest rates are to become a monetary tool.' Indeed, if the central bank is bent on dampening inflation, it should also have raised the cost of borrowing for short-term loans, which it conspicuously failed to do. Analysts estimate that about 80 per cent of the working capital of state enterprises comes from bank borrowings. Any squeeze on short-term bank loans would therefore hit where it hurts most. Yet the central bank chose not to clamp down on these loans, apparently because of the potential political and social consequences of squeezing state enterprises so close to the Lunar New Year. That leaves the central bank with little room to manoeuvre. To raise interest rates on lending would improve the balance sheet of specialised banks and make a dent in inflation. Not to do so would mean excessively high inflation continuing to eat into profits, wages and export competitiveness. Yet there is no denying that interest rates on the mainland are markedly higher than those elsewhere, and have prompted state enterprises with access to overseas capital markets to borrow from abroad. That, in turn, will lead to a rise in the value of the yuan as foreign loans are converted into demand for the local currency to meet operational expenses. What the central bank and those who guide its policies must admit is that in China's position, there is no easy option. The pain is inevitable; the key is in making it worthwhile.