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SCMP Reporter

Cynics say China tends to be more interested in drum-beating than action when it comes to speeding up financial reforms.

  Yet, last week it undertook what was arguably its toughest move to build up a market-driven financial sector over the next decade.

 The move incorporated three measures essential to building up a money market: allowing the interbank market to go public after a three-month trial; setting up an apparatus for conducting open market operations; and ending an inflation-linked subsidy for medium-term deposits.

  Analysts said the measures showed Beijing's intention to free up interest rates and enable the People's Bank of China (PBOC) to use the rates to regulate money supply and the economy.

 'This is probably the most sensitive aspect of financial reform, because if it is not carried out well, it will have repercussions for the banking and state sectors,' said Lian Ping , head of the East China Normal University's department of international finance.

  The first step was to develop the China interbank offered rate (Chibor) into a benchmark for other short-term interest rates.

 When the PBOC buys and sell short-term government securities (treasury bills) to increase or decrease banking reserves, the most immediate effect should be felt in Chibor.

  In reality, Chibor is still miles away from being a barometer of short-term lending, limiting the PBOC's use of open market operations to affect money supply.

  The interbank market has 54 primary dealers: head branches of 19 banks and 35 short-term fund-raising centres.

 Bank branches participate in the market through their head offices, while non-bank financial institutions do so via the fund-raising centres.

 Transactions in the interbank market totalled 98.33 billion yuan by the end of last month, with the fund-raising centres emerging as more active dealers than the banks.

 The banks still prefer to turn to the PBOC to meet their short-term funding needs, because it provides cheaper funds.

   'Why would a bank borrow from the interbank market, when it has access to cheaper funds from the central bank?' one banker said.

 The discount rate - the interest rate the PBOC charges banks for borrowing directly from it - for a 90-day loan is 10.62 per cent, against about 10.82 for the interbank rate for a similar loan.

  Bank borrowings accounted for about 54 per cent of the PBOC's assets, down from 59.8 per cent in 1994, and 78.1 per cent in 1987.

 'Although the ratio has come down, central bank lending remains the biggest source of funds for the state banks,' he said.

 Also, banks earn interest on reserves and excess reserves placed with the central bank, removing the incentive for lending the excess deposits in the interbank market.

   'But with the desire to create a more active interbank market, the central bank would probably have to make it less easy for banks to borrow from it gradually, forcing them to go to the interbank market,' Gu Mingde , an assistant researcher with the PBOC Shanghai branch, said.

 Analysts said encouraging participation in the interbank market to the point where Chibor could reflect the true cost of short-term borrowing was just part of the story.

 The crucial part Beijing would have to tackle is to allow Chibor to influence the most politically sensitive interest rates - the lending and saving deposits rates for retail customers.

 These rates are set by the State Council, which gives more regard to politics than the dictates of supply and demand of money.

 'This is understandable as state enterprises rely extensively on bank loans to finance their working capital, and they are finding the lending rates very high,' Mr Lian said.

 There is talk that the State Council will give banks some flexibility in deciding lending rates later this year, based on interbank rates and the financial standing of state enterprises.

 Beijing sent a signal that it was ready to adjust interest rates when it cancelled the inflation-linked subsidy - paid on top of the interest - for medium-term loans.

 With the subsidy removed, once changes in the interbank rate are allowed to be reflected in the retail borrowing and lending rates, it would be easier to achieve the intended impact of open market operations.

 Analysts said for now, the trade in treasuries was little more than symbolic.

  Mr Gu said the value of treasury bills issued so far this year - about 60 billion yuan (about HK$55.64 billion) - was just too small to have any significant effect on money supply.

 Besides, treasuries form a tiny portion of the assets of commercial banks and securities houses.

 'Given the small size of treasuries, controlled interest rates, and the state banks' slow progress towards commercialisation, you cannot have open market operations as you see elsewhere,' Mr Gu said.

 China has, however, made a start in the right direction and, if things go smoothly, the country will have built up enough market-based tools to influence the economy.



Leap forward in money markets