China should widen the reform of its financial sector by liberalising controls on bank interest rates as a way to ensure the quality of domestic lenders' assets, an International Monetary Fund director suggested. 'The move towards a more market determined interest rate mechanism is important,' said Jose Vinals, the director of the IMF's Monetary and Capital Markets Department. 'This is something which should go hand in hand with the deepening of capital markets reform.' In a recent review of China's financial system, the IMF said the country's reforms were progressing well, but the financial sector was still confronting 'near-term risks, structural challenges, and policy-induced distortions'. Vinals said the reform of the interest-rate mechanism was among the steps China should consider taking. The People's Bank of China, the mainland's central bank, sets lending and deposit rates by administrative decree. The one-year benchmark lending rate stands at 6.56 per cent, almost double interest paid on one-year deposits - a wide interest margin that has helped banks earn handsome profits in recent years. The government also uses lending quotas as a policy tool for macroeconomic control, and under government directives banks have extended easy credit to support the nation's infrastructure-focused stimulus package since late 2008 - resulting in a mounting bad-debt problem for lenders as borrowers default on their loans. As a result, Beijing tightened monetary policy settings and controls on bank lending this year to prevent the bad-loan problem from worsening. The move made it difficult for small- and medium-sized firms to secure bank loans. Vinals said the government could free itself from the need to take such administrative measures by implementing a market-based interest-rate mechanism. Talks about a reform on the interest-rate mechanism started in the late 1990s as Beijing planned to give commercial banks more business freedom. But the move has yet to materialise. Yang Zaiping, executive vice-president of the China Banking Association, a government-controlled banking group, said last month that administrative control on bank operations was unscientific and banks were 'smart enough' to do business by themselves. The central bank has said it will eventually set up a market-based interest-rate mechanism, but it has not announced a timetable.