February 2005

China’s Interest Rate Policy Outlook

As foreign investment and the private sector will continue to contribute a bigger share of economic output, interest rate policy will be an indispensable tool for the government in steering the economy.

lending rates in accordance with the cost of funds in the money market, while the central bank sets only the Fed fund target rate, which guides the overnight interbank rate. In China, however, the PBOC stipulates the commercial banks’ benchmark deposit and lending rates of all maturities, although commercial banks are given a certain degree of flexibility to adjust their commercial rates. The PBOC needs to regulate commercial rates because of the underdevelopment of the money market. Although a national interbank market was set up in 1996, it has yet to become active in transactions of funds among commercial banks. The CHIBOR and REPO rates (the latter of which use government bonds as security) have yet to form a benchmark yield curve as the market is rarely traded beyond three months. In 2003 the Mainland’s interbank market turnover accounted for only 60% of total bank assets, while the same ratio in Hong Kong was 723%. The PBOC made significant progress in its policy of liberalising interest rates last October, when it raised

In October last year, the People’s Bank of China (PBOC) raised interest rates for the first time in nine years in an attempt to rein in the fast growing economy. The adoption of monetary policy tools six months after the introduction of such administrative measures as the banning of investment in and loans to specific industries and projects marked a new phase of macroeconomic controls, with market-oriented policy tools being combined with policy directives. State enterprise and financial sector reforms over the past decade have laid the foundation for interest rates to work through the economy and for monetary policy to become an increasingly important tool of the government to achieve its economic targets.

Table 1 Interbank Money Market Turnover, 2003

Interest Rate Structure
In the last 10 years, the PBOC has made progress building up its money market as a means for letting interest rates be determined by market conditions. Nonetheless, the PBOC continues to play a more significant role regulating interest rates than other market economies. In the US, for example, commercial banks determine their own deposit and

Mainland China Interbank Money Market Turnover (USD Bn) Total Bank Assets (USD Bn) Money Market Turnover as % of Bank Assets (a) 2,089

Hong Kong 6,031




( a)/(b)



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As many SOEs face no real threat of bankruptcy and do not see profit-making as their major goal. including commercial banks’ benchmark deposit and lending rates. It also provides the banks with the incentives needed to finance new customers such as small non-state enterprises. the PBOC will continue to set the whole range of interest rates. On the other hand. some sectors of the Chinese economy are sensitive to interest rate movements. This gives commercial banks greater flexibility to price their loans so that they reflect the risk of the borrowers. probably to prevent excessive competition for deposits among banks. The Mainland’s consumer loans accounted for 9. On the other hand. The prerequisite for achieving such a goal is a well-developed money market that can offer benchmarks for commercial banks. In addition. interest rate fluctations do not have as equally a powerful effect on private consumption in China as they do in more developed economies. however.interest rates and removed the ceilings on the lending rates that commercial banks could charge their customers. China witnessed buoyant housing market activities Impact of Interest Rates on the Economy There has been intense debate over the effectiveness and desirability of interest rates versus administrative measures for slowing investment and economic growth since the macroeconomic control programme was implemented in early 2004. Credit cards are still relatively new.2% and 61. Non-state enterprises. Taking into account the increasingly liberalised economy. Another area that is becoming increasingly sensitive to interest rate fluctuations is the housing sector. Similarly. which contributed over 60% of industrial production and over 70% of urban employment in 2003.9% of total loans and 13. Before a mature money market is put in place. the higher financing costs brought on by higher interest rates do not necessarily affect their investment equations. allowing banks to offer deposit rates below the benchmarks set by the PBOC. Instead. the lower limits on deposit rates were removed. which are implicitly supported by government bodies. Many SOEs. 2003 Mainland China (Rmb Bn) Mortgage Other Consumer Loans Total Consumer Loans (As % of Total Loans) (As % of GDP) 1. have only a limited effect on the investment behaviour of SOEs. we believe a combination of both administrative measures and interest rate rises is required to effectively steer the economy. while hire purchase arrangements for durables such as motor vehicles have yet to become widely implemented. which are generally considered high risk due to a lack of financial information for assessing their creditworthiness. they have to base their investment decisions on financing costs and rates of return. saying that administrative measures are much more effective at curbing overinvestment. subject to the approval of the State Council. It is widely accepted that interest rate movements Table 2 The Role of Consumer Finance.7% respectively in the same period.178 395 1. The ultimate objective of China’s interest rate reforms is to allow commercial banks to decide all their commercial rates in accordance with market forces and have the PBOC set only the interest rates on which commercial banks borrow short-term liquidity from it. The Mainland’s low household debt level means that the negative impact of higher interest rates on household consumption should be relatively small. Some emphasise the point that monetary policy lacks a transmission mechanism. advocates of interest rates cite the difficulty of using administrative tools to control an increasingly market-oriented economy as well as the risk of overtightening associated with administrative measures.5% of GDP at the end of 2003.9%) (13. The comparable ratios in Hong Kong were 39.2%) (61.573 (9. have been tasked with increasing market share. attracting foreign investment or creating employment opportunities.7%) . are not protected from bankruptcy. but with the SOEs still representing a major portion of capital investment. The ceilings on deposit rates were retained.5%) Hong Kong (HKD Bn) 616 137 753 (39. which still consume almost half of corporate lending in China despite their declining contributions to the economy.

the effectiveness of administrative measures depends on the authority of the executing officials. Nor can past experience offer much insight into the interest rate outlook. And an increase in interest rates would likely put some of the marginally profitable SOEs into financial difficulties. But this past experience offers little reference value today. However. economic growth. who must use their personal judgement to screen projects and may sometimes face resistance. mainly because of the mixed signals conveyed by the statistics of the fourth quarter of last year. do have a part to play in the Chinese economy. it is not clear which factors will be most important for the PBOC in recommending any changes to interest rates. and with the one-year lending rate at 5. will prompt the PBOC to consider raising interest rates again. The last tightening cycle in which interest rates were raised took place some ten years ago. we believe the Chinese government is likely to shift the focus of its macroeconomic controls from administrative measures to interest Conclusion As foreign investment and the private sector will continue to contribute a bigger share of economic output. Therefore.5% in 2005. with due consideration to their so-called “fiscal role” in the economy. Interest Rate Outlook The process the PBOC takes and the factors considered to determine changes in interest rates have not been fully understood by the market. employment. employment costs are likely to continue their uptrend amid robust export demand and tight supply of itinerant workers in the coastal areas. we believe the PBOC can hardly avoid raising interest rates again this year. China still needs time to fully deregulate interest rates before they become a true reflection of market demand and supply of funds. With CPI projected to stay at 3. interest rates probably will not be raised aggressively. The Monetary Policy Committee under the PBOC is the organisation that recommends changes in interest rate policy for the State Council’s final approval. rates this year. projecting the trend and timing of interest rate changes in China is more difficult than in other market economies. will all be considered in the process of determining interest rates. However.8% in 2005. . as the financial system and the composition of the economy have undergone dramatic changes since then. therefore. Nevertheless. The PBOC has not made any additional interest rate hikes since raising interest rates by 27 basis points in October 2004. as there is no established convention yet for adjusting rates in China. Interest rates. the PBOC will probably take a cautious attitude in order not to overdo the tightening process. Thus. Many SOEs are still burdened with debts. the bottlenecks in the upstream industries are unlikely to show great improvement and the upward pressure on prices. such as inflation. As the government is emphasising stability in regard to SOE reform and the employment market. particularly producer prices. On the other hand. which were almost non–existent seven years ago but have since grown to over 7% of all loans.in the past few years. investment momentum and industrial bottlenecks. any rate hike is likely to be limited to about 50 basis points. Despite this. What’s more. and the role of interest rates as seen by the PBOC as a policy tool needs to be clarified. the use of interest rates to allocate funds and suppress lowreturn projects is more desirable over the medium term. thus either requiring government assistance or putting pressure on the banks. interest rate policy will be an indispensable tool for the government in steering the economy. In addition. although we believe interest rates are likely to go up again this year.58%. and before they can guide the allocation of funds and credits to the most worthy investment projects. The pace of economic growth is projected to remain brisk at 8. monetary trends. it is likely to use interest rates as a last resort and any rate rise would probably be mild to assist the state sector. Government officials have said on different occasions that a number of factors. The main reason is that the interest rate policy should be a more efficient – if not more effective – tool than administrative measures for steering the economy. monetary policy reform is necessary. underpinned by the rising popularity of home mortgages. However. Thus.

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