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Further Promoting Interest Rate and Exchange Rate Reforms

04-24 14:26 Caijing
The marketization of China’s exchange rate and interest rates is not yet complete.

This is an exclusive interview with Central Bank Governor Zhou Xiaochuan

Expanding the Floating Range of the RMB Exchange Rate

Caijing: You once said that the RMB to U.S. dollar exchange rate is moving towards equilibrium. Does this mean the time has come to further adjust the formation mechanism of the exchange rate?

Zhou: As the exchange rate gets close to equilibrium, both capital and the exchange rate move both ways, at which point it will be easier to promote exchange rate reform. The time is ripe to further improve the formation mechanism of the exchange rate.

Caijing: Is it risky to expand the floating range of the RMB exchange rate? Will the central bank change the frequency and means of its market intervention?

Zhou: So far, a transition period of five years has passed since the floating range of the RMB exchange rate was expanded to 0.5 percent in 2007. With the development of the domestic foreign exchange market since the onset of foreign exchange reform, and with market players’ (independent) pricing and risk management capabilities improving, it is necessary to modestly expand the floating range of the RMB exchange rate. The central bank also has a variety of means to administer and regulate the exchange rate when necessary. So the risks are manageable.

As the floating range of the exchange rate expands, the flexibility of the RMB exchange rate’s daily middle rate, intraday rate and closing rate will all see corresponding increases. In this case, market supply and demand will play a bigger role, and the central bank will only intervene when the market exchange rate moves beyond the specified range. Future interventions will be less frequent and more flexible.

Caijing: How much will the appreciation of the RMB (exchange rate) impact China’s export sector?

Zhou: The impact of exchange rate reforms will depend on how fast export enterprises improve themselves by gradually adjusting their products and techniques and gaining some pricing power. Over the medium to long term, the adjustment of the exchange rate will send a clear signal that more capital should be invested in the domestic sector (especially the service sector) while investment in export capacity should be reduced, so as to promote a domestic demand-oriented industrial restructuring over the medium term.

Further Drive Forward the Marketization of Interest Rates

Caijing: Should China further promote market-oriented reform of interest rates?

Zhou: The marketization of interest rates is a process that can be advanced further. China could start with reforming the lending rate, while the reform of the deposit rate could be advanced through approaches including promoting the development of alternative debt products and expanding the floating range of interest rates.

Caijing: You recently pointed out that the time has come to further promote the marketization of interest rates. How do you draw this conclusion? Is it feasible to lift the controls on interest rates?

Zhou: Since the liberalization of the interbank offered rate in 1996, the market-oriented reform of interest rates has progressed steadily: financial institutions tend to have more pricing power in the market; and market mechanisms tend to play a bigger role in the pricing of financial products including loans, deposits and bonds. In recent years, domestic commercial banks have achieved initial success in financial restructuring and joint-stock reform; in the meantime, hard financial constraint mechanisms on financial institutions have been further strengthened, enhancing the institutions’ interest rate-pricing and risk management capacities substantially. In addition, the central bank has become more proficient in adjusting market interest rates through open market operations, while the Shanghai Interbank Offered Rate (SHIBOR), which can serve as a reference to the pricing of financial products, has been fostered. Moreover, a deposit insurance system and an exit mechanism featuring the “survival of the fittest” financial institutions are being established. In light of these facts, it is fair to say that the time has come to further promote the marketization of interest rates.

Of course, it is impossible to meet all the requirements for the reform, and there is no such reform that brings nothing but benefits without any drawbacks. Reform is about timing. Right now, externally, the global financial crisis has not subsided, while internally there is danger of an economic slowdown and inflation in China. Hence we need to wait for the appropriate time to see if we can reach a consensus.

Caijing: How can we drive forward the market-oriented reform of interest rates?

Zhou: A possible option is to allow financial institutions which satisfy hard financial constraint requirements and comply with the macro-prudential policy framework to increase their independent pricing power; and to allow the aforementioned institutions to begin to set prices for interest rates by themselves after establishing and improving a self-discipline mechanism for fair competition. In the meantime, a market benchmark interest rate system should be fostered to further improve the central bank’s interest rate regulatory mechanism and to help financial institutions raise their pricing power over interest rates. In this manner, the marketization of interest rates will be realized after a certain transition period.

Reform Requires Favorable Supporting Conditions

Caijing: What are the supporting conditions needed to further promote the reform of interest rates and the exchange rate?

Zhou: China's reform is a systemic institutional transition which requires favorable supporting conditions. In essence, the reform of interest rates and the exchange rate is a price reform which would grant institutions in the financial sector independent pricing power. On the one hand, banks should have independent pricing power, and their customers should be able to freely choose which banks they want; hence it all comes down to whether there is a competitive environment to generate competitive market pricing. On the other hand, prices set by some institutions may deviate from reasonable levels. The deviation has much to do with the fact that there may be information asymmetry between consumers and financial institutions, which would eventually be corrected by a competition mechanism. However, if you are unprepared for possible mispricing, you would probably want to turn back the clock on the reform. Besides, both interest rates and the exchange rate are comprehensive prices, which means they would be influenced and even impacted by the marketization level of prices in other important areas, and vice versa. Of course, the two processes may also reinforce each other if all goes well.

While we need to take all factors into consideration when driving forward interest rate and exchange rate reform, I don’t think we should wait until all conditions are fully mature to promote the reform; rather, I think the reforms can serve to reinforce each other. However, conflicts and perhaps even some negative effects may arise in the beginning. This requires perseverance on our part.

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