March 24, 2011 / 7:25 AM / 9 years ago

China central bank aims to make interest rates main policy

BEIJING (Reuters) - China should refine its monetary policy system over time to allow interest rates to become its primary policy tool, a central bank official said on Thursday.

Underscoring a growing wish among some Chinese officials to reduce the government’s role in financial markets, Zhang Xiaohui, head of the monetary policy department at the central bank, said China should rely more on controlling the price of credit rather than the quantity of money.

“We will continue to reform interest rate and exchange rate markets, and that will pave the way in allowing interest rates to become a core tool in monetary policy,” Zhang said in a statement published on the central bank’s website.

“In doing that, we will shift from a policy that focuses on quantitative measures to price control tools,” she said.

Interest rates are one of an array of monetary policy tools that China uses right now. But its main way of managing financial conditions is to tell banks how much they can lend over the course of the year, prodding them to issue more or less credit depending on the economy’s needs.

These lending quotas have been crude but effective in steering the Chinese economy over the past decade. But they have also led to a variety of problems, with banks largely allocating credit to large state-backed firms.

Zhang’s remarks highlighted China’s long-standing wish to gradually free-up its tightly controlled markets, to accord more power to investors in pricing interest rates.

In doing so, it hopes to accelerate the growth in its burgeoning financial markets and turn Shanghai into a global financial centre by 2020.

The Chinese government sets a floor on lending rates and a ceiling on deposit rates to protect China’s commercial banks, the biggest of which are state-owned.

That gives Chinese banks a guaranteed net interest margin of about 300 basis points, driving the bulk of their revenues.

AWASH IN CASH

Zhang said China faced many hurdles in reforming its financial markets.

“Currently, China’s monetary policy still faces the problem of imbalances in its balance of payments and excessive liquidity,” she said.

“The central bank still needs to step up the management of liquidity to control the liquidity gate.”

China is struggling to tame inflation, which has in part been driven by a surfeit of cash in its economy accumulated from years of hefty trade surpluses.

To soak up excess cash, the central bank has relied on repeatedly raising the reserve requirement ratio for banks to force them to lock up more deposits and lend less.

On Friday, the central bank raised the ratio to a record 20 percent, its sixth increase since October when it said fighting inflation was a policy priority.

The hefty reserve requirements are beginning to erode banks’ profits, but many analysts say China has little choice but to rely on this quantitative tool for now as it cannot raise rates fast enough to curb prices.

Higher rates would further burden indebted local governments, and exacerbate inflation woes by attracting more speculative funds into the country.

Reporting by Koh Gui Qing; Editing by Ken Wills

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