MNI ANALYSIS: China Int Rate Reform Mired in Chaotic Structure

--Major Early Move to Freer Interest Rates Unlikely

--Shadow Banking Helps Balance Credit Supply and Demand

     BEIJING (MNI) - China is unlikely to make a major breakthrough any time

soon in its stated push for a market-based interest rate formation system,

despite positive-sounding statements from key government officials and advisors,

MNI understands.

     A free interest rate mechanism, which China has touted for years, implies

revolutionary changes to its complicated policy framework constrained by layers

of financial regulatory bodies. The current environment simply won't accept

these changes, MNI learned.  

     Speculation that China may reform its opaque system of interest rates has

grown since last month when Yi Gang, the governor of the People's Bank of China,

reiterated that policymakers intend to integrate benchmark and money market

rates, the so-called dual-track system that operates with multiple and often

competing goals.  

     Some interpreted Yi's talk, made at the Boao Forum, as a signal that the

PBOC is making a major push for a unified rate-setting approach similar to its

western peers: setting a benchmark rate as a forward-looking guidance on market

rates movement and conducting monetary policy at an accurate and market-set pace

to meet identified objectives such as inflation, growth and employment. 

     The competing rates from China's separate financial markets largely operate

under separate administrative authorities that dish out varying quantities and

costs of capital, as well as making statements with mixed policy signals, MNI

learned from discussions with policy sources, including those who advise the

central bank.

     --"FRAGMENTED AND SHORT-TERM-BASED"

     Those rates include the so-called policy rates of open market operations

set by the PBOC, yields on sovereign bonds dominated by the Ministry of Finance,

and the ceilings of loan and deposit interest rates by semi-autonomous banking

associations.

     This "fragmented and short-term-based" system of tools, as described by

critics including Ma Jun, former PBOC chief economist, greatly limited the

ability of the central bank to achieve its own monetary objective. 

     More than just a central bank, the PBOC is tasked with achieving political

objectives, some of which fundamentally contradict the spirit of a free

interest-rate mechanism, such as preventing capital flight thus stabilizing the

currency, regulations forcing capital back onto banks' balance sheet, or

squeezing the so-called shadow banking sector, MNI learned from corresponding

with policy insiders. 

     To have a freer interest rate mechanism necessitates a reduced role by

Chinese banks, which lock up a big chunk of the capital. Instead, allowing more

direct interaction between providers and borrowers of capital will help achieve

fairer prices in the form of interest rates.

     --INFLEXIBLE BANKS

     However, Chinese banks, mostly state-controlled institutions, dominate an

inflexible financial system that cannot be altered in the near term. They are

all holding back capital, pressured by the current campaign of preventing

systemic risks. 

     The existence of a market with capital and independent of the banks is

therefore essential for the economy to function, MNI understands. The pejorative

connotation of the term "shadow bank" shouldn't undermine the fact that it also

has a positive role to play.

     More over, shadow banking can serve as an important force advancing

interest rate reform as it provides credit without increasing money supply,

optimizing the functions of the financial system, sources told MNI. 

--MNI Beijing Bureau; +86 (10) 8532 5998; email: marissa.wang@marketnews.com

--MNI Beijing Bureau; +86 10 8532 5998; email: william.bi@mni-news.com

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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