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The People's Bank of China announced Tuesday that China will free-up interest rates on foreign currency loans and part of the rates on foreign currency deposits from September 21, a major step forward in the liberalization of its tight interest rate system.

Financial institutions will, from now on, be able to set their foreign currency lending rates in line with the international market, the central bank said in a circular Tuesday.

Presently, loan rates at Chinese banks are permitted to float only 10 per cent above or below a base level set by the central bank.

Interest rates on foreign currency deposits of US$3 million or more will also be liberalized.

Rates on deposits of less than that amount will be fixed by the China Association of Banks, a national-level non-governmental organization launched in May to promote self-discipline and co-operation in the domestic banking sector.

A central bank spokesman said the move was aimed at advancing the banking sector's interest rate reform process.

Central bank governor Dai Xianglong said in July that China's interest rate system would be relaxed over the next three years to allow the market to decide deposit and lending rates.

These changes will give the central bank more power to adjust the monetary policy through interest rates, as is the practice in Western countries.

Insiders have said China will first allow the market to set foreign exchange interest rates, which are sensitive to changes in the international money market.

This will be followed by the liberalization of the renminbi, which it is believed will occur in two or three years time, according to Wang Yuanlong, a senior researcher with the Institute of International Finance affiliated to the Bank of China.

"The liberalization of foreign currency rates heralds an accelerated pace of reform of the interest rate system in China," said Wang.

The reforms, which aim at allowing market demand and the supply of currency and goods decide interest rates, was started several years ago.

Since May 1996, China has cut its interest rates seven times, which did lead to some expansion of the economy, but the impact was not as strong as expected.

Bankers, entrepreneurs and experts have complained about the fixed currency rate as it leads to an unbalanced relationship between money supply and demand, which does not concord with a market-oriented economy.

China's banks tended to lend more to big State-owned enterprises and refuse small and private firms due to concerns about risks.

"It would be unfair for banks to offer loans with the same interest rates to different enterprises with different levels of risk," said Wang.

The new rate policy, though only a small part of the reshuffle of the financial system now under way, has encouraged hopes that China's currency will, in time, be linked to the international market.

(China Daily)