Interest rate reform is one of the most pressing issues facing Chinese leaders. It goes to the heart of one of China's biggest economic problems, the massive misallocation of credit. Unworthy state borrowers are flush with cash, while deserving private firms are starved of it. China's impending entry to the World Trade Organisation, and efforts to clear bad loans off the books of its banks, have given Beijing more resolve to make banks face the market. Interest rate liberalisation will give the People's Bank of China a powerful new tool for monetary policy, but could hurt banks by introducing more competition.

"It will obviously introduce more competition into the market," said Christian Murck, senior country officer for Chase Manhattan Bank in Beijing. "If you have rates that either float or at least move, it gives the People's Bank of China a policy instrument."

The governor of the People's Bank of China, Dai Xianglong, said the central bank would push to liberalise interest rates, allowing the market to set deposit and lending rates. He gave no timetable.

Initial steps should be made over the next two to three years, though the government could move as fast as the beginning of next year, bankers said. It would probably first allow the lending rates of rural credit cooperatives and foreign currency loans to move in a wider band, they said.

"First will be lending rates and deposit rates will follow," said Liao Qun, senior economist with the Standard Chartered Bank in Hong Kong. "Deposit rates are more sensitive."

Lending rates of Chinese banks are now only permitted to float 10 per cent above or below a base level set by the central bank for loans to large companies. For loans to small companies, rates are allowed to float up to 30 per cent.

The interest rate on the benchmark one-year deposit is now 2.25 per cent. The rate for a one-year loan is 5.85 per cent. Analysts said interest rate liberalisation and entry to the WTO could give a rude shock to complacent domestic banks, although some local bankers said they would welcome competition in exchange for more independence.

-- (Reuters)"For us, the impact ought to be good," said Liu Changming, president of the Shenzhen branch of China Minsheng Banking Corp Ltd, China's only private bank. "If we can arrange things ourselves, it's better. It's more free."China has committed itself to full market access in five years for foreign banks, removing both geographic and customer limits, after entry to the WTO.One of the winners will be shunned private and high-technology firms, which have been unable to get loans because of perceived higher risk, officials said."The risk for small and medium-sized enterprises is high, but rates can only float 20 to 30 per cent above the base," said Di Na, deputy director general of the state economic and trade commission's department of small enterprises.More flexible lending rates would allow banks to judge the risk and set their own levels, bankers said.Market-driven rates would also allow the central bank to exercise monetary policy more effectively, they said. China has cut interest rates seven times since May 1996 to spur the economy but the impact has been muted."The kind of transmission belt from monetary policy to the real economy is weak in China," said Murck of Chase Manhattan."One of the problems that they have faced in reducing interest rates, it's sort of like pushing on a string because interest rates don't flow through directly into any market." (Reuters)