Interest Rate Determination in China: Past, Present, and Future

Abstract

How should we think about the determination of interest rates in China after interest rate liberalisation? Would effective deposit rates, lending rates and bond yields move higher or lower? We argue that interest rates in a liberalised environment would need to be anchored by the conduct of monetary policy. If monetary policy is to achieve the objective of price and output (or employment) stabilisation, the policy rate should be set close to China’s equilibrium or natural rate. We sketch three preliminary approaches to estimation of the natural rate in China. Based on these we argue that interest rates on large deposits in the banking system and short-term money market rates would likely to move higher following interest rate liberalisation. The effect on effective lending rates is somewhat ambiguous as the contestability of the banking sector and the competition in bond markets are likely to increase after interest rate liberalisation. We leave the determination of the curvature of the yield curve to future research.