- Hassanali Mehran, Marc Quintyn, and Bernard Laurens
- Published Date:
- December 1996
Monetary and exchange system reforms in China since the beginning of economic reform in late 1978 emphasized institution building in general and institutional and market development in the foreign exchange system and the capital market in particular.1 The development of nationally integrated money markets—that is, markets for short-term funds—is becoming a priority. This would enhance the effectiveness of monetary policy, support the capital markets in providing liquidity and funding for portfolios, and allow further progress in the operation of the foreign exchange market. Inherently related to all aspects of money market development is interest rate liberalization, an area where reforms are also lagging in China. Moreover, achievements in reforming the foreign exchange system—the exchange rate was unified as of January 1, 1994, and much progress was accomplished toward convertibility of the renminbi—make domestic interest rate flexibility highly desirable as a tool to support the exchange rate.
The seminar on interest rate liberalization and interbank market development was held in the context of a new impetus given to financial reform. This was supported by the decision of the Third Plenum of the Fourteenth Central Committee of the Communist Party, which, back in November 1993, outlined and approved a comprehensive reform strategy in which financial reforms are described as a key element in the macroeconomic management in a market environment.2
In contrast with the experience in many other countries, the liberalization of interest rates is the last item in China’s reform agenda, coming after the liberalization of the exchange rate and the establishment of a securities market. The People’s Bank of China’s tentative plans to liberalize interest rates and to establish a nationally integrated interbank market were discussed during the seminar on the basis of presentations by officials from the People’s Bank of China (PBC).
This introduction summarizes the seminar discussions and brings together the common themes, focusing on the policy implications that flow from the experiences of the different countries—Italy, Korea, Malaysia, Thailand, and Turkey—as described in the papers presented during the seminar. Certain aspects of the financial reforms in the United States over the past 35 years, addressed by Victor Chang in his presentation at the seminar, were also brought into the discussion and served as background in considering the lessons that could be drawn from other countries’ experiences.
Policy Implications of Country Experiences
Interbank Market and Financial Reforms
The establishment of a domestic interbank market is critical for the conduct of monetary policy. It allows the central bank to implement liquidity management, which is required whether the central bank uses genuine open market operations or refinance instruments such as a discount facility. The importance of a nationally integrated interbank market for the efficiency and effectiveness of monetary policy is recognized in China and was made part of the financial sector reform program for 1996. The reform of the interbank market in China raises four main issues: the involvement of the central bank, the participants in the market, the degree of centralization of the market, and the role of the interbank market in the conduct of monetary policy. Country experiences were discussed along these lines, although the papers that were presented on country experiences also included references to a number of other issues.
Involvement of the Central Bank
A common feature in many countries embarking on financial reforms is that the development of the interbank market is a stage-by-stage process. Experiences from Italy, Korea, Thailand, and Turkey show that the central bank can play an active role, not only from the general point of view of capital market development, but also in using the interbank market as a “playground” where monetary operations can be conducted and in which it could become an important player.
In Turkey, owing to a variety of factors, some of which are more of a political nature than economic, the banking system was highly segmented. Public sector banks were reluctant to lend to private banks not only because of their assessment of commercial risks but also, and perhaps more important, because of political considerations. Similarly, private banks tended to minimize their transactions with other commercial banks owing to competition. In particular, many of the private commercial banks in Turkey belonged to different industrial groups. Competition and rivalry between these industrial groups often led to a reluctance by their banks to deal with each other directly, and almost completely prevented lending between banks. As a result, the interbank market did not exist in Turkey. However, banks were willing to participate if their counterpart was the central bank. This situation prompted the central bank to develop a framework for an interbank market in which it was acting as a blind broker, that is, as the counterpart of all transactions. Thus, the market was organized around the central bank as the intermediary. The parties to a transaction did not know each other’s identity and, therefore, from a practical as well as a legal standpoint, their counterpart was the central bank. The central bank operated as a broker in that it borrowed only when it could on-lend the proceeds at the same interest rate. In order to cover for the credit risk, all transactions intermediated by the central bank had to be backed by acceptable collateral, such as government securities.
In Thailand, a repurchase market within the central bank was created in 1979 with a view to further developing the fledgling money market and providing the central bank with a mechanism to monitor and, if necessary, intervene in the market. Participants are allowed to place buying and selling orders with the central bank, indicating the amount, interest rate, and maturity of the desired transactions. The central bank then tries to match the orders and determine a single “market” repurchase rate (that is, a fixing). If needed, the central bank intervenes to absorb or inject liquidity.
In Italy, although an over-the-counter interbank market was operating for a long time, the central bank was prompted to take action because oligopolistic behavior led to segmentation of the market. Also, the subsequent excessive volatility of the market was an impediment to using interest rates as a channel of transmission of monetary policy. In 1990, the central bank promoted the establishment of a screen-based interbank market. This was accompanied by a thorough modernization of the payment system, enabling a real-time and direct movement of funds on banks’ centralized accounts with the central bank. Participation in the system is voluntary and participants agree to abide by a set of clear and binding procedures. All interbank transactions among participants on contracts quoted in the system are carried out on the screen-based market and are cleared through the clearing house or by entries in the centralized accounts with the central bank. Transactions outside the system are allowed, and nonparticipant banks can freely trade among themselves in all types of deposits on the over-the-counter interbank market.
In Korea, the central bank promoted the establishment of brokers and dealers for call transactions in order to enhance the adjustment function of the interbank market and break the segmentation of the existing call market between bank and nonbank financial institutions (NBFIs).
Participants in the Interbank Market
Generally, participation in the interbank market is confined to financial institutions with a current account at the central bank since the interbank market is that part of the money market where financial institutions can trade their deposits held at the central bank. Therefore, interbank markets may or may not include NBFIs, depending on whether or not they are authorized to maintain current accounts with the central bank. Among the countries represented at the seminar, Korea is the only country in which NFBIs that do not maintain a settlement account with the central bank participate in the interbank market. Participation of these institutions, which could have contributed to enhancing market liquidity, resulted in a segmentation of the market between banks and NBFIs, because of differences in the pattern of transaction behavior. The integration of the interbank market with the over-the-counter market between NBFIs was eventually achieved at the end of the 1980s with the nomination of brokers and dealers for call transactions as mentioned above.
However, as a consequence of financial innovation, the boundaries between banking institutions, which were allowed to participate in the interbank market, and other entities has blurred. A money market has emerged that provides economic entities, such as financial institutions, business firms, government, and individuals, with various kinds of instruments to intermediate in the short-term demand for, and supply of, funds. The money market comprises the interbank market (or call market), secondary markets for securities (treasury bills, commercial paper, negotiable certificates of deposit), and the repurchase market, which is from an economic perspective a secured means of short-term borrowing and lending.
The development of repurchase transactions brings about important consequences in terms of financial reforms. Since it is not necessary to have developed financial markets to undertake them, repurchase transactions can take place at the onset of financial reforms, even while interest rates on deposits or on interbank transactions remain controlled. When repurchase transactions are treated as collateralized lending, interest rate regulations may apply, whereas when they are treated as a sale with an agreement to buy back they may not. Thus, repurchase transactions can be used as a way to circumvent central banks’ regulations on interest rates that may apply on interbank transactions as well as on deposits, since repurchase transactions are not circumscribed to participants in the interbank market. The development of repurchase transactions thus blurs the boundaries between the various segments of the money market.
The United States offers a model of such market structure. There are two overnight money markets, the federal funds market and the repurchase market. The federal funds market is strictly an interbank loan market; in that market, banks with clearing accounts with the Federal Reserve make uncollateralized loans of reserves to each other, at the federal funds rate. The repurchase market is mainly a financing market for dealers of government and other securities. Dealers, with huge inventories, finance their securities by borrowing from banks and institutional investors, using the securities as collateral.
Repurchase agreements were introduced in Korea in 1977 to provide securities companies with an instrument to finance their portfolios. Gradually all financial institutions were allowed to engage in such transactions. Repurchase agreement rates are freely determined subject to a ceiling set by the Chairman of the Securities and Exchange Commission, but interest rates on the large denomination repurchase agreements are free. The main borrowers of funds are financial institutions, including securities companies and business corporations, while the main investors are individuals and nonprofit corporations. The repurchase agreements have functioned mainly as an alternative form of interest-bearing demand deposit. Recently, however, the financial institutions have gradually begun to use them as a means of adjusting their short-term liquidity positions for longer periods than those of call transactions.
Degree of Centralization of the Interbank Market
Although central banks play a catalytic role in interbank market development, typically they do not intend to centralize transactions on their books. When it occurs, as is the case in Turkey with the establishment of the “official” interbank market intermediated by the central bank, direct transactions among banks are nevertheless permitted. Moreover, in Turkey the establishment of a centralized interbank market was seen only as a temporary arrangement to “educate” participants and thus facilitate direct transactions. In the case of Italy, participation in the centralized market is on a voluntary basis. Moreover, it operates outside the central bank, which only provides settlement arrangements in support of market transactions. In Thailand, Korea, and Malaysia, the interbank market is over the counter, that is, participants are free to trade between themselves. In these countries, interbank brokers play an active role as facilitators for the transactions and thus in promoting smooth adjustment of surpluses or shortages of short-term funds among financial institutions. In Korea, for instance, measures implemented to integrate the segmented market between banks and nonbank financial institutions included the appointment of brokers for call transactions. In February 1992, a “Blind Brokerage System,” designed to ensure perfect competition between participants, was introduced. The importance of brokers in Korea can be assessed through the volume of transactions they intermediate. In May 1995, the daily average transactions volume in the call market amounted to W 2.8 trillion, of which W 1.8 trillion was transacted through brokers.
Brokers are also an important feature in all the segments of capital markets in the United States. Of special relevance for monetary policy conduct are the government securities brokers, which serve as facilitators for transactions between the primary dealers. Brokers work on an agent basis to protect the “anonymity” of both the buyer and seller. They occupy a very important place in the daily distribution of government securities. On any given day, over $200 trillion are traded on government securities in the secondary market. Typically about 50 percent of this volume is transacted through the government brokers. While today’s brokers are well capitalized, this has not always been the case. Twenty years ago, many brokers began to operate with almost no capital and relied on their relationship with dealers and traders in order to get business from them.
Interbank Market and Conduct of Monetary Policy
The interbank market is a natural playground for central banks. Their involvement in market development has increased with the shift to indirect instruments of monetary policy, more particularly to open market operations. The interbank market rate is often used as an operational target or a main indicator for the central bank. This is typically the case in the United States, where the Federal Funds rate (that is, the rate at which non-interest-bearing deposits held by banks at the Federal Reserve are traded) serves as indicator of monetary conditions, whereas the discount rate is perhaps the most decisive signal that the Federal Reserve uses to confirm the direction of interest rates and monetary policy (it usually follows changes in the level of the Federal Funds). This model, however, requires a sufficient degree of liberalization of interest rates and liquid and efficient markets. In Korea, for instance, the behavior of the interbank market does not yet provide adequate information on market conditions and the most immediate indication of the current relationship between the supply of and demand for funds. In other words, because deregulation of interest rates is not yet complete, the interest rate does not yet function satisfactorily as an information variable.
In countries where secondary markets in government securities are liquid, central banks tend to operate through outright sales and purchases of securities to influence banks’ liquidity rather than through interventions on the interbank market. This is typically the case in the United States and Italy. However, in these countries central banks’ repurchase operations also affect banks’ reserves in the short term.
The United States has had long experience with open market operations through outright sales or purchases of government securities. In the early 1950s and 1960s, when secondary markets for government securities were not as liquid as they are now, discussions took place on the kind of securities that should be sold or bought. From the point of view of the control of the money stock, the question is not significant; the effect on the monetary base depends solely on the amount of open market operations. But from the point of view of the “credit” effects of monetary policy, that is, the determination of the pattern or structure of interest rates, the kind of securities is important particularly because of the influence of long-term interest rates on investment decisions. What is known as the “bills only” policy, whereby the Federal Reserve would conduct open market operations on short-term government securities to avoid undue influence on long-term rates, was discussed in the early 1950s. In taking this course, the Federal Reserve would have implemented the concept that markets should be as free as possible to allocate available funds among alternative uses through competition. Open market operations by the Federal Reserve would have one purpose only, to control the amount of bank reserves to promote economic stability and growth. This option was also based on the fact that the market in the short end was more liquid and thus open market operations were less likely to impact interest rates. The “bills only” policy became a topic of discussion for many years and was officially abandoned in the early 1960s. It was generally considered by economists to be a mistake because it unnecessarily restricted the powers of the central bank. Moreover, this episode illustrates the importance of a liquid secondary market to conduct outright sales or purchases of securities for monetary policy purposes. In any event, the U.S. government securities market has grown so much in the last 15 years that outright open market operations now have little impact on the market.
Current operating procedures implemented by the Federal Reserve in the United States were presented at the seminar as they set a sort of model for open market operations for central banks around the world. Open market operations in the United States are the primary tool for adjudicating monetary reserves in the system. The Federal Reserve conducts open market operations exclusively through a network of 36 primary dealers who report to the Market Division of the Federal Reserve Bank of New York. The primary dealers have earned the right to have a direct line to the open market desk of the New York Federal Reserve Bank. Open market operations include frequent negotiation of repurchase agreements to supply reserves and less frequent matched-sales agreements to drain reserves mostly with government securities as collateral. In addition, the open market desk will buy securities outright to supply permanent reserves. Outright sales rarely occur these days.
In some countries, however, the use of government securities for monetary policy purposes raises difficulties. This is because the market is narrow in comparison to the size of the central bank’s open market operations. In Turkey, for instance, over the years the central bank concentrated increasingly on the interbank market in order to avoid conflicts with the treasury. Often when the central bank was selling government securities to drain the excess liquidity, the treasury objected on the grounds that the open market operations of the central bank were raising interest rates on government securities. As a result, open market operations in the interbank market taking the form of repurchase agreements came to be a major instrument of short-term liquidity management. In many ways, it proved to be more efficient than outright sales or purchases of government securities in the secondary market, especially when the volume of intervention was large. Interventions on the interbank market have the added advantage of having relatively limited impact on the government securities market over short periods of time, although in the long run yields on government securities tend to follow interbank market rates. In Thailand, owing to the small and illiquid secondary market for government securities, outright sales or purchases of securities are limited. Therefore, the central bank relies mainly on repurchase operations—on government securities or securities guaranteed by the government—to conduct day-to-day open market operations.
To avoid conflicts of interest and increase the effectiveness of monetary policy, central banks have increasingly been issuing their own securities. In Korea, the central bank started issuing its own securities—monetary stabilization bonds—in 1961. Monetary stabilization bonds are negotiable securities of the Bank of Korea issued to control monetary growth. They are currently one of the most important instruments of open market operations. Their issuance expanded rapidly in the period, 1986–89 as the central bank sought to absorb excess liquidity resulting from the large current account surpluses. Although during the 1986–89 period the issuance of Treasury bills was resumed as an instrument of monetary control, currently they play a limited role. In Thailand the central bank recently started auctioning its own securities to improve the effectiveness of its open market operations. A similar stance was taken by the central bank in Malaysia. In 1993 Bank Negara Malaysia introduced Bank Negara Bills as a monetary instrument, in an effort to manage the liquidity in the system. Although there was already a market for government securities, it could not be used by the central bank to regulate and control the money supply because the secondary market was not active and government securities were held to meet statutory requirements. It is expected, however, that reforms undertaken these last few years will promote the development of an efficient and liquid secondary market in the years ahead, which will increase the effectiveness of open market operations using government securities.
Interest Rate Liberalization
Issues discussed at the seminar in relation to interest rate liberalization focused on the following topics: the sequencing of liberalization, the period of time required to achieve liberalization, constraints and pitfalls, ways to ensure transparency in the market, and preferential interest rate schemes.
Sequencing of Liberalization
In Thailand, Korea, and Turkey, the liberalization of deposit and lending rates was not simultaneous. Thailand started with the liberalization of deposit rates. The rationale behind this sequencing, which had the additional advantage of being accepted with less political impact, was to provide an incentive for savings mobilization. It was only after all deposit rates were liberalized that ceilings on commercial bank lending rates were abolished. In Korea, after a first attempt to liberalize interest rates failed because the necessary macroeconomic preconditions did not exist, liberalization of lending rates started before liberalization of deposit rates. In their decision to avoid simultaneous liberalization of lending and deposit rates, the Korean authorities were driven by the difficult situation of the banks, which had a large portfolio of nonper forming assets. An early liberalization of deposit rates could have provoked fierce competition among financial institutions with the risk of precipitating bank insolvencies. In addition, the liberalization of lending rates was first seen as a means to enhance earlier resource allocation. In Turkey, after a first failed attempt, lending rates were liberalized prior to deposit rates. The rationale behind such sequencing was, as in the case of Korea, to limit competition between banks that could have precipitated some bank insolvencies. By contrast, in Malaysia, lending and deposit rates were liberalized simultaneously. Until 1991, however, banks were requested to set their lending rates with reference to the cost of resources (see below).
Duration of the Process of Liberalization
Although the time needed to complete interest rate liberalization varies substantially among countries, the process is gradual in all cases. In the case of Korea, the whole process will take some 15 years if one takes into account the first unsuccessful attempt in the early 1980s. The second phase of the liberalization process started in 1991 and will be completed by 1996. Turkey went through a similar process. The first attempt, in the early 1980s, had to be reversed in 1982. The second successful liberalization stretched over four years, from 1984 with the liberalization of lending rates until 1988 with the liberalization of deposit rates. In Thailand, liberalization took three years from the start of the liberalization of deposit rates in 1989 until the lifting of the ceiling on lending rates in 1992. However, in 1993, the central bank and the Bankers, Association agreed to establish a mechanism that links lending rates to deposit rates that is still in place. Malaysia liberalized all deposit and lending rates in 1978. However, to prevent excessive increase in banks’ lending rates, all rates were anchored to each bank’s cost of funds. This mechanism is still used, although the central bank no longer establishes a maximum margin for lending rates compared to banks’ cost of funds.
Constraints and Pitfalls
The setbacks experienced by Korea and Turkey in their first attempt to liberalize interest rates as well as the long process in the case of Thailand illustrate some of the constraints and pitfalls of such an exercise. In Thailand, the program of interest rate liberalization could not be pursued more aggressively in the first half of the 1980s because of serious macroeconomic problems as well as solvency problems faced by a number of financial institutions. The main concern of the Thai authorities in the first half of the 1980s was to restore macroeconomic and financial stability. In Turkey, the first attempt to liberalize interest rates, at the beginning of the 1980s, failed because of insufficient preparation to support the reform program. Soon after the liberalization of interest rates, banks started to compete for deposits by offering higher interest rates without much regard to how they could utilize the high-cost deposits. Eventually this resulted in a financial system crisis, during which some of the smaller banks and most of the brokerage houses collapsed. This motivated the reversal of the liberalization process. In Korea, at the time of the first attempt at liberalization in 1988, there was heavy demand for funds caused by the rapid economic growth during 1986–1988. Macroeconomic conditions deteriorated and market interest rates began to move upward sharply. This led to the reintroduction of de facto controls on liberalized interest rates, marking the abandonment of the first attempt at interest rate deregulation. In the second attempt in 1991, the economy was slowing down, and there was no longer excess demand for funds as a result of stabilization policies. Also, market interest rates had been easing, causing the gap between them and regulated rates to narrow. These three episodes illustrate the importance of macroeconomic stability, sound financial institutions, and adequate regulatory and supervisory frameworks for the liberalization of interest rates to proceed smoothly.
The savings and loan crisis of the 1980s in the United States was presented at the seminar as an illustration of the dangers of allowing overly fierce competition between financial institutions. At the end of the 1970s, the removal of deposit ceilings in thrifts permitted banks and thrift institutions to bid aggressively for funds, but later contributed to an imbalance between rising deposit costs and locked-in asset-based earnings, which later precipitated the savings and loan crisis. An increase in the Federal Deposit Insurance Company deposit insurance on individual accounts from $40,000 to $100,000 made the crisis more burdensome. The savings and loan restructuring took several years, and by the time Congress came up with a rescue plan, losses had accumulated to over $200 billion when funding costs were taken into account. The Resolution Trust Corporation was formed to take over the assets of failing savings and loans and liquidate or merge them.
The United States’s financial history provides an illustration of the potential threat for central bank independence in trying to peg interest rates on the yield curve. At the time of the Second World War, the Federal Reserve willingly supported the government securities market, viewing its cooperation with the treasury as necessary to meet urgent political and economic requirements of the times. The Federal Reserve pegged long-term rates by purchasing long-term government bonds in the open market. This was possible because at that time the secondary market on long-term issue was relatively narrow compared with the size of open market operations. After the war ended, continuing the pegging policy clearly suited the treasury’s needs by holding down the interest on government debt, while the Federal Reserve was willing to regain freedom in the conduct of monetary policy in view of its own need to regain control over the monetary stock and inflation. Eventually a denouement was reached in the form of the Federal Reserve-Treasury Accord of March 4, 1951. The Accord is of great significance because it brought an end to Federal Reserve support of the government securities market, thus enabling the Federal Reserve to resume a truly independent monetary policy. Thereafter, interest rates were allowed to fluctuate with market conditions.
What is known as “Operation Twist” or “Operation Nudge” in the United States illustrates the difficulties of policies intended to influence interest rates on the yield curve. In the late 1950s and early 1960s, at a time when deposit rates were still regulated under Regulation Q, the policy implemented by the Federal Reserve intended to twist the term structure of interest rates. Banks were allowed to raise short-term rates to slow the outflow of capital and so to help solve the balance of payments problem, while, in order to encourage domestic private investment, long-term rates were kept low, or at least stabilized, through open market operations on long-term securities, which were holding down interest rates on the long end of the yield curve. The policy was talked about more than it was acted on, and after 1965 it disappeared from view. Subsequently, the concept itself came in question on the grounds that international capital flows and private investment spending are a function of interest rates in general, which would make twisting the term structure unimportant.
U.S. financial history also provides relevant experience on the impact of financial innovation on the conduct of monetary policy. Market innovations such as interest-bearing demand deposits, mutual funds with check-writing privileges, and the securitization of assets have led to changes in the way people save and hold money. In this environment of high innovation and change, the Federal Reserve experienced difficulties with money measurements, as banking deregulation changes both deposit composition and the behavior of money velocity. Consequently, in the 1980s and early 1990s, the Federal Reserve had to shift its focus a number of times, moving from narrowest definitions of money to wider liquidity measurements. Furthermore, the Federal Reserve broadened the scope of the variables that it monitors in formulating and evaluating policy to include a wide range of what it considers to be leading indicators of the course of the economy and inflation, such as commodity prices, exchange rates, the yield curve, and indicators of incipient pressures in the real economy, and an aggregate of total domestic nonfinancial debt. Eventually in 1993 Federal Reserve Chairman Alan Greenspan stated that M2 had been “downgraded as a reliable indicator of financial conditions in the economy, and no single variable has been identified to take its place.”
Measures to Ensure Transparency
In Malaysia and Thailand, measures were taken to ensure transparency, and thus fair competition, in the market. In Thailand, the central bank and the bankers association agreed in 1993 to establish the minimum retail rate, which links lending rates to deposit rates. The minimum retail rate includes four components: the average cost of funds, the operating cost, a tax levied on financial transactions, and a normal profit margin set at 2 percent. The minimum retail rate is issued as a benchmark for small borrowers and helps move lending rates in a less sticky manner. In Malaysia, all rates used to be anchored to each bank’s declared base lending rate, which was based on a bank’s cost of funds. At some point, the central bank issued guidelines requiring the base lending rate of the banks to be no more than 0.5 percentage point above the base lending rate of the two lead banks. The margin by which lending rates could exceed the base lending rate was limited to no more than 4 percentage points. The base lending rate, although still used by the banks, was freed from the administrative control of the central bank in 1991. It now has similarities to the prime rate used by commercial banks in the United States.
Preferential Interest Rate Policies
The experience of Italy is quite relevant in this respect because of the extensive use of programs providing subsidized credit facilities in support of sectorial and regional development. The scheme adopted to administer interest rates subsidies is based on two rates: the one received by the bank (the reference rate) and that paid by the borrower (the subsidized rate). The former is estimated on the basis of the cost of funds for the bank plus a fixed commission for intermediation. The latter is set by law for each program. The difference between the two is funded by the government budget.
Overall, the experience with subsidized interest rates schemes has been mixed, because of the overlapping of two decision-making processes, namely, that of the bank in assessing the creditworthiness of the project, and that of the government agency in charge of assessing the need for a subsidy. In particular, it is usually difficult for a bank to deny credit after the project has been positively evaluated by the government agency. Currently a new system is under preparation whereby the borrower would agree on the conditions of a loan directly with the bank. If the project is considered to be eligible, the subsidy would be provided directly to the borrower by the public agency on the basis of the prevailing market rates.
Current PBC Plans to Establish a Nationwide Integrated Interbank Market
Shortcomings of Current Market Arrangements
In contrast with developments in other sectors of the financial system, the money market has been slow to develop in China during the 1980s. Moreover, the interbank market, the main component of the money market, is still not integrated at a national level (see Box 1). The importance of a nationally integrated interbank market for the efficiency and effectiveness of indirect monetary policy has recently been recognized.
The involvement of the PBC in the interbank market is seen in China as a means to restore orderly conditions so that the interbank market does not function as a channel for speculative financing, as occurred in 1988–89 and again in 1993, but instead contributes to the development of a broader money market and to the transmission of monetary policy.
PBC Plans to Establish Integrated Interbank Market
Enhanced efficiency, transparency, and self-discipline are the main goals of the project. This will be done by establishing a National Interbank Trading Center. Regional centers (35 in total) will collect bids and offers from participating financial institutions. These will be transmitted to the center, where all bids and offers are shown on a screen, enabling parties to contact each other and close a deal. In the initial stages, participants will be state commercial banks (represented through their major provincial branches), other commercial banks, and selected urban credit banks and NBFIs. The center, which will have a legal status, will be under the direct control of the PBC, which will supervise the participants, inform them of possible violations of (potential) counterparts, and impose penalties. Although the market will be centralized, the parties will contract the deals at their own risk, and the center will not be party to the contracts. The center will not assume any settlement or credit risk. Restrictions will be applied on the volumes and maturities that can be traded, particularly regarding the NBFIs.
Discussions on PBC Plans
While the infrastructure (satellite-based and screen-driven) does not seem to present major obstacles, the main issues discussed were the market structure, including the status of the National Interbank Trading Center and the number and types of participants.
Some participants expressed concern about what they considered to be a rather formal approach taken by the PBC. The PBC’s concern with the possible use of the interbank market as a permanent source of long-term finance and its desire to control the proceedings of the market were acknowledged. It was expected, however, that over time, as the market becomes more disciplined, a more informal approach could be adopted, allowing for more initiative to be taken by the market participants.
In order to avoid overlapping of supervision and sanctioning responsibilities between the National Interbank Trading Center and the PBC, the view was expressed that it was necessary that the National Interbank Trading Center receive clearly delegated powers from the PBC and operate in close contact with the latter. In particular, its supervision of the participants and the publication of violations should be handled with caution. Publication of violations may have adverse effects on the operation of the interbank market, in particular, and on the operation of the financial system, in general, because it might prematurely alert other market participants to problems in particular institutions. The prime responsibility for supervision should remain with the PBC’s banking supervision department. This department, through its off-site analysis and on-site inspection, should stay abreast of financial sector developments and take action if needed. The National Interbank Trading Center should inform the PBC when it detects any payments problems or persistent delinquent behavior, and the banking supervision department, after careful analysis, should take the necessary steps. Over time, the participants themselves will, based on the information that can be disclosed legally about their potential counterparts, establish individual credit limits to cover themselves against risks. Although there is certainly a learning process involved in these actions, it was felt that the Center should develop itself as a distant observer of the operations among the participants.
Participants in the Market
With regard to the participants, three groups in China: deserve attention the nonfinancial institutions, the NBFIs, and the branches of commercial banks. Country experience indicates that the nonfinancial institutions should not be allowed to participate in the interbank market. Enterprises may have access to other money market segments as these develop over time (commercial paper, certificates of deposit, banker’s acceptances, treasury bills, etc.), but the interbank market—by definition—should not be open to them. This should close one channel of potential speculative financing in China’s economy.
As for the NBFIs, China’s realities today favor allowing them to participate in the interbank market. Several of them—the Trust and Investment Companies—collect deposits and perform other functions similar to banks. These institutions are also subject to reserve requirements and, by the same token, have an account at the PBC. Based on country experience, the decision as to whether they should be allowed in the newly designed interbank market in the future should be based on the following leading principle: the interbank market, by definition, is a market where financial institutions trade reserve balances at the central bank (reserve money). Hence, only those that have an account at the PBC (i.e., those that have access to reserve money) should participate in the interbank market.3 As long as this principle is followed, there seems to be no obstacle to the smooth functioning of this market. Additionally, the PBC may want to impose limits on maturities and volumes that these NBFIs can trade in the interbank market, while staying close to the principle of a level playing field.
Box 1.China—Recent Interbank Market Development
In contrast with developments in capital markets, a money market has been slow to develop in China during the 1980s. The interbank market is still the main component of the money market. More recently (1993) a repurchase market emerged but this market is still relatively underdeveloped. Other market segments, like a treasury bill market, do not exist.
In 1984, the first information centers made their appearance in some major cities like Beijing, Shanghai, and Guangzhou, thereby introducing the concept of an interbank market. These information centers were either the PBC branches themselves, PBC-sponsored agencies, or agencies jointly sponsored by the PBC and the specialized banks. The centers received bids and offers for funds from bank branches and NBFIs.
During the first years, this embryo interbank market grew slowly, but during the boom years—1988–89—interbank operations increased rapidly. As the market conditions—and particularly the interest rates—were partially deregulated, interest rates started soaring and varied greatly among regions. Funds were systematically attracted by high-growth regions, where they were often used for speculative real estate projects. Faced with this situation, the PBC started regulating the market: a “reference rate” was introduced around which the interbank market rate could fluctuate within a 30 percent margin.
As interbank market activity grew, it also began to diversify. The number of information centers (now called financing centers) grew steadily and they now cover most of China (44 centers in 1994). However, the market remains segmented as these centers are regionally oriented. For a long time, transactions among regional centers were rare because of technical and, more important, political problems (the local authorities did not want the funds to flow out of their jurisdictions and therefore put restrictions on the outflows). Thus, the interbank market could not play a redistributive role. Redistribution of funds in the country was done through the PBC on the basis of its lending to the banks and the required reserves.
Gradually, bank branches and NBFIs started conducting transactions with each other directly, that is, without using the information center. This market, mainly for short-dated transactions (for a few days to one month) is known as the intangible or invisible market, whereas the information center market is known as the tangible or visible market. Until 1993, maturities in the latter market were usually longer—up to three years. The 16-point program introduced in 1993 to combat inflation reduced the permissible maturities in the visible interbank market.
In the period 1992–93 the interbank market started growing dramatically. Growth in 1994 continued, albeit at a slower pace, mainly as a result of the measures taken in 1993 to counteract the overheating of the economy. The 16-point program, adopted in the summer of 1993, focused, among other areas, on the “leakages” in the interbank market that had been fueling inflation. More particularly, banks and NBFIs were ordered to recall before a specified date all loans “illegally” made. These were mainly loans made directly or through the interbank market to real estate and securities.
To prevent similar problems in the future, the PBC issued new guidelines on interbank activities, setting ceilings on the interest rates and limits on the volumes and maximum maturities of the transactions, specified according to the type of institution involved (bank or NBFI). The major effect of the new and stricter guidelines was that the NBFI sector saw its access to the interbank market greatly restricted.
While the interbank market has gained significance in channeling funds at the regional level, several features mean that this market is still fairly different from an interbank market in the traditional sense. First, participants also include NBFIs, and transactions with these institutions tend to have long maturities. Second, given the structure of the banking system, most transactions are initiated by bank branches that act in a semiautonomous way (and for a long time transactions between branches of the same bank were also conducted through the interbank market). Third, the PBC’s involvement differs from center to center. Some centers only bring together bids and offers, while other centers take positions to balance the market. In fact, for a long time PBC was reluctant to absorb any liquidity overhang in the interbank market, which is one of the reasons the central bank encouraged the NBFIs to become active in the market.
In the same vein, participation of commercial bank provincial branches may be a necessary transitional arrangement. The suggestion was presented during the seminar that participation of these branches be seen as a responsibility delegated from headquarters so that the bank’s creditworthiness backs each and every transaction. In this way, the legal requirement that banks as a whole are responsible for their liabilities and commitments and the reality that liquidity management is still somewhat decentralized could be reconciled. Later on, as the new Law on Commercial Banks takes effect through regulations, and banks are relicensed under this new law, these transitional arrangements should be abolished. Such action will increase the transparency of the interbank market. Measures that will promote centralized RMB liquidity management should also be encouraged. These would include integration of the mandatory and excess reserve requirement, stringent PBC policies regarding the entitlement of branches and subbranches of financial institutions to have an account with the PBC, daily account reconciliation by all account holders with the PBC, and more generalized acceleration of accounting reform in the financial system and development of the China national payments system.
Current PBC Plans to Liberalize Interest Rates
Drawbacks of Current System of Interest Rates
The drawbacks associated with a system of administrative interest rate setting are increasingly being felt in the current phase of transition to a market-oriented economy (see Box 2). The main drawbacks are the following.
1. The system’s centralized nature. All decisions regarding interest rate changes have to be made by the State Council. On many occasions, approvals had been delayed and these often had put proposed changes out of line with economic circumstances.
2. The rate structure is too complicated. There are too many types and levels of interest rates.
3. The system contains too many preferential rates. Currently there are more than 30 such rates. For about two-thirds of them, the subsidy is borne directly by the government; commercial banks and the PBC bear the subsidy on the other third. Both (2) and (3) make it difficult to control the system.
4. The interest rate margins for the banks are very narrow. Taking into account taxes, operating costs, and provisioning for non-performing loans, some banks end up with a negative margin.
5. Interest rate calculations, still based on simple instead of compound interest rates, are not in accordance with international standards.
The blueprint for financial sector reform adopted at the end of 1993 called for a reform of interest rate policies and vested the power to formulate policy decisions in the PBC, under the leadership of the state council. The blueprint called for the establishment of a market-oriented rate system by the end of the year 2000.
Since the adoption of these principles, some flexibility has already been introduced to the conduct of monetary policy, such as more frequent changes in the rates to signal to the markets the adoption of a new strategy; a decrease in the number of preferential rates by eliminating some and merging others; and a switch to direct subsidies from the government to the agricultural sector.
Current PBC Plans to Liberalize Interest Rates
It is the authorities’ intention to liberalize interest rates in three stages: the first stage will be the interbank market rate liberalization; the second will be lending rate liberalization; and the third, deposit rate liberalization. The rationale behind this sequencing is that the interbank rate does not affect the public directly, so its liberalization has the least political and social exposure, and that lending rates have already been partially liberalized. Deposit rates are scheduled to be liberalized last because it is felt that it will take longer for the population to become used to a different way of setting these rates.
However, there is no agreement yet on how liberalization will proceed. One option would be to follow and broaden the approach adopted since the end of the 1980s, that is, to allow institutions to set their lending rates within prespecified margins above the administered rates set by the PBC. Another option is to proceed with a liberalization according to the types of institutions, with nonbank financial institutions and urban credit banks first, followed by commercial banks, and state commercial banks last. Opponents of this view argue that it would create unfair competition. Finally, a third option is to liberalize the rates earlier in some regions than in others. Opponents of this approach argue that this could expose the system to interest rate differentials that could provoke undesirable flows between regions and, in fact, reinforce current regional disparities, finally, liberalization of deposit rates should come at the end of the process, perhaps after the turn of the century.
Box 2.China—System of Administrative Interest Rates
China’s interest rate structure has always been very complex, with more than fifty rates administered by the PBC. On the lending side, besides the basic distinction between working capital loans and fixed assets loans, a distinction is also made between industrial and commercial loans, agricultural loans, and household loans. On the deposit side, a distinction is made between individual and institutional depositors, and the PBC sets different rates for different maturities up to eight-year deposits.
Shortly after its establishment, the PBC tried to make interest rates more flexible and to partially liberalize them. The central bank was handicapped in its attempts because interest rate changes have to be approved by the state council. However, after 1985, and particularly since 1988, interest rates were adjusted more frequently, primarily in response to inflationary pressures. During periods of low inflation, most interest rates were positive in real terms.
Interest rate flexibility seemed to be constrained by at least two factors. First, during most of the period the authorities’ interest rate policy was directed toward two often conflicting goals: to encourage long-term savings mobilization, and to facilitate borrowing by state-owned enterprises—particularly those with financial problems. These motivations often led to inconsistencies, such as the fact that interest rates for some deposits were higher than lending rates for the same duration, resulting in a negative interest rate margin for banks. In general, the margin between most lending and deposit rates of equivalent duration is very narrow. To resolve these inconsistencies the authorities resorted to an indexation scheme for long-term deposit rates, which allowed them to keep lending rates low in times of high inflation, while keeping deposits still attractive. Another constraining factor was the heavy reliance by the specialized banks on borrowing from the PBC—up to one-third of their resources. This heavy reliance is an obstacle to an active management of PBC lending rates because a change in those rates would directly affect the average cost of the banks’ resources.
A first attempt to liberalize interest rates took place in 1986–88. Banks were allowed to adjust loan rates within a 10 percent margin around the administered rate. There was no such flexibility for deposit rates. The austerity program of 1989 reversed this partial interest rate liberalization. In the early 1990s, when the austerity period had come to an end, the banks were again allowed to set their lending rates within prespecified margins (60 percent for the rural credit cooperatives, 30 percent for the urban credit cooperatives, and 20 percent for the other banking institutions). On the other hand, lending rates to the private sector are freely determined.
Related issues that still need to be addressed are the liming of the introduction of auctions of government securities relative to the liberalization of other interest rates, the transfer of interest rate subsidies from banks and the PBC to the government, and the management of the banks’ interest rate spread, if needed.
Discussions on PBC Plans
These proposals appeared to be in line with country experiences presented during the seminar. Issues discussed related to the speed of liberalization, its sequencing, ways to proceed with liberalization, and monitoring of financial institutions during the process of liberalization.
Speed of Liberalization
Since there are many institutional and local factors involved, the seminar discussions on the speed of liberalization did not come to a definite conclusion as to what is best for China. The consensus was that this will have to be gauged by the Chinese authorities in the context of China’s overall reform program. For example, the pace of the reform of the state-owned enterprises is a major determinant of the speed with which the financial sector reform could proceed, and this is supported by the experience of Korea. In Korea, the authorities attempted to determine the optimal speed of liberalization by analyzing the effects of deregulation on the overall economy, that is, investment demand, financial burden of enterprises, and, thus, competitiveness of export industries, growth rates, and balance of payments conditions. It was felt that a similar approach could give the Chinese authorities better insight into the speed of financial sector reform. However, some participants stressed that a gradual approach should not be stretched too long for fear of losing the momentum of the reform and introducing new distortions into the system (for instance, disintermediation) or prolonging existing ones (such as black market phenomena).
The importance of control of inflation in the liberalization process was stressed by a number of participants. A further reduction in inflation will reduce the likelihood that liberalization would lead to higher interest rates. This was supported by country experiences showing that after the completion of the liberalization process the existing interest rates tend to rise. As inflation subsides, the absolute gap between official rates and black market rates decreases and facilitates liberalization. In the same vein, inflation control will also facilitate the development of an integrated interbank market. Since 1992, several of the irregularities that were discovered in the interbank market have been fed by inflationary circumstances.
The sequencing envisaged by the Chinese authorities (interbank rates first, followed by lending rates and deposit rates) appeared to be in line with the approach adopted by several countries around the world. Of the countries represented in the seminar, Korea, Malaysia, Turkey, and the United States also followed this sequence.4 Country experiences showed that almost inevitably, interest rate liberalization is accompanied by an (initial) rise in the rate structure and higher volatility of the rates.5 Hence, the logic behind this sequencing is that the educational process that necessarily has to go with interest rate liberalization—and with the acceptance of the two above-mentioned phenomena—should be gradually spread from a core group of sophisticated market parties (financial institutions and government) to a wider group of less sophisticated participants (enterprises and the general public).
Two considerations regarding the sequencing were stressed by participants. The first concerns liberalizing interest rates on government securities, and the second is that of deposit rate liberalization relative to lending rate liberalization.
1. Some participants stressed the importance of resuming the issuance of short-term government securities, but now at a market-determined rate (that is, issued through an auction system) in an early stage of the process, that is, shortly after the liberalization of the interbank rate.6 This action would have several advantages. First, it is in line with the above-mentioned logic in the sequencing, namely, to involve the government in the process at an early stage. Second, it will give the (wholesale) market an instrument that can be used if necessary as collateral in interbank operations, lending from the PBC, and future open market operations. Third, in light of the likelihood that the interbank market rate might be volatile in the early stages,7 the rate on short-term government securities may be a better benchmark to be followed by the PBC in the conduct of its monetary policy. To serve the purposes highlighted above, the maturity of this new instrument could be three months, or six at the most, and issued to financial institutions that are directly involved in the monetary policy transmission process (that is, banks and NBFIs).
2. While there may be good grounds for postponing the liberalization of deposit rates until the end of the process,8 it was also considered appropriate not to wait to start this process until all lending rates are fully liberalized. In accordance with the education principle referred to above, it could make sense to start the liberalization of large time deposits at an earlier stage. Usually, these large deposits are held by enterprises and institutional investors—some of which will be affected by the liberalization of lending rates—and have therefore to be distinguished from the “retail” deposits. These large deposits will increasingly have to withstand competition from many money market instruments such as treasury bills or repurchase agreements, another factor that justifies an earlier than planned liberalization. As a matter of fact, many industrialized countries, including the United States, Japan, and most West European countries, liberalized the so-called “wholesale” deposit rates at an early stage, an example that has also been adopted by Korea. Also in Korea, interest rates on large denomination repurchase agreements were freed.
The education process of the public at large could be expedited by the introduction of more flexibility in setting the rates on their savings and time deposits. This is one of the objectives of the PBC, adopted at the beginning of 1995, which may prove to have beneficial effects on the reactions of the public. Thailand’s experience indeed proves that increased flexibility in setting the (administered) rates facilitated the liberalization process.
How to Liberalize
With regard to the technique to be used in liberalizing lending rates, the PBC’s current practice of allowing the banks to set their lending rates within a prespecified margin above the administered rates provides a good tool for further liberalization. In fact, this is very close to the technique used in several other countries of setting a minimum and maximum rate. It was noted that the other views, which included a staged liberalization by type of institution (NBFIs first, followed by commercial banks, and later state commercial banks) or a liberalization based on regions (richer regions first, poorer regions later) had several specific drawbacks. An institution-based approach may lead to unfair competition (the absence of a level playing field), while a regionally diversified approach may exacerbate the regional differences and draw away funds from the poorer regions. Branches in rich regions have a competitive advantage because they have access to a larger deposit base while deposit rates are still regulated. Furthermore, banks or branches in backward regions are inherently more fragile, a situation that may be exacerbated under a regionally uneven liberalization process. The experience of Italy is quite instructive in this regard as the country also copes with marked differences between the richer north and the poorer south. During the liberalization process, conditions that avoid further divergences should be created. Thus, a combination of a flexible lending rate set by the PBC with a mark-up margin that gradually converges between the different types of institutions would lead to the creation of a level playing field among different types of financial institutions and would at the same time allow the institutions in richer regions to set different rates from those in other parts of the country.
The PBC’s intention to reduce the number of preferential interest rate schemes (through mergers or elimination of schemes) was considered most appropriate by all participants. While it is understandable that the existence of preferential rates is still justified in China’s current developmental stage, there was a broad consensus that the most important goals at this time are to shift the fiscal burden of these policies from commercial banks and the PBC to the government, and to make these operations transparent on the books of all institutions and agencies involved.
Monitoring of Financial Institutions
As evidenced by country experiences, the overall soundness of the banking system and the viability of the major financial institutions is of paramount importance. At a minimum, this requires regular monitoring of the financial positions of the financial institutions and, in particular, the profit margin under which they operate. Monitoring developments in this area and effectively supervising the financial system appeared to be critical to the success of China’s liberalization program. A major ingredient in this process is the development of a mechanism to determine the spreads for the banking system.9 Thailand’s experience with the minimum retail rate and that of Malaysia with the base lending rate was of particular interest to the Chinese authorities.
In Thailand, the minimum retail rate was introduced in 1990, on or after full liberalization of interest rates, as a benchmark rate for small borrowers, which usually have to borrow at the highest rate. The minimum retail rate should be known to the public and be comparable (but not necessarily equal) among banks. This system has helped strengthen the bargaining power of small borrowers. In the transition to full liberalization, the base lending rate in Malaysia helped in monitoring and guiding the banks’ interest rate spread, particularly in periods of downward stickiness of the lending rates. Since 1991, there has been no central bank control over the base lending rate and banks are free to set the base lending rate based on their own cost of fund structure.
At this stage of financial reforms in China, the liberalization of interest rates emerges as an area where reforms are increasingly urgent and critical. This is not because of low performance in savings mobilization, which has remained high. Rather, liberalization of interest rates becomes critical at this stage because the inconsistencies in the sequencing of reforms would lead in the long run to increased inefficiency in the allocation of resources. Furthermore, as segments of the financial market such as the capital and foreign exchange markets are liberalized along with sectors in the real economy, while the money market remains highly regulated, arbitrage opportunities are created between the various segments of the capital market and between the capital market and other sectors of the economy, which in the view of the Chinese authorities are “speculative activities.” The interbank market in particular could become a channel for speculative financing because funds borrowed at official rates at the PBC could be re-lent at market rates in sectors such as real estate or securities markets.
The PBC is currently confronted with the challenge of conducting monetary policy in the context of increased inefficiency of its direct controls, while indirect instruments cannot yet be used effectively. The PBC cannot rely on the level of interest rates in the money market as an information variable on the liquidity conditions in the system since interest rates are not free, except for repurchase operations. At the same time, a framework allowing a centralized management of liquidity is not yet available. Also, the “dual track of interest rates” presented by Xie Ping in his paper makes indirect monetary management almost impossible. In sum, the stage of financial reforms is such that market mechanisms already in place make direct controls less and less effective, while not allowing an effective implementation of indirect instruments. This undoubtedly points to the urgency of liberalizing interest rates as soon as possible, for instance by taking advantage of every opportunity allowing the implementation of additional measures of liberalization.
In October 1995, the PBC announced its intention to auction its own securities to 14 commercial banks. The auction procedure followed will be a volume tender that allow banks to bid for volumes supplied by the central bank at a preset and preannounced interest rate. The PBC also announced its intention to start open market operations on its securities through repurchase agreements. The choice of a volume tender, rather than an interest rate tender that would have allowed banks to bid for both the amount and the rate, illustrates the gradualism in the Chinese approach. Implementing a volume tender can help make monetary policy intentions (as regards interest rates) explicit and stabilize market expectations. However, it is crucial that interest rates be set at a market level. The central bank can be guided by the level of interest rates on the interbank market provided that market operates freely; interest rates on the repurchase market would provide adequate information since this market already operates freely in China. The central bank can also be guided by the level of inflation so that interest rates remain positive in real terms and are adjusted flexibly as the outlook for inflation changes. Provided the PBC sets the interest on its securities in relation to market rates, this new instrument can be seen as one step asked in the gradualist approach with interest rate liberalization followed by China.
An important step was made on January 1, 1996, when new arrangements were established for a national interbank market. The new interbank market system comprises a two-level arrangement. The first level—the National Interbank Trading Center—links the headquarters of the commercial banks and 35 Regional Financing Centers. The National Interbank Trading Center is an electronic system that provides market information and a framework for trading between participants in a transparent and secure way. The second level is made up of the 35 Regional Financing Centers located in 35 provinces, autonomous areas, and cities with independent planning status, and their subordinate subcenters. These centers and subcenters link the branches of banks at the various administrative levels.
No regulations have yet been issued concerning the legal form that Regional Finance Centers should adopt. Some have taken a shareholding form, others are organized according to membership model, and in limited cases the PBC acts as the regional financing center.
Trading at the first level is done directly between the participants, which are able to select their counterparts, and which agree on an interest rate for the transaction. The settlement of trades is done directly between the parties concerned through their accounts with the PBC; the National Interbank Trading Center is not a party to these transactions. At the second level, the regional financing center, which is a party to each transaction, takes the settlement and credit risks. The regional financing centers are not allowed to maintain an open position at the end of the day, that is, all borrowing from participants must be onlent before the close of business. However, the regional financing centers may be exposed to liquidity and interest rate risks. Direct transactions between banks, that is, outside the system, are not allowed. However, the regional financing centers can operate as brokers between a lender and a borrower; in this case the regional financing center does not bear the credit risk. Currently, most transactions at both levels of the market are unsecured.
Participation is allowed to those financial institutions that have an account with the PBC—commercial banks as well as NBFIs. Lending by those NBFIs that are allowed to participate on in the second level is not regulated. However lending to NBFIs is still subject to the limits on the volumes and maximum maturity of the transactions that were set up in 1993. Commercial banks or their branches are also subject to prudential limitations established in terms of a ratio to deposits collected from customers; in addition, participation in the market is not allowed by those banks that do not comply with the reserve requirement ratio. The participation of branches of financial institutions is permitted at this stage as telecommunications do not yet allow a centralized liquidity management. However, branches need the formal approval of their headquarters. This important provision is meant to safeguard the head-quarter’s responsibility over the activities of all its branches.
Daily information on the rate and amount of the trades in the first level is used to calculate the China Interbank Offered Rate (CHIBOR), which is a weighted average interest rate of real transactions for each maturity traded in the market—currently 7, 20, 30, 60, 90, and 120 days. The ceiling on interest rates set up in 1993 was lifted on June 1, 1996, for interbank transactions on the first level. Besides being a reference rate for interbank transactions, the CHIBOR serves as a basis for transactions in the second level.
These new arrangements, which formalize the system of interprovincial lending and borrowing, are expected to facilitate the interprovincial flow of funds. They are also expected to enhance the use of funds and, in particular, to prevent the buildup of excess reserves by some banks’ branches.