CHINA started to experiment with interest rate liberalization in the late 1980s. The original roadmap of interest rate liberalization reform was set at first to liberalize the money market and bond market interest rates, and then gradually liberalize deposit and lending rates.

The sequencing of interest rates reform was designed to minimize the negative repercussion to the financial market stability.

A series of liberalization measures according to this roadmap have been implemented over the past three decades and the pricing of capital in the domestic financing market has been increasingly market driven. The market development paves the way for further deepening of interest rate reforms and the eventual transition of monetary policy transmission mechanism which allows price signals, such as interest rate or exchange rate, to play a more important role.

On September 20, the People's Bank of China, jointly with other financial regulators, published the 12th Five-Year Plan for financial sector development and reform. In this blueprint, the government reiterates its commitment to, and provides a more detailed agenda for, monetary policy reforms, interest rate liberalization, yuan internationalization, the opening of the capital account, and the enhancement of the role of direct financing in all-system financing aggregates.

In summary, we believe interest rate liberalization reforms will reshape the monetary policy framework.

The initiative will help unleash substantial development potential in the domestic financial markets, such as money market, bond market and derivative market by expanding availability of financial and investment products and diversity of issuers and investor base. It will also help develop a sound interest rate market infrastructure which will support sustained growth of the country's real economy.

Money market outlook

We believe from now to 2015, money market liberalization reform will focus on:

a) Developing three-month or longer money market products to substitute deposit funding. This will facilitate commercial banks' money market pricing for term funding, extending the money market term structure beyond the three-month tenor, as well as better pricing of time deposits.

The domestic Certificate of Deposit (CD) market is more likely to develop, and Chinese commercial banks' practical experiences from CD market funding in the offshore yuan market over the past two years will be valuable references in developing the domestic CD market.

b) Improving the monetary transmission of the Shanghai Interbank Offered Rate and the Repurchase rate. This requires more transparency in the fixing of SHIBOR and Repo rates, and the establishment of a new base monetary policy.

c) Developing multi-layered interest rate derivatives market.

We expect the one-year lending and deposit rate Interest Rate Swap market to disappear as the benchmark policy rates will be replaced by a single base policy rate.

The growth in the depth and efficiency of IRS market allows for corporations and real money investors to better hedge interest rate exposures and optimize their funding and asset-liability management strategies.

Alongside with the likely strong growth in the domestic corporate credit market, we project such demand to generate an additional IRS derivative market volume by about 2 trillion yuan (US$321 billion) per annum.



Bond market outlook

We believe domestic bond market liberalization will deepen in the following areas in the next few years:

a) Direct financing in the domestic credit market to accelerate. We forecast the total size of credit market to grow to 15 trillion yuan by 2015.

b) High yield bond market to develop. We expect the domestic high-yield bond market to grow to 2 percent of the domestic credit market by the end of this year, and gradually rise to 10 to 12 percent of the domestic credit market by 2015.

c) Financial product innovation to be reflected in the growing issuance of bonds embedded with call/put options or floating rate bonds which offer interest rate hedges.

d) More diversified investor base. We expect domestic insurance companies and central as well as local pension funds to increase investment in the fixed income market.

Domestic asset management industry will gradually replace shadow banking and other irregular financial services.

On this front, we project by 2015, the total assets under management of the wealth management industry on Chinese mainland will likely grow to a size of 4 to 5 trillion yuan.

We also expect China to accelerate its pace of capital account liberalization in the next few years and the Qualified Foreign Institutional Investors quota approval to increase to US$20 billion per year going forward.

Foreign access to domestic interbank bond market will likely be expanded to 100 to 200 billion yuan per year.

e) Panda bond market to be opened to foreign corporations.

f) Credit derivative markets to take off. We project about 30 percent of the credit market investment needs to be hedged, and this will translate into 4.5 trillion yuan of total demand.



Monetary policy reform outlook

In developing a more price-based monetary policy framework, we expect three key reform measures:

a) Further widening of the floating ranges for benchmark lending and deposit rates in the next one to three years.

b) Establishment of a single short-term base monetary policy rate to guide the market level of interest rates; and to replace the benchmark policy deposit rates and lending rates term structure in the next three to four years. We think either an interbank funding rate or a Repo rate can be the final choice of China's base policy rate and the tenor of this rate can be overnight or up to 7 days.

The new base policy rate will serve as the anchor of the domestic interbank term structure and the rest of the interbank term structure will be determined by the market. This term structure then helps price the government bond yield curve as well as the domestic credit risk matrix according to credit rating, liquidity risk assessments.

c) Open market operations to target base policy rate.



Liu Linan is a senior strategist of Deutsche Bank. Ma Jun is the Chief China economist of Deutsche Bank.