The liberalization of interest rates in China should be pushed forward in an orderly and careful way because there are many obstacles to surmount.

The country's social funds - which consist of fiscal expenditure, financial funds like bank loans, funds raised from issuing stocks, financial and corporate bonds, and actual foreign investment and foreign exchange - have jumped to about 4.2 trillion yuan (US$506 billion) in 2001 from less than 846 billion yuan (US$102 billion) in 1991.

Since the country adopted a proactive fiscal policy in 1998, the share of fiscal funds has soared by 17 per cent to reach 45 per cent of the total pool of social funds by 2001. The contribution of financial funds and foreign capital and exchange to social funds dropped by 9 and 8 percentage points respectively to 37 per cent and 18 per cent.

The increased share of fiscal funds indicates the government is taking a greater role in the national economy. In the meantime, the shrinking proportion of financial funds implies the market's role has waned in distributing resources.

The trend not only goes against the country's primary goal of market-oriented economic reform, but also hampers the liberalization of interest rates. The government-led allocation of social resources tends to crowd out private investment and distort prices in the capital market, regardless of supply and demand.

Under such circumstances, it is impossible to achieve a market-oriented interest rate. The impact of macroeconomic policies should therefore be taken into consideration during interest rate reform.

To accelerate this reform, the government should finetune its proactive fiscal policy to reduce its role in the economy. The focus of treasure bond expenditure should be shifted from direct investment to supporting structural tax cuts to boost investment. And monetary policy needs to be made more "proactive" to clear credit circulation.

Another cloud over the country's plans to liberalize interest rates is the widening gap between outstanding deposits and loans in domestic banks.

Domestic banks had accrued 4.3 trillion yuan in deposit surpluses by the end of 2002.

But they remain reluctant to extend credit. For instance, the proportion of new loans granted by the four major State-owned commercial banks, out of the total nationwide, plunged from over 70 per cent in 1997 to 49 per cent in 2001 and 43 per cent in the first quarter of 2002. The yawning gap between deposits and loans has become a potential financial risk for domestic banks because it erodes their meagre profits.

The liberalization of interest rates would constitute a serious challenge to State-owned banks. Unless they reform quickly, interest rate liberalization will narrow the interest rate gap between loans and deposits and shake up banks which rely heavily on that source of income.

In other words, sluggish reform of State-owned banks will, to a certain extent, postpone market-oriented interest rate reform.

But the reform is necessary for State-owned banks because it will increase competition and force them to commercialize.

The growing income gap in society is also a factor that must be taken into account when liberalizing interest rates.

Latest surveys show the richest 10 per cent of families own 45 per cent of the wealth in cities, while the 10 per cent at the other end of the spectrum hold merely 1.4 per cent.

As the concentration of wealth increases, interest rates will inevitably rise once they are no longer regulated. Consequently, people will be likely to save by cutting consumption, denting the government's effort to boost economic growth. In addition, a higher interest rate will benefit high-income groups more, which will in turn further expand the income gap.

Hence, financial institutions should first experiment by floating rates for long-term, large-sum deposits before attempting to liberalize other deposit interest rates.

Meanwhile, it is also necessary to impose differential interest taxes on deposits of varying sizes to close the income gap. Interest rate reform will therefore require changes to the existing interest taxation approach.

The unemployment problem always weighs heavily on policymakers' minds when they press ahead with interest rate reform.

By the end of 2002, the country's registered unemployment rate in urban areas reached 4 per cent, excluding 4.1 million laid-off workers, the highest level in the past five years. It is estimated the country's total labour supply is 23.5 million, while there is demand for only about 10.7 million workers this year.

Under such conditions, rising interest rates will raise the cost of borrowing, which could prove the last straw for many troubled enterprises. This is particularly true for some large and medium-sized State-owned enterprises whose bankruptcy could result in massive unemployment.

It is thus obvious that successful corporate reform, focused on improving efficiency, is one of the prerequisites for successful interest rate reform. The tough employment situation requires gradual interest rate liberalization to avoid a sudden increase in bankruptcies.

Finally, deflationary pressure has made the headlines as prices spiral downward, hindering the interest rate liberalization process.

After eight consecutive cuts in recent years, the country's interest rates have touched bottom but have not done much to boost investment and consumption.

Continuous deflation would push up real interest rates, adding to borrowers' difficulties in repayment of loans. If borrowers become insolvent, this in turn will lead to an increase in banks' bad assets, which could bring down some banks as well as the financial system.

Therefore, the liberalization of interest rates should also be based on the government's solution to the problem of insufficient domestic demand.

The authors are researchers with the Institute of Fiscal Science under the Ministry of Finance.