The reforms mean banks will now give risk pricing to different borrowers based on their credit situation. However, this means banks will need to improve their risk pricing ability, which requires the establishment of an effective credit appraisal system as well. This will allow banks to compete on price.

Canceling the floor for lending rates is also intended to lower the financing costs for companies and optimize financial resources to boost the real economy. However, these benefits are based on theoretical analysis and the experiences of developed countries, where banks compete on price. Since the current Chinese financial market is still developing, many companies, local governments and individuals are "capital hungry", so the level of demand will keep rates high despite the scrapping of the floor.

Lending rates represent profit for banks, while deposit rates represent costs. So if the liberalization is only on the profit side, over-expansion of credit can hardly be avoided, because the more banks' credit expands the larger profits they can earn, and the interest margin can be even higher when the loanable funds are constrained. This means banks may increase the financing costs for the real economy and those funds raised with higher costs will drive up the prices of all kinds of assets, especially real estate prices.

Even though the central bank has liberated interest rates, if the market's old concepts and benefits pattern continue, over-expansion in credit and constraints in loanable funds will still coexist in the market. Removing the controls could provide even more space for "rent seeking" in the system. And with capital closely related to power and personal relations, it will still be extremely difficulty for small and medium enterprises to get financing.

Interest rate liberalization in China is being carried out gradually, and to some extent, that is why many problems in financial market exist.

The key is freeing deposit rates. A liberation of deposit rates would force banks to carry out effective risk pricing considering the floating costs and make them more cautious and rational in their commercial activities. Therefore, after removing the control on the interest rates for lending, China should seek to liberate the deposit rates in a timely manner.

The recent move is an important step, but not the final step for realizing interest rate liberalization. Only when the controls on commercial banks' deposit interest rates are lifted, will an effective price mechanism be established and the financial market be dominated by supply and demand.

The author is a columnist with China.org.cn. For more information please visit:

http://www.shenbo75.com/opinion/yixianrong.htm