## _wp09189

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### I. Introduction
- Roles of short-term interbank interest rates:
  - Indicate macroeconomic and liquidity conditions.
  - Provide a building block for pricing financial assets.
- China’s interest rate liberalization status:
  - Interbank interest rates and bond yields are market determined; key retail rates remain administratively constrained.
- Channels by which regulated deposit and lending rates affect liquidity and interbank rates:
  - Regulating the deposit rate influences supply of funds into the financial system and affects liquidity and the interbank rate.
  - Regulating the lending rate affects the volume of loans demanded and thus the interbank rate.
- Empirical evidence (Section IV) on the 7-day repo rate:
  - Interbank rates increase with administered lending rates and fall with deposit rates, even after controlling for systematic liquidity variations (week, month, Chinese New Year timing).
  - After controlling for administered retail interest rates, changes to policy variables have a surprisingly small impact on the interbank rate.
  - Changes to administered retail interest rates affect interbank rate volatility; announced changes to reserve requirements also affect volatility.
- Policy implication:
  - Further liberalization of deposit and lending rates should strengthen the interbank rate’s role as an independent benchmark and in monetary policy formation.
  - Liberalization may increase interest rate volatility, reflecting incorporation of macroeconomic and financial news into pricing.

### II. Institutional Structure of Interest Rates
- Mixed determination of interest rates: regulated outcomes, market determination, quantity controls, and official “window guidance.”
- Money market shaped by gradual deregulation alongside remaining administrative controls.

A. Interest Rate Regulation
- Timeline and features of deregulation:
  - June 1996: Upper limits on interbank lending rates abolished; rates became market determined.
  - June 1997: Repos and outright cash settlement of secondary transactions introduced into the interbank lending market; rates market determined.
  - 1998–1999: Rates on policy bank financial bonds and Treasury bonds allowed to be market determined.
  - 2005 onward: Corporate fixed income financing liberalized with creation of short-term bill financing (commercial paper) market.
  - 2007: Referencing of corporate bond yields off SHIBOR began.
  - 2008: Medium-term corporate note market created; rates market determined.
- Retail rate regime specifics:
  - Upper bound on lending rates gradually lifted from 1998 and finally removed in October 2004.
  - Floor on renminbi deposit rates removed; a ceiling on deposit rates remains (deposit rates typically clustered at their benchmark).
  - Lending rates typically cannot be lower than 90 percent of the benchmark lending rate (mortgage rates allowed to fall to 70 percent of the benchmark since October 2008).
  - Deposit rate ceiling is generally considered binding; real deposit rates have at times been close to zero or negative for long periods.
  - Deposit rate ceiling not binding for large long-term depositors (since October 1999, rate for deposits over Y 30 million held for more than 5 years is negotiable).
- Benchmark rates adjusted by the PBC on an irregular basis; average lending rates follow benchmark movements relatively closely.

B. Market Determined Interest Rates
- Bond market segmentation and issuance restrictions have influenced funding costs; restrictions being gradually eased.
- Creation of the modern interbank market:
  - PBC established the first unified national interbank lending market in January 1996 (CHIBOR market followed).
  - Initial focus on temporary account discrepancies and working capital loans, majority of lending up to one week.
- Repo market characteristics:
  - Two types of interbank lending: uncollateralized lines of credit and collateralized repos; repos are far more important and typically very short term (overnight to 7 days), though maturities up to one year are possible.
  - Structural liquidity imbalances: large state commercial banks are major suppliers of liquidity in the repo market; other financial institutions, foreign banks, and some other commercial banks are net recipients.
  - In the unsecured lending market, other commercial banks are principal suppliers of liquidity.
  - Repo activity concentrated at short maturities; repo market turnover far exceeds uncollateralized CHIBOR market turnover.
  - Expansion of instruments increased the use of PBC paper and commercial paper in repo transactions.
- Bond markets:
  - Interbank bond market is wholesale (banks and institutional investors); exchange markets allow individual investor participation.
  - Interbank trading is quote driven OTC; exchange markets are order driven.
  - Majority of government bonds and almost all financial bonds issued in the interbank market; larger corporates increasingly list on exchange bond markets.
  - Segmentation has produced pricing uncertainty across the yield curve and price variation across markets.
  - Despite majority of treasury bonds being listed on the interbank market, overall turnover of these bonds (including for repos) is higher on the Shanghai exchange than in the interbank market.
  - Corporate bond issuance was tightly regulated until recently; 2007 pilot reforms moved toward a disclosure-based system and removed bank guarantee requirements.
  - Interbank commercial paper market reforms:
    - Prior to 2005 operated largely as a “bankers acceptance market.”
    - Post-2005 issuers with a credit rating and audited accounts able to issue commercial paper.
    - April 2008 market extended to medium-term notes (up to five years), temporarily suspended between July and September 2008.
    - In the first six months of 2009, short-term commercial papers and medium-term notes accounted for almost half of the issuance of nongovernment and non-PBC paper in the interbank market.

C. Interbank Offered Rates and Other Interest Rates
- January 2007: PBC established the Shanghai Interbank Offer Rate (SHIBOR) System to build a benchmark yield curve.
  - SHIBOR is calculated as an arithmetic average of renminbi offered rates by participating banks (currently 16), fixing at 11:30 a.m. each business day.
  - SHIBOR extends maturities to one year relative to CHIBOR.
  - SHIBOR is not determined in a funding market and aims to remove the impact of trading volumes on benchmark rates.
- Relationship among short-term rates:
  - CHIBOR, SHIBOR, and the repo rate have followed each other closely in recent years; volatility has increased substantially since late-2005.
  - Greater repo market liquidity and tight relationship between SHIBOR/CHIBOR and the repo imply SHIBOR adds little additional information when interbank trading is active; SHIBOR provides a benchmark when interbank trading is limited.
  - Correlations:
    - High correlation between SHIBOR/CHIBOR and the 7-day repo rate during periods of heavier repo transaction volumes; relationship less uniform at longer maturities (especially 12 months) due to limited liquidity.

D. Interest Rates and Monetary Policy
- PBC instruments and practice:
  - Uses a variety of direct and indirect instruments; open market operations have grown, but reserve requirements, annual bank-by-bank credit caps and window guidance remain important.
  - PBC regulates retail interest rates, typically moving them in conjunction with other monetary instruments.
  - Chinese monetary policy relies heavily on quantity-based instruments (annual credit caps) and administrative measures (reserve requirements and window guidance).
- Literature notes:
  - Koivu and others (2008) argue observed Chinese monetary growth is consistent with a McCallum monetary growth rule.
  - Laurens and Maino (2007) find the PBC is able to meet its base money target but is less effective at achieving broad money targets or influencing economic growth.

### Box 1. Interest Rate Volatility and China’s Reserve Requirements

Reserve requirement design and implications for interest rate volatility
- Reserve requirements in China must be met strictly on a daily basis; the PBC has not adopted reserve averaging.
- China uses a differentiated reserve ratio system—required reserves from renminbi deposits differ from those from foreign currency deposits.
- To calculate the required value of reserves on any day (for both renminbi and foreign currency deposits), the level of deposits at the end of the previous Xun is used.
  - Each month is divided into three segments (Xuns): the “upper Xun” (first ten days), the “middle Xun” (11th to 20th), and the “lower Xun” (after the 21st).
- Daily reserve ratio formula (as given in the source):
  - Daily reserve ratio = Reserves at close of business / Deposit level at the end of the preceding Xun.
- Banks may hold too few reserve before closing, but they are penalized for not holding sufficient reserves at closing.
- Mechanism increasing volatility:
  - By not averaging reserves over a maintenance period, the additional trading to borrow sufficient funds or lend surplus funds is required every day, thereby resulting in higher average volatility.
  - A longer reserve maintenance period would allow banks to hold fewer precautionary excess reserves and would require less liquidity in the system for a given level of volatility.
  - Central bank liquidity adjustments within a maintenance period in response to shocks to bank liquidity can further limit volatility.

Stylized model of China’s interbank market — equilibrium properties and comparative statics
- Model setting:
  - Competitive model of N independent price-taking banks.
  - Banks take as given: lending rate (rL), deposit rate (rD), bond yield (rB), reserve remuneration rate (rR), and the interbank lending rate (r).
  - Banks have liquidity preference and face real costs when their reserve target T(αD) is not met; β measures strength of liquidity concerns.
  - Market clearing requires MDBLRRER = − − − − (as in source).
- Result 1:
  - There exists an equilibrium market determined interbank rate, r*, that solves the interbank market clearing condition (3), and r* is a unique function of the administratively set benchmark interest rates, reserve requirement, and government bond issues. The same holds for market determined bond yields.
- Result 2 (comparative statics when lending rate does not exceed its equilibrium):
  - r* is increasing in the lending rate.
  - r* is decreasing in the deposit rate.
  - r* is increasing in central bank bond issuance.
  - An increase in the required reserve ratio has an indeterminate impact on r*, although if banks have a sufficient liquidity preference (1/β > ? — as presented in source conditional), an increase in the required reserve rate will increase r*.
  - If the lending rate exceeds its equilibrium, then r* is decreasing in the lending rate.
- Result 3:
  - If the deposit (savings) market is allowed to clear, then an increase in the deposit rate would increase the interbank rate. All other comparative static results from Result 2 continue to hold.
- Other short-term liquidity shocks (IPO activity, exchange rate intervention, capital inflow) should influence interbank rates as exogenous changes in bond holdings do—raising r* when liquidity falls and lowering r* when liquidity rises.

Empirical model, data, and specification
- Target rate analyzed: 7-day repo rate (R_REPO).
- Modeling approach: exponential GARCH (EGARCH) with Student’s t-distributed innovations.
- Mean equation specification:
  - rt = μt + √ht vt, with μt modeled by autoregressive terms and exogenous factors Xmt including benchmark deposit and lending rates, open market operations, reserve requirement changes, IPOs (amounts raised in billions of renminbi), and liquidity dummies (day-of-week, proximity to end of month, Chinese New Year timing).
- Variance equation specification:
  - ln(ht) follows an EGARCH form with ARCH (α), GARCH (γ), and asymmetric (λ) terms; exogenous drivers include absolute changes in benchmark interest rates, open market operations, reserve requirement changes and their announcements, IPO leads (+5 and +10 days), and liquidity dummies.
- Data sample used for the main 7-day repo estimation:
  - Daily data spanning October 2003 to August 2008; included observations: 1159 after adjustments.

Key empirical findings — mean (level) of interbank rates
- Persistence:
  - China’s interbank rate is extremely persistent; more than proportionate response to a change on the previous day with subsequent unwinding over days following.
- Administered interest rates:
  - Changes to benchmark interest rates have significant impacts on the interbank rate, with opposite effects for lending and deposit rates and non-monotonic dynamics.
  - The initial direct impact of a 100 basis points rise in the lending rate is to increase the interbank rate by 75 basis points; after three days this direct impact is only 3 basis points.
  - The initial direct impact of a 100 basis points rise in the deposit rate is a 43 basis points fall in the interbank rate; after three days the interbank rate is less than 3 basis points lower (but still significant).
  - Given persistence, the long-run impact of a simultaneous 100 basis point increase in both deposit and lending rates is a 40 basis point rise in the interbank rate.
- Monetary policy instruments (open market operations and reserve requirements):
  - Conditional on the level of benchmark interest rates, changes to policy variables—open market operations and reserve requirements—do not have any significant impact on the level of the interbank rate.
  - Even the announcement of a change in the reserve requirement has no significant immediate impact on the level of the interbank rate (in the mean equation).
- IPOs:
  - IPOs have no significant impact on the mean interest rate (despite expectations that locked-up funds would matter).
- Liquidity effects:
  - Chinese New Year timing has the largest impact on average interest rates: average repo rates are lower during the week before New Year, jump significantly above average on the day before the New Year, and decline gradually in the subsequent week.
  - End-of-month effects: average interest rate is especially higher after the end of the month.
  - Within-week effects: interest rate is significantly lower on Friday than on other days of the week.

Key empirical findings — volatility of interbank rates
- Distribution and residual characteristics:
  - Estimated degrees of freedom for the error term (T-DIST. DOF) = 2.0630. This implies heavy tails and noisy innovations.
  - Standardized residuals show no remaining volatility clustering in the estimated model.
- Volatility dynamics:
  - Volatility clustering is confirmed with significant GARCH effects; variance is relatively persistent with a half-life of over two weeks.
  - First-order ARCH effect is marginally significant; asymmetric term implies “negative news” has a smaller impact on volatility than news that increases the interest rate.
- Administered interest rates and volatility:
  - Changes in benchmark interest rates affect volatility, though less than their effect on the mean.
  - Changes in the deposit rate tend to reduce volatility; changes to the benchmark lending rate tend to increase volatility within the week around the change.
- Monetary policy and volatility:
  - Reserve requirement changes have a larger impact on interest rate volatility than on the mean; announcement of reserve requirement changes causes a jump in volatility (anticipatory effect).
  - Net liquidity injections through open market operations have little impact on volatility (consistent with OMOs stabilizing interbank rates).
- IPOs and volatility:
  - IPO activity increases volatility ahead of the IPO (when funds are locked up); IPO(+10) coefficient in variance equation = 0.0770.0135.9450.000 (statistically significant).
- Liquidity calendar effects on volatility:
  - Chinese New Year: volatility below average ahead of the holiday but jumps substantially the day before; higher volatility persists through the trading week after the holiday and declines in the second week.
  - Within-month: volatility is significantly higher around the middle of the month and declines as the end of the month approaches; volatility is significantly below average during the first two weeks of the month.
  - Weekday effects: volatility typically highest on Fridays and significantly lower on Mondays.

### Selected quantitative estimates and diagnostics
- Mean equation notable coefficients (selected):
  - R_REPO(-1): 1.1780.01388.3510.000
  - Benchmark Deposit Rate (contemporaneous): -0.43420.0962-4.51610.0000
  - Benchmark Loan Rate (contemporaneous): 0.75800.07589.99620.0000
- Variance equation notable coefficients (selected):
  - C_var: -0.9040.219-4.1250.000
  - ABS(RESID(-1)/@SQRT(GARCH(-1))): 1.7411.0211.7060.088
  - RESID(-1)/@SQRT(GARCH(-1)): 0.6890.4061.6980.089
  - ln(GARCH(-1)): 0.5940.0698.5740.000
  - ln(GARCH(-2)): 0.3410.0685.0110.000
  - IPO(+10): 0.0770.0135.9450.000
  - RR: -0.0120.002-4.7620.000 (reserve requirement contemporaneous effect in variance equation)
  - RR Announcement: 2.5321.0572.3960.017 (announcement effect on volatility)
- Model fit and diagnostics:
  - Included observations: 1159 after adjustments
  - T-DIST. DOF = 2.0630.07627.1060.000
  - R-squared = 0.838
  - Adjusted R-squared = 0.831
  - S.E. of regression = 0.363
  - Durbin-Watson stat = 2.064
  - F-statistic = 46.0420.000
- Joint significance tests (selected totals from Table 3):
  - Mean equation: Before Chinese New Year total impact = -0.40875.4067.65E-15
  - Mean equation: After Chinese New Year total impact = 0.16057.0924.84E-11
  - Variance equation: Change in deposit rates (all lags) total impact = -6.36739.8344.91E-07
  - Variance equation: Change in loan rates (all lags) total impact = 10.94514.7260.022
  - Variance equation: Anticipated reserve requirement change (all lags) total impact = 1.96349.5707.48E-07

### Policy implications and recommendations
- Interbank rate as benchmark:
  - Short-term interbank lending rates are not currently an independent benchmark for asset pricing or an independent indicator of macroeconomic or financial conditions because they are materially driven by administered interest rates.
- Benefits of further liberalization:
  - Allow the interbank rate (and other interest rates) to better provide essential price signals.
  - Better allocate capital.
  - Strengthen tools for macroeconomic management.
- Potential effects of liberalization:
  - Further interest rate liberalization may increase volatility of interest rates after liberalization, depending on post-liberalization conduct of monetary policy.
  - If short-term interbank rate becomes a target for monetary policy, volatility may decline.
  - Even if volatility rises, it would reflect greater responsiveness to fundamentals (liquidity and risk) rather than to changes in regulated interest rates—strengthening price signals.
- Preconditions and safeguards:
  - Liberalization requires strengthened supervision and monetary policy formation.
  - Without strengthened supervision, liberalization could lead to excessive lending and pressure on credit quality and banks’ profitability.
  - If liberalization is accompanied by heightened supervision and strengthened monetary policy, further liberalization is unlikely to create unnecessary instability.

*_wp09189 - References_*

### References..............................................................................................................

### References

### I. Introduction
- Short-term interbank interest rates play two important roles: indicating macroeconomic and liquidity conditions, and providing a building block for pricing financial assets.
- China has gradually liberalized interest rates for more than a decade; interbank interest rates and bond yields are market determined while key retail rates remain administratively constrained.
- Regulated deposit and lending rates affect liquidity and interbank rates:
  - Regulating the deposit rate influences supply of funds into the financial system and affects liquidity and the interbank rate.
  - Regulating the lending rate affects the volume of loans demanded and thus the interbank rate.
- Empirical evidence (Section IV) on China’s 7-day repo rate indicates:
  - Interbank rates increase with administered lending rates and fall with deposit rates, even after controlling for systematic liquidity variations (week, month, Chinese New Year timing).
  - After controlling for administered retail interest rates, changes to policy variables have a surprisingly small impact on the interbank rate.
  - Changes to administered retail interest rates affect interbank rate volatility; announced changes to reserve requirements also affect volatility.
- Policy implication: Further liberalization of deposit and lending rates should strengthen the interbank rate’s role as an independent benchmark and in monetary policy formation; liberalization may increase interest rate volatility, reflecting incorporation of macroeconomic and financial news into pricing.

### II. Institutional Structure of Interest Rates
- Interest rates in China result from a mix of regulated outcomes, market determination, quantity controls, and official “window guidance.”
- The money market and main features of Chinese interest rates and monetary policy are shaped by gradual deregulation alongside remaining administrative controls.

#### A. Interest Rate Regulation
- Timeline and features of deregulation:
  - June 1996: Upper limits on interbank lending rates abolished; rates became market determined.
  - June 1997: Repos and outright cash settlement of secondary transactions introduced into the interbank lending market; rates market determined.
  - 1998–1999: Rates on policy bank financial bonds and Treasury bonds allowed to be market determined.
  - 2005 onward: Corporate fixed income financing liberalized with creation of short-term bill financing (commercial paper) market.
  - 2007: Referencing of corporate bond yields off SHIBOR began.
  - 2008: Medium-term corporate note market created; rates market determined.
- Retail rate regime:
  - Upper bound on lending rates gradually lifted from 1998 and finally removed in October 2004.
  - Floor on renminbi deposit rates removed, but a ceiling on deposit rates remains (deposit rates typically clustered at their benchmark).
  - Lending rates typically cannot be lower than 90 percent of the benchmark lending rate (mortgage rates allowed to fall to 70 percent of the benchmark since October 2008).
  - Deposit rate ceiling is generally considered binding; real deposit rates have at times been close to zero or negative for long periods.
  - Deposit rate ceiling not binding for large long-term depositors (since October 1999, rate for deposits over Y 30 million held for more than 5 years is negotiable).
- Benchmark rates are adjusted by the PBC on an irregular basis; average lending rates follow benchmark movements relatively closely.

#### B. Market Determined Interest Rates
- Bond market segmentation and issuance restrictions have influenced funding costs; these restrictions are being gradually eased with plans to address segmentation.
- Background: Creation of the modern interbank market
  - PBC established the first unified national interbank lending market in January 1996 (CHIBOR market followed).
  - Initial focus on temporary account discrepancies and working capital loans, majority of lending up to one week.
- Repo market:
  - Two types of interbank lending: uncollateralized lines of credit and collateralized repos; repos are far more important and typically very short term (overnight to 7 days), though maturities up to one year are possible.
  - Structural liquidity imbalances: large state commercial banks are major suppliers of liquidity in the repo market; other financial institutions, foreign banks, and some other commercial banks are net recipients.
  - In the unsecured lending market, other commercial banks are principal suppliers of liquidity.
  - Repo activity concentrated at short maturities; repo market turnover far exceeds uncollateralized CHIBOR market turnover.
  - Expansion of instruments increased the use of PBC paper and commercial paper in repo transactions.
- Bond markets:
  - Interbank bond market is wholesale, for banks and institutional investors; exchange markets allow individual investor participation.
  - Interbank trading is quote driven OTC; exchange markets are order driven.
  - Majority of government bonds and almost all financial bonds issued in the interbank market; larger corporates increasingly list on exchange bond markets.
  - Segmentation has resulted in pricing uncertainty across the yield curve and price variation across markets.
  - Despite majority of treasury bonds being listed on the interbank market, overall turnover of these bonds (including for repos) is higher on the Shanghai exchange than in the interbank market.
  - Corporate bond issuance was tightly regulated until relatively recently (merit-based issuance, annual caps, bank guarantees); 2007 pilot reforms moved toward a disclosure-based system and removed bank guarantee requirements.
  - Interbank commercial paper market reforms: prior to 2005 operated largely as a “bankers acceptance market”; post-2005 issuers with a credit rating and audited accounts able to issue commercial paper; April 2008 market extended to medium-term notes (up to five years), temporarily suspended between July and September 2008.
  - In the first six months of 2009, short-term commercial papers and medium-term notes accounted for almost half of the issuance of nongovernment and non-PBC paper in the interbank market.

#### C. Interbank Offered Rates and Other Interest Rates
- January 2007: PBC established the Shanghai Interbank Offer Rate (SHIBOR) System to build a benchmark yield curve.
  - SHIBOR is calculated as an arithmetic average of renminbi offered rates by participating banks (currently 16), fixing at 11:30 a.m. each business day.
  - SHIBOR extends maturities to one year relative to CHIBOR.
  - SHIBOR is not determined in a funding market and aims to remove the impact of trading volumes on benchmark rates.
- Relationship among short-term rates:
  - CHIBOR, SHIBOR, and the repo rate have followed each other closely in recent years; volatility has increased substantially since late-2005.
  - Greater repo market liquidity and tight relationship between SHIBOR/CHIBOR and the repo imply SHIBOR adds little additional information when interbank trading is active; SHIBOR provides a benchmark when interbank trading is limited.
  - Correlations:
    - High correlation between SHIBOR/CHIBOR and the 7-day repo rate during periods of heavier repo transaction volumes; relationship less uniform at longer maturities (especially 12 months) due to limited liquidity.

#### D. Interest Rates and Monetary Policy
- PBC uses a variety of direct and indirect instruments; open market operations have grown, but reserve requirements and annual bank-by-bank credit caps and window guidance remain important.
- PBC regulates retail interest rates, typically moving them in conjunction with other monetary instruments.
- Chinese monetary policy relies heavily on quantity-based instruments (annual credit caps) and administrative measures (reserve requirements and window guidance).
- Literature findings:
  - Koivu and others (2008) argue observed Chinese monetary growth is consistent with a McCallum monetary growth rule.
  - Laurens and Maino (2007) find the PBC is able to meet its base money target but is less effective at achieving broad money targets or influencing economic growth.

### Key Figures and Tables Referenced (contents only)
- Box 1: Interest Rate Volatility and China’s Reserve Requirements.
- Figures:
  - Figure 1. Interbank Market Activity.
  - Figure 2. Interbank Rate Persistence.
  - Figure 3. Properties of the Standardized Residuals.
- Tables:
  - Table 1. Estimated GARCH Parameters.
  - Table 2. Estimated Liquidity Effects.
  - Table 3. Joint Significance Tests.
  - Table 4. Standardized Residuals: ARCH Tests.

*Source: _wp09189 - References (IMF staff working paper content provided).*

### Box 1. Interest Rate Volatility and China’s Reserve Requirements

### Box 1. Interest Rate Volatility and China’s Reserve Requirements

### Reserve requirement design and implications for interest rate volatility
- Reserve requirements in China must be met strictly on a daily basis; the PBC has not adopted reserve averaging.
- China uses a differentiated reserve ratio system—required reserves from renminbi deposits differ from those from foreign currency deposits.
- To calculate the required value of reserves on any day (for both renminbi and foreign currency deposits), the level of deposits at the end of the previous Xun is used.
  - Each month is divided into three segments (Xuns): the “upper Xun” (first ten days), the “middle Xun” (11th to 20th), and the “lower Xun” (after the 21st).
- Daily reserve ratio formula (as given in the source):
  - Daily reserve ratio = Reserves at close of business / Deposit level at the end of the preceding Xun.
- Banks may hold too few reserve before closing, but they are penalized for not holding sufficient reserves at closing.
- Mechanism increasing volatility:
  - By not averaging reserves over a maintenance period, the additional trading to borrow sufficient funds or lend surplus funds is required every day, thereby resulting in higher average volatility.
  - A longer reserve maintenance period would allow banks to hold fewer precautionary excess reserves and would require less liquidity in the system for a given level of volatility.
  - Central bank liquidity adjustments within a maintenance period in response to shocks to bank liquidity can further limit volatility.

### Stylized model of China’s interbank market — equilibrium properties and comparative statics
- Model setting:
  - Competitive model of N independent price-taking banks.
  - Banks take as given: lending rate (rL), deposit rate (rD), bond yield (rB), reserve remuneration rate (rR), and the interbank lending rate (r).
  - Banks have liquidity preference and face real costs when their reserve target T(αD) is not met; β measures strength of liquidity concerns.
  - Market clearing requires MDBLRRER = − − − − (as in source).
- Result 1:
  - There exists an equilibrium market determined interbank rate, r*, that solves the interbank market clearing condition (3), and r* is a unique function of the administratively set benchmark interest rates, reserve requirement, and government bond issues. The same holds for market determined bond yields.
- Result 2 (comparative statics when lending rate does not exceed its equilibrium):
  - r* is increasing in the lending rate.
  - r* is decreasing in the deposit rate.
  - r* is increasing in central bank bond issuance.
  - An increase in the required reserve ratio has an indeterminate impact on r*, although if banks have a sufficient liquidity preference (1/β > ? — as presented in source conditional), an increase in the required reserve rate will increase r*.
  - If the lending rate exceeds its equilibrium, then r* is decreasing in the lending rate.
- Result 3:
  - If the deposit (savings) market is allowed to clear, then an increase in the deposit rate would increase the interbank rate. All other comparative static results from Result 2 continue to hold.
- Other short-term liquidity shocks (IPO activity, exchange rate intervention, capital inflow) should influence interbank rates as exogenous changes in bond holdings do—raising r* when liquidity falls and lowering r* when liquidity rises.

### Empirical model, data, and specification
- Target rate analyzed: 7-day repo rate (R_REPO).
- Modeling approach: exponential GARCH (EGARCH) with Student’s t-distributed innovations.
- Mean equation specification:
  - rt = μt + √ht vt, with μt modeled by autoregressive terms and exogenous factors Xmt including benchmark deposit and lending rates, open market operations, reserve requirement changes, IPOs (amounts raised in billions of renminbi), and liquidity dummies (day-of-week, proximity to end of month, Chinese New Year timing).
- Variance equation specification:
  - ln(ht) follows an EGARCH form with ARCH (α), GARCH (γ), and asymmetric (λ) terms; exogenous drivers include absolute changes in benchmark interest rates, open market operations, reserve requirement changes and their announcements, IPO leads (+5 and +10 days), and liquidity dummies.
- Data sample used for the main 7-day repo estimation: daily data spanning October 2003 to August 2008; included observations: 1159 after adjustments.

### Key empirical findings — mean (level) of interbank rates
- Persistence:
  - China’s interbank rate is extremely persistent; more than proportionate response to a change on the previous day with subsequent unwinding over days following.
- Administered interest rates:
  - Changes to benchmark interest rates have significant impacts on the interbank rate, with opposite effects for lending and deposit rates and non-monotonic dynamics.
  - The initial direct impact of a 100 basis points rise in the lending rate is to increase the interbank rate by 75 basis points; after three days this direct impact is only 3 basis points.
  - The initial direct impact of a 100 basis points rise in the deposit rate is a 43 basis points fall in the interbank rate; after three days the interbank rate is less than 3 basis points lower (but still significant).
  - Given persistence, the long-run impact of a simultaneous 100 basis point increase in both deposit and lending rates is a 40 basis point rise in the interbank rate.
- Monetary policy instruments (open market operations and reserve requirements):
  - Conditional on the level of benchmark interest rates, changes to policy variables—open market operations and reserve requirements—do not have any significant impact on the level of the interbank rate.
  - Even the announcement of a change in the reserve requirement has no significant immediate impact on the level of the interbank rate (in the mean equation).
- IPOs:
  - IPOs have no significant impact on the mean interest rate (despite expectations that locked-up funds would matter).
- Liquidity effects:
  - Chinese New Year timing has the largest impact on average interest rates: average repo rates are lower during the week before New Year, jump significantly above average on the day before the New Year, and decline gradually in the subsequent week.
  - End-of-month effects: average interest rate is especially higher after the end of the month.
  - Within-week effects: interest rate is significantly lower on Friday than on other days of the week.

### Key empirical findings — volatility of interbank rates
- Distribution and residual characteristics:
  - Estimated degrees of freedom for the error term (T-DIST. DOF) = 2.0630. This implies heavy tails and noisy innovations.
  - Standardized residuals show no remaining volatility clustering in the estimated model.
- Volatility dynamics:
  - Volatility clustering is confirmed with significant GARCH effects; variance is relatively persistent with a half-life of over two weeks.
  - First-order ARCH effect is marginally significant; asymmetric term implies “negative news” has a smaller impact on volatility than news that increases the interest rate.
- Administered interest rates and volatility:
  - Changes in benchmark interest rates affect volatility, though less than their effect on the mean.
  - Changes in the deposit rate tend to reduce volatility; changes to the benchmark lending rate tend to increase volatility within the week around the change.
- Monetary policy and volatility:
  - Reserve requirement changes have a larger impact on interest rate volatility than on the mean; announcement of reserve requirement changes causes a jump in volatility (anticipatory effect).
  - Net liquidity injections through open market operations have little impact on volatility (consistent with OMOs stabilizing interbank rates).
- IPOs and volatility:
  - IPO activity increases volatility ahead of the IPO (when funds are locked up); IPO(+10) coefficient in variance equation = 0.0770.0135.9450.000 (statistically significant).
- Liquidity calendar effects on volatility:
  - Chinese New Year: volatility below average ahead of the holiday but jumps substantially the day before; higher volatility persists through the trading week after the holiday and declines in the second week.
  - Within-month: volatility is significantly higher around the middle of the month and declines as the end of the month approaches; volatility is significantly below average during the first two weeks of the month.
  - Weekday effects: volatility typically highest on Fridays and significantly lower on Mondays.

### Selected quantitative estimates and diagnostics (from Table 1 and tables)
- Mean equation notable coefficients (selected):
  - R_REPO(-1): 1.1780.01388.3510.000
  - Benchmark Deposit Rate (contemporaneous): -0.43420.0962-4.51610.0000
  - Benchmark Loan Rate (contemporaneous): 0.75800.07589.99620.0000
- Variance equation notable coefficients (selected):
  - C_var: -0.9040.219-4.1250.000
  - ABS(RESID(-1)/@SQRT(GARCH(-1))): 1.7411.0211.7060.088
  - RESID(-1)/@SQRT(GARCH(-1)): 0.6890.4061.6980.089
  - ln(GARCH(-1)): 0.5940.0698.5740.000
  - ln(GARCH(-2)): 0.3410.0685.0110.000
  - IPO(+10): 0.0770.0135.9450.000
  - RR: -0.0120.002-4.7620.000 (reserve requirement contemporaneous effect in variance equation)
  - RR Announcement: 2.5321.0572.3960.017 (announcement effect on volatility)
- Model fit and diagnostics:
  - Included observations: 1159 after adjustments
  - T-DIST. DOF = 2.0630.07627.1060.000
  - R-squared = 0.838
  - Adjusted R-squared = 0.831
  - S.E. of regression = 0.363
  - Durbin-Watson stat = 2.064
  - F-statistic = 46.0420.000
- Joint significance tests (selected totals from Table 3):
  - Mean equation: Before Chinese New Year total impact = -0.40875.4067.65E-15
  - Mean equation: After Chinese New Year total impact = 0.16057.0924.84E-11
  - Variance equation: Change in deposit rates (all lags) total impact = -6.36739.8344.91E-07
  - Variance equation: Change in loan rates (all lags) total impact = 10.94514.7260.022
  - Variance equation: Anticipated reserve requirement change (all lags) total impact = 1.96349.5707.48E-07

### Policy implications and recommendations
- Short-term interbank lending rates are not currently an independent benchmark for asset pricing or an independent indicator of macroeconomic or financial conditions because they are materially driven by administered interest rates.
- Further liberalizing interest rates would allow the interbank rate (and other interest rates) to better:
  - Provide essential price signals.
  - Better allocate capital.
  - Strengthen tools for macroeconomic management.
- Potential effects of liberalization:
  - Further interest rate liberalization may increase volatility of interest rates after liberalization, depending on post-liberalization conduct of monetary policy.
  - If short-term interbank rate becomes a target for monetary policy, volatility may decline.
  - Even if volatility rises, it would reflect greater responsiveness to fundamentals (liquidity and risk) rather than to changes in regulated interest rates—strengthening price signals.
- Preconditions and safeguards:
  - Liberalization requires strengthened supervision and monetary policy formation.
  - Without strengthened supervision, liberalization could lead to excessive lending and pressure on credit quality and banks’ profitability.
  - If liberalization is accompanied by heightened supervision and strengthened monetary policy, further liberalization is unlikely to create unnecessary instability.

*Source: Box 1, “Interest Rate Volatility and China’s Reserve Requirements,” _wp09189 (IMF).*

### References

### References

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*_wp09189 - References_*

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