A Quantitative Evaluation of Interest Rate Liberalization Reform in China

Based on the characteristics of monetary policy and term structure of bond yields, this paper proposes an interest rate model to evaluate the consequences of interest rate liberalization in China. Our empirical results show that bench- mark interest rates and expected inflation are strongly correlated, although the relationship between expected inflation and market interest rates of all terms is relatively weak. Additionally, our model provides a superior goodness-of-fit over the predicted mean, the variance and the correlations of treasury bond yields, and the inflation estimated from the proposed model demonstrates more preferable forecasting accuracy by outperforming the results estimated from either Langrun or Baidu CPI index. Our findings suggest that adjustment of benchmark rates and reserve requirement are the most important price-based tools for the central bank to transmit the effects of monetary policy along the yield curve. The development of interest rate liberalization further requires prudential managements by the central bank to focus on short-term interest rate intervention besides policy support, in emphasizing the power of market forces to eventually link the change in market interest rates with economic fundamentals.