China will take a gradual approach to yuan reform and will not be in a hurry to free up deposit rates offered by banks, as it seeks to rebalance its economy and deepen its financial markets.

Beijing doesn't plan a one-off revaluation of the currency and will instead allow market forces to determine the yuan's value, Zhou Xiaochuan, governor of the People's Bank of China (PBOC), was quoted in a magazine interview.

Banks will soon be allowed to set their lending rates, but liberalizing deposit rates will depend on the strength of banks and other lenders, Caijing magazine quoted Zhou as saying.

A flexible yuan and a freer interest rate regime will help Beijing boost domestic demand in the economy, which relies too much on investments and exports at a time when the global economy is battling a slowdown.

Since we have decided on the gradualism approach (for the yuan), and we have been implementing that for years, we are almost there and we must stick to the path, Zhou said.

A 2.1 percent revaluation of yuan against the dollar in July 2005 had been successful as its impact on the domestic economy was smaller than feared and at the same time relieved international pressure, but another similar move is not on the cards, he added.

There will be no need to leap forward at one time and opt for gradual reform at another, Zhou said.

The interview, which is published on the latest edition of Caijing, was conducted apparently before the central bank's move last weekend to widen the yuan trading band.

Zhou, who had been talking about band widening for months before the bank finally made the move, said it will make the yuan exchange rate more flexible, adding that the PBOC will intervene less in the currency market.

The market supply and demand will play a bigger role, and the central bank will only intervene when the exchange rate movement is out of the normal range -- the frequency of our intervention will be less and the way of doing it will be more flexible as well, Zhou said.

INTEREST RATE REFORM

Its approach to freeing interest rates will however be influenced by the risk management systems of banks and capital inflows, Zhou was quoted by the magazine as saying.

China currently sets a floor for lending rates and a ceiling for saving rates. While lending rates are likely to be freed soon, deposit rates will continue to be regulated, he said.

The worst banks are often the boldest in offering high deposit rates. Without proper capital constraint systems, competition will just become chaotic, Zhou added.

Moreover, a free interest rate regime will also put one third of China's rural credit-co-operatives, which have a capital adequacy ratio below 4 percent, at risk, he said.

Zhou said the roadmap of China's interest rate reform will start from giving greater pricing power to good banks, namely banks with sound financial conditions and internal control systems.

But he noted that the reform process will depend on China's economic conditions.

If we push ahead reforms when the inflation level is low, commercial banks will have pressures from both sides on pricing, or they may set interest rates higher or lower (than benchmark), Zhou said.

But if the inflation level is high and people have price rise expectations, banks, provided they are allowed to set prices freely, will set their prices one-way, which in turn may make people angry and impede or terminate the whole reform process, Zhou said.

(Reporting by Zhou Xin and Nick Edwards; Editing by Ramya Venugopal)

China