New instrument will allow market forces to have greater influence in determining interest rates.

China has taken a giant step toward freeing interest rates, with the central bank introducing a new instrument to the interbank market, which lets the market set the rates.

Banks were able to issue interbank negotiable certificates of deposit as of Monday, the People's Bank of China said on its website.

The interest rate on the new instruments will be determined by the market, with the Shanghai Interbank Offered Rate to be used as a reference. Regular bank deposits are subject to an interest-rate cap in China, so the new negotiable CDs will initially, be available to fund managers and participants in the interbank market, but not to individuals or financial enterprises.

"This move marks another important step for overall interest rate liberalization," said Lu Hongjun, president of the Shanghai Institute of International Finance.

With the IBNCD, banks will have to negotiate the cost of lending among themselves, and thus provide a clearer picture of the cost of capital in a market-driven environment.

The maximum maturity for fixed-rate IBNCDs is capped at one year, with additional terms of one month, three months, six months and nine months, while maturities for adjustable-rate CDs are required to be longer than one year, with one-year, two-year and three-year terms. The minimum investment for a single IBNCD will be 50 million yuan ($8.2 million), according to the PBOC.

The PBOC also ordered banks to disclose their annual issuance plans, and it said that the outstanding value of interbank CDs may not exceed the annual quota at any time during the year.

"It benefits liquidity management of banks, especially small and medium-size banks, as they need to plan long term and avoid blind pricing. It also helps commercial banks with their capital management, reducing the cost of liability," Lu said.

Given that all kinds of short-term interbank borrowing and lending methods are already in place, and short-term Shibor rates already reflect their pricing to a large extent, the announced liberalization of interbank CD rates "serves as a formalization of largely existing instruments and practices", Harrison Hu and Wang Tao, economists with UBS China, wrote in a note Monday.

During the liquidity crunch this past June, the Shibor hit record highs with the overnight rate surging to 13.4 percent and the seven-day Shibor rising to 11 percent.

Analysts said the next step in interest-rate deregulation would be extending the IBNCD market to corporate and individual investors, offering higher interest rates to individual savers than they would get from an ordinary deposit, and liberalizing rates for deposits with terms of five years or longer.

Although the CD will be issued and traded in the interbank market, the list of buyers (or investors) is likely to be quite inclusive, said Ting Lu, China economist with Bank of America Merrill Lynch.

According to PBOC guidelines, the IBNCD can be purchased by members of interbank markets, including banks, most insurance companies, finance companies owned by big corporations, securities houses and fund managers.

"Put differently, although individuals, governments and non-financial corporates are excluded from the IBNCD market, they can indirectly get access via funds and finance companies," Ting wrote.

"The IBNCD market paves the way for introducing NCDs. The latter opens to individuals and non-financial institutions, and is considered the most important step in fully realizing free interest rate,s" said Lu Hongjun.

Banks and financial institutions' pricing abilities will now improve, he added. Furthermore, a deposit insurance system should be put in place before the deposit rate ceiling is scrapped.

Some big banks' net interest margin may be affected, while nimbler, better managed banks could seize the opportunity to expand their client base, he said.

Some privileged State-owned enterprises might pay higher funding costs and earn less on arbitraging.

Chinese savers, who already have seen a long-overdue jump in returns on their deposits and quasi-deposits in bank-issued wealth management products and money market funds, are unquestionably the winners of the IBNCD through access to funds (including MMFs), BofA Merrill Lynch's report said on Monday.