China''s central bank needs to sharpen its knives. Monetary tightening measures have so far failed to rein back runaway economic growth or stop share prices from reaching vertigo-inducing heights. Further measures expected in the second half of 2007 are likely to have only a limited cooling effect. Standard & Poor''s Ratings Services believes that a judicious mix of interest, exchange, and reserve rate adjustments, as well as direct administrative measures, will be the key to dampening unsustainable growth and safeguarding long-term stability. A heavy-handed approach, however, could have a significantly negative impact on the economy.

We maintain our positive outlook on the banking sector over the medium term. Reform initiatives remain on track and credit profiles continue to improve. Nevertheless, small banks--in particular small city commercial banks--are likely to face more pressure than their stronger counterparts over the near term as a liquidity tightening cycle weeds out weak corporate players.

Cuts Haven''t Hit Home
China''s central bank, the People''s Bank of China, has turned on the sprinklers several times this year. On May 18, 2007, it raised the one-year benchmark deposit rate by 27 basis points (bps), the one-year benchmark lending rate by 18 bps, and the reserve requirement ratio for banks by 50 bps to 11.5 per cent. The central bank also widened the Chinese renminbi''s daily trading band against the U.S. dollar to 0.5 per cent from 0.3 per cent. Since April 2006, the deposit rate has risen by 81 bps and the lending rate by 99 bps.

The latest interest rate changes signal the authorities'' wish to harness emerging inflation and rein in surging share prices. But more than baby-steps are needed. Slightly higher lending rates won''t discourage most firms from expanding capacity, given nominal annual GDP growth of more than 10 per cent in recent years.

The ear-popping returns for equity investors over the past 18 months mean that few will be tempted to sell up and place their assets in bank deposit accounts, particularly at a time when inflation expectations are gathering momentum. China''s Consumer Price Index stood at 3 per cent in April 2007, compared with a marginally higher one-year benchmark deposit rate of 3.06 per cent after the recent interest rate hike.

Rising Reserve Ratio Mops Up Liquidity
We expect the Chinese renminbi to appreciate only mildly over the next six months, despite the widened daily trading band. This is unlikely to dent growth. The central bank''s reluctance to expose the export-dependent economy to excessive currency risk and its desire to stave off carry losses on its foreign assets limit the scope for appreciation.

The spread between the yield on long-term US Treasuries and the interest rate on required bank reserves is only about 300 bps. The central bank could suffer losses if the Chinese renminbi appreciates significantly more than 3 per cent a year. The reserve ratio should therefore remain the major tool to sterilize liquidity flooding into the market. The series of bank reserve ratio hikes have been effective in absorbingliquidity generated from new inflows of foreign exchange and containing sterilization costs. Liquidity is still too high, however, and further hikes in the reserve ratio could hit small banks.

Banks with narrow customer funding bases, particularly small city commercial banks, could face increasing pressure to make asset composition adjustments as the required reserve ratio continues to
climb. The average deposit reserve ratio of city commercial banks was only about 11.4 per cent at the end of 2006. We expect a significant slowdown in loan growth in this segment, which will have a knock-on effect on interest income generation.

Intervention Needs To Be Handled Carefully
A heavy-handed application of direct measures to restrain investment growth and asset prices could have a significantly negative impact on the economy. Direct administrative and tax measures are abrupt; their impact unpredictable. Policy missteps could trigger a sharper slowdown than intended. A significant weakening of borrowers'' credit profiles would hit the banking sector particularly hard.

Our positive outlook is supported by strong reform momentum and an ongoing improvement in the sector''s credit profile, primarily driven by improving financial positions, corporate risk cultures, and risk management capabilities.

Non-interest income exhibits strong growth momentum. We estimate the sector''s non-interest income will grow at a sustained rate of more than 20 per cent for the next five years. The impact of interest rate hikes on banks'' real funding costs will likely be limited. Higher deposit rates should be partly offset by shorter deposit maturities, as savers won''t want to tie up their cash for too long in a rising interest rate environment. In addition, the deposit rate on demand deposits, which account for about 40 per cent of the sector''s total deposits, remains unchanged.

While banks'' asset quality and profitability could take a near-term knock, the economy would be hit far harder over the long term if rapid growth is left unchecked. The central bank therefore needs to show its claws.