Banking on a high household savings, a possible hike in interest rate will give domestic residents more interest income on their savings, which will provide consumers more spending power, said Qu Hongbin, an economist with the Hongkong and Shanghai Banking Corp.

Though basic economics also says that a rise in interest rate may have substitution effect, which encourages people to spend less and save more, it does not apply to China as historical data show that domestic consumption growth is not sensitive to interest rates, said Qu.

Since 1996, the People's Bank of China has lowered the one-year benchmark deposit rate from 11 percent to 2 percent. In comparison, the real annual consumption growth has remained flat at around 6 percent for the past six years.

"A 100 basis points rate hike would boost the household sector's interest income by 100 billion yuan (US$12.05 billion), an income effect that would dilute the substitution effect," said Qu.

Consumers in China have accumulated more than 11 trillion yuan in bank savings, far exceeding their total debt of around 1.4 trillion yuan.

"For such people, higher rates would mean extra interest income, offsetting the substitution effect on consumption growth," said Qu.

Meanwhile, as the Chinese government is taking steps, such as tighter monetary policies, to cool the economy, bank lending may slow, which will create asset quality problems at commercial lenders, said Moody's Investors Service in a report.

"Bank earnings could slow and non-performing loans rise, although different banks will fare differently," it said.

"Bank lending has funded much of China's rapid economic expansion of the last few years. Foreign direct investment inflows and a propensity to save mean a continued build-up in deposits, leading to pressure on the banks to keep lending," said Wei Yen, vice president of Moody's Investors Service.

The ratings agency said raising rates to slow demand is a double-edged sword.

"If the central bank raises the base lending rates, it could slow demand from the fast growing coastal cities," it said.

(eastday.com May 10, 2004)