CHINA'S latest step to deregulate and cut interest rates is positive to its sovereign credit rating but is negative for local banks as the move erodes profits, Moody's Investors Service said yesterday.

Last Thursday, the People's Bank of China allowed lenders to be more flexible in setting borrowing and lending rates. They are allowed to set a deposit rate up to 10 percent above the benchmark deposit rate and lend at a discount of as much as 20 percent from the benchmark lending rates.

"By allowing banks to offer higher deposit rates, household incomes will rise, which will lead to higher levels of private consumption. A more sustainable growth model will enhance economic resilience, supporting sovereign creditworthiness," Moody's wrote in a report published yesterday.

Moody's said flexibility is much needed in reforming the nation's financial system, although the PBOC still has sway over the interest rates by setting reference for the banks.

Meanwhile the PBOC cut interest rates last week for the first time since December 2008 amid a slowing economy.

The report also noted that liberal interest rates will enhance a more market-based and efficient allocation of capital, which has a positive impact on the nation's sovereign credit rating.

However, the agency said a wider official interest rate range and lower interest rates are credit negative for local lenders due to declining margin and higher risks.

"A gradual erosion of the protected loan-to-deposit spreads via a rate deregulation is a negative development for Chinese banks" whose profitability will be hurt, Moody's said.

It also said banks will face challenges to managing risk if they compensate by raising their risk profile.

Source:shanghaidaily