Mild China rate hike seen keeping market jittery

By Lu Jianxin - Analysis

SHANGHAI (Reuters) - China's latest interest rate rise was too mild to ease investor worries about more tightening and will weigh on bonds, but Chinese stocks should rise after initial volatility.

China's stock market, which rebounded on Friday after a deep correction over the past six weeks, may also be hit next week by an announcement made later that a tax on interest income would be cut.

However, signs of strong first-half corporate earnings were expected to outweigh worries about macroeconomic measures.

The central People's Bank of China announced after the markets closed it would raise its one-year benchmark lending and deposit rates by 0.27 percentage point, effective from Saturday. It was its third rise this year aimed at curbing excess liquidity.

Shortly afterwards, the official Xinhua news agency said China would reduce the withholding tax on interest income on bank accounts to 5 percent from 20 percent from August 15, with the aim of making bank deposits more attractive as inflation gathers steam.

"Even combining the two measures, the latest tightening is far too mild to help check the overheating trend in the economy, leaving substantial leeway for the government to take further measures," said economist Wang Haoyu at First Capital Securities.

More tightening measures appear likely.

"It's not the end of this year's tightening. Many in the market expect another two 27 basis-point rate hikes this year, and so bond yields will continue to move at high levels," added Zhao Wuling, senior money market analyst at Everbright Securities.

Several traders said yields on central bank bills with maturities of less than one year would rise 5 to 10 basis points on Monday, with others forecasting medium- and long-term government bond yields would rise by 10 basis points or more.

STOCKS VOLATILE

Fund managers and analysts said China's main stock index would fluctuate sharply around the psychologically important 4,000 point level next week.

The Shanghai Composite Index .SSEC, which closed up 3.73 percent at 4,058.853 points on Friday, would likely open down 1 to 2 percent on Monday but could quickly rebound and rise as much as 2 percent the same day, analysts said.

"It is clear to the market that the regulator is not going to let inflation go up and let the market become too hot," said Gabriel Gondard, deputy chief investment officer at Fortune SGAM Fund Management Co. Ltd.

"So I think the first impact is going to be on the psychological side rather than on money flows. Real interest rates are still negative," Gondard said. "We have to keep in mind that the main driver of the market is corporate earnings growth."

The latest rate hike and the reduction in the tax on interest income will raise China's interest rate for one-year yuan deposits to 3.16 percent from 2.45 percent, but that is still below the 4.4 percent consumer price inflation rate in the year to June.