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* Nikkei hits highest since June 5 * Easing worries about China banking system helping mood * Strong industrial production data, CPI lift market * All sectors in positive territory By Ayai Tomisawa TOKYO, June 28 (Reuters) - Japan's Nikkei share average rose 3.3 percent to a three-week high on Friday morning, helped by optimism that the Federal Reserve will not rush to rein in its stimulus measures and by encouraging domestic economic data. Gains in Asian markets also lifted the mood, sending the Nikkei up 435.26 points to 13,648.81 at the midday break, its highest since June 5. The Nikkei has dropped 0.9 percent this month so far, while it is up 10 percent for the second quarter. Japan's core consumer prices were flat in May compared with a year earlier, marking the first time they have stopped falling in seven months, government data showed on Friday. Meanwhile, Japanese industrial output rose 2.0 percent in May from the previous month, up for the fourth consecutive month, a sign that a pick-up in exports is underpinning factory output and the broader economy. The figure was better than a market consensus of a 0.2 percent increase. "Investors are cheered by the better data and see that Abenomics is being effective for the economy," said Takuya Takahashi, an analyst at Daiwa Securities. Analysts said that gains in Asian markets including Shanghai shares are also underpinning sentiment as concerns about a potential banking crisis in China continued to ease. China's one-week cash rate fell to its lowest since last week's sharp credit squeeze and stocks rose as much as 2 percent on Friday morning, with banks having little trouble securing funds to meet their end-of-quarter requirements. "Investors were relived that one of the biggest worries is receding," said Hiroichi Nishi, an assistant general manager at SMBC Nikko Securities. The Topix gained 3.2 percent to 1,133.66. The weak yen is also helping the mood, and exporters attracted buyers with the dollar up at 98.81 yen, from around 98.40 yen in early Asian trade. Toyota Motor Corp gained 2.2 percent, Sony Corp added 2.5 percent, and Nikon Corp advanced 2.7 percent. Panasonic Corp rose as much as 6.2 percent after the company sold about 60 percent of its holdings in other firms to repay debt. The benchmark Nikkei has dropped 14 percent since reaching a 5-1/2-year high on May 23, hurt by slowing growth in China, fears of a pullback in U.S. stimulus and disappointment over the Japanese government's recently announced growth strategy. However, it is still up about more than 30 percent this year on the back of Prime Minister Shinzo Abe's expansionary policy, weaker yen as well as the Bank Of Japan's sweeping monetary easing. Market players said that the Nikkei may remain resilient as overseas headwinds such as worries about the U.S. Fed's plan to trim its stimulus and fears for the stability of the Chinese banking system are easing. But they added that volume may stay subdued in the absence of firm catalysts. Volume on the Topix at the midday break was around 1.6 billion shares, on track to undershoot last month's average daily volume of 4.67 billion shares. "Buying may be contained in short-covering," said Mitsushige Akino, chief fund manager at Ichiyoshi Asset Management. "The market wants to see April-June results, and investors want to see the results of the upper house election to trade proactively." On Thursday, U.S. stocks rose after three Fed policymakers sought to downplay the notion that the central bank would bring an imminent end to its bond-buying programme. All of Topix's 33 subsectors were in positive territory.