To stabilize economic growth, the Chinese government recently initiated various stimulus measures. This could be a short-term positive for China bank shares, in our view. In addition, it appears increasingly likely the government may lower interest rates, on top of "window guidance" and reserve requirement ratio cuts, to encourage borrowing and to force bank lending.

These should be positives for an economic rebound. However, we believe resorting to investment stimulus and rates cuts are contrary to what China needs in the long run, namely economic rebalancing to consumption-driven, higher equilibrium interest rates and deleveraging of the economy.

While bank shares rallied post the 2008-stimulus announcement, they underperformed the market both in terms of share prices and valuations since the start of the 2008 stimulus. We see a short-term upside in China bank shares, but maintain our 12-18 month range-bound 2-Neutral sector view. A major downside risk to this short-term outlook is further deterioration of the Europe debt crisis.

Bank loans are at the core of the date about China's economic growth. In 2012, banks have been "reluctant" to give loans quickly, and loan growth has been driven by short-term loans and discounted bills, due to: 1) weak loan demand for large banks because of infrastructure/property controls; 2) loan-to-deposit ratio constraints at small banks, 3) bank concerns about credit risks; and 4) no strong incentive for banks to pursue loan growth.

There is an increased likelihood of interest rate cuts. Rate cuts (symmetrical or asymmetrical) may force banks to pursue loan volume to compensate for narrowing net interest margins as banks try to protect profit growth. This was the reason behind very rapid loan growth in 2009 and could again occur. Mid-to-long-term corporate loans may gradually pick up with accelerated investment growth.

However, loan growth in May could still be challenging, but in June should be helped by strong deposit growth at the quarter-end.

Resorting to investment stimulus may cause short-term gains but long-term pains for Chinese banks shares. Rate cuts and narrowing net interest margins may not deter banks' rally in the near term as was the case in 2009. However, from a long-term financial sector rebalancing perspective, interest rate liberalization (rate hikes instead of rate cuts), we think, is the way to correct capital misallocation. A new round of stimulus, if excessive, could also lead to more non-performing loan concerns and add to financial sector distortion down the road.

The article was written by Barclays analysts May Yan, Sean Hung and Shujin Chen. The opinions are their own.