China's move to allow more competition in its state-dominated banking sector revives a reform shelved for nearly a decade and defies expectations of a policy freeze before leadership change this year.

In what analysts see as a significant step for economic reform, the central bank will allow banks more flexibility to set interest rates, effectively introducing greater competition and improving allocation of capital.

Just two months ago, Chinese Premier Wen Jiabao railed against the "monopoly" of big banks, which have reaped healthy profits and funnelled cash to state enterprises while shunning more nimble private firms.

In a policy announcement on Friday -- made along with the first interest rate cut in over three years -- banks can offer a 20 percent discount on loans against a government-set benchmark and a 10 percent premium on deposits.

"The People's Bank of China has resumed its interest rate liberalisation process, stalled since 2004," said Qu Hongbin, co-head of Asian economics research for HSBC in Hong Kong.

"This... also implies that Beijing is getting ready to step up its pace of financial reforms."

The change means banks can attract borrowers with cheaper loans while drawing deposits by offering higher interest rates. Previously, lending rates only could float just 10 percent below the set rate.

Such a reform was not expected to happen ahead of a once-in-a-decade leadership shake-up in the autumn, with expectations the government would avoid change to preserve political and financial stability.

"We didn't get it until now, when arguably the political background is less certain," Ken Peng, senior economist at BNP Paribas in Beijing, told AFP.

"Generally, people didn't expect such momentous change until after the 18th Party Congress," he said, referring to the communist party meeting which will usher in the country's new leaders.

For years, officials have pledged to further liberalise rates. The last moves date to 2004, when the government removed a ceiling on lending rates and scrapped a floor on deposit rates.

There are signs of movement on other economic reforms. A month ago, China began allowing its currency to trade in a wider band against the US dollar, on the long march for the yuan to become freely convertible.

"As China has put internationalisation of the renminbi (yuan) on the agenda, it must also carry out internal liberalisation," Liao Qun, chief economist at Citic Bank International in Hong Kong, told AFP.

Some analysts argue the time for interest rate liberalisation is ripe, even as the world's second largest economy slows. More competition should drive lending rates lower, helping pump more funds into the flagging economy.

"These policies are positive for China's long-term growth, as financial resources can be allocated more efficiently," said Zhang Zhiwei, chief China economist for Nomura Securities.

"But they also bring risks to financial stability."

Banks will be the biggest losers as the reform will eat into their profits by narrowing the spread between lending and deposit rates. Publicly traded Chinese banks fell on Friday on those worries.

The Industrial and Commercial Bank of China (ICBC) -- the country's biggest lender -- tumbled 4.9 percent in Hong Kong trading while another state banking giant, China Construction Bank, fell 4.0 percent.

With the potential for risk to the banking system, China will move carefully to implement further reforms, analysts said.

"Of all the structural changes in the rebalancing process, interest rate liberalisation may be the hardest to implement," Chris Leung, senior economist at DBS in Hong Kong, said in a recent report.

"The government must have a strong will, whilst banks must be willing and able change the way they assess credit risks and grant loans."