The People''''s Bank of China, the country''''s central bank, said on Saturday 10 November that it would raise the cash reserve ratio (CRR) requirement for banks by half a percentage point, to 13.5 per cent. The move is aimed at cooling China''''s rapidly expanding lending and capital markets growth

The hike in the CRR, which is the amount of capital domestic banks are required to hold against liabilities, will take effect on 26 November. It is the ninth time Beijing has lifted the key benchmark rate this year. China has a severe excess liquidity problem.

China''''s last CRR hike took effect on 25 October. On the same day, Beijing announced that GDP growth had eased, and markets saw the largest one-day fall in a three-month period, when the Shanghai Composite Index dropped 4.8 per cent.

More to come
Many analysts and traders see the hike as a defensive move, to help prevent monetary conditions from loosening in the coming months. They say it aims mainly at the October trade surplus, expected to be announced on Monday 12 November, of a record $30 billion - easily exceeding the previous peak of $26.9 billion in June. The CRR rise is expected to drain about 190 billion yuan ($25.6 billion) from the money market.

The authorities also seem to be preparing for 1.5 trillion yuan in central bank bills that mature between December 2007 and the end of March 2008. The maturing bills could create a huge glut in money supply, unless action is taken to offset their impact.

China''''s Shanghai Composite Index, which closed on Friday at 5,315 points, has risen 190 per cent this year. Money managers have expressed concern lately about the possibility of excessive loans in the domestic economy. The week also saw the Chinese yuan rise to 7.46 against the dollar, its highest level ever.

A rising yuan?
There is also speculation that China will permit substantially faster appreciation of the yuan against the dollar in coming months. This is seen as a deliberate inflation-fighting step.

Previously, authorities kept domestic monetary policy and foreign exchange policy separate. But last week''''s third-quarter policy report said the central bank would "strengthen the coordinated use of interest rates and the exchange rate to help stabilise expectations of inflation". Analysts see this as an important policy shift.

From the start of 2007 to mid-October, the yuan rose at an annualised rate of 4.7 per cent against the dollar. Since then, it has climbed at a rate of nearly 20 per cent, to Friday''''s record post-revaluation high.

The rapid pace is not expected to continue. Currency traders predict an appreciation of around 7 per cent over the next 12 months; but much of that may be concentrated in the next few months.

Lid on liquidity
In the money market, the CRR hike may help keep bill yields under upward pressure and put a new floor under the key measure of short-term liquidity, the seven-day bond purchase rate.

Economists are already forecasting another potential rise in CRR requirements this year. They also say that day before yesterday''''s move sets the stage for an interest rate hike. The country''''s central bank has raised interest rates five times this year as it tries to rein in China''''s red-hot economy and hold off inflation.

All eyes are now on the statistics from the national bureau, scheduled to come out sometime this week. China''''s growth is 11.5 per cent this year. May economists feel the present CRR and interest rates will not be enough to cool China''''s inflation.

The weighted average seven-day repo edged down to a three-week low of 2.66 per cent last week. Traders think the central bank may be seeking to establish a high unofficial floor of 3 per cent.

No gain without pain
But the move will not be without pain. Big Chinese banks still have plenty of money, but smaller banks have suffered in the last few months from monetary tightening and funding squeezes caused by big equity offers.

The reserve hike is bound to worsen things, not least because of a parallel campaign by authorities to persuade banks to cut back their corporate lending growth through ''''window guidance'''' - advice given in private meetings with commercial bankers.

The CRR hike will mean that big banks will likely reduce lending to small banks further. Analysts say smaller banks to have to resort to selling bills to raise money. How this will affect the Chinese stock market, whose main stock index - which more than doubled this year to a record high last month - plunged 8 per cent last week, its biggest weekly drop this decade, remains to be seen.

Many investors have already discounted the possibility of an interest rate increase this month, so the CRR rise may not push stocks down further. In any case, the market is still set to consolidate in November, as the losses suffered last week and the prospect of further monetary tightening will probably keep stocks subdued for a while.