More monetary tightening is expected to follow China's increase in bank reserve ratios to record highs, keeping the money and stock markets under pressure and possibly accelerating appreciation of the yuan.
The central bank said on Saturday that it was lifting the proportion of deposits that commercial banks must keep in reserve by 0.5 percentage points, to 13.5 percent for big banks.
The hike brought the ratio into uncharted territory for the first time in nearly two decades. The previous ratio of 13 percent had been in effect from September 1988 to March 1998.
Many analysts and traders see the hike as more of a defensive move, designed to help prevent monetary conditions from loosening in the coming months, than a dramatic new tightening step.
It seems to aim mainly at the October trade surplus. The money absorbed by the reserve ratio rise will just offset the amount which the central bank needs to sterilize from one month's surplus, said Gene Ma, head economist at China Economic Monitor.
A Reuters poll of economists gave a median forecast for the October surplus, expected to be announced on Monday, of a record $30 billion -- easily exceeding the previous peak of $26.9 billion in June.
The reserve rise, to take effect on November 26, is expected initially to drain about 190 billion yuan ($25.6 billion) from the money market.
Wu Haijun, analyst at Power Pacific Corp of Canada, said the authorities also seemed to be preparing for 1.5 trillion of central bank bills that will mature between December and the end of March 2008. The maturing bills could create a glut of money without action to offset them.
But analysts think the reserve rise will be followed in quick succession by other tightening steps, including this year's sixth rise in benchmark interest rates -- probably in November -- and faster appreciation of the yuan.
All other monetary tools, including interest rate hikes and yuan appreciation, are likely to be used as well, said Ma.
YUAN APPRECIATION ACCELERATES
The reserve rise is expected to fuel speculation that China will permit substantially faster appreciation of the yuan against the dollar in coming months -- not just because of the dollar's global weakness, but as a deliberate inflation-fighting step.
Previously, authorities kept domestic monetary policy and foreign exchange policy largely separate, changing one or the other but not both simultaneously to avoid destabilizing markets.
But in last week's third-quarter policy report, the central bank vowed to strengthen the coordinated use of interest rates and the exchange rate to help stabilize expectations of inflation -- something which analysts saw as an important shift.
From the start of 2007 to mid-October, the yuan rose at an annualized rate of 4.7 percent versus the dollar. Since then it has been climbing at a rate of nearly 20 percent, to Friday's record post-revaluation high of 7.41.
That pace is not expected to continue in the long term. But currency traders are now predicting appreciation of around 7 percent over the next 12 months -- and much of that may be concentrated in the next few months.
In the money market the reserve 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.
The weighted average seven-day repo edged down to a three-week low of 2.66 percent last week. Traders think the central bank may be seeking to establish an unofficial floor for it as high as 3.0 percent.
While big Chinese banks still have plenty of money, smaller banks have suffered in the last couple of months from monetary tightening and funding squeezes caused by big equity offers.
The reserve hike may worsen their plight, especially as it coincides with a 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 reserve ratio rise comes on top of these instructions on lending. So big banks will likely reduce lending to small banks further, said a trader at a European bank, who expects smaller banks to have to resort to selling bills to raise money.
The latest monetary tightening comes at a sensitive time for the stock market, where the main stock index more than doubled this year to last month's record high but then plunged 8 percent last week, its biggest weekly drop this decade.
Since many investors had feared the harsher step of an interest rate increase this month, the reserve rise may not push stocks down further. Wu at Power Pacific Corp predicted the market might rebound 1 or 2 percent on Monday.
But any rebound will not be large and the market is still set to consolidate in November, he said, adding that the losses suffered last week and the prospect of more monetary tightening would keep stocks subdued for a while.
(Editing by Andrew Torchia, Greg Mahlich)