China's central bankers have found a new way of keeping banks from lending too much, a step Beijing hopes will help it tackle the country's persistent inflation woes.

Sources told Reuters on Friday that China has ordered banks to include margin deposits as part of required reserves set aside at the central bank to rein in excess liquidity.

This would pull an estimated 800-900 billion yuan ($125-141 billion) of deposits from the banking system, or the equivalent of between two and three 50-basis-point increases in the reserve requirement ratio.

Here are some questions and answers about the move:

 

 

HOW DOES IT WORK?

To control bank lending, China forces banks to turn over a certain percentage of their deposits to the central bank for safekeeping.

Previously, banks only had to turn over part of their traditional bank deposits. Now they also have to include margin deposits -- the security deposits customers put down in order to receive banker's acceptance, letters of guarantee and letters of credit.

China's top five commercial banks and the Postal Savings Bank of China will feel the pinch of the new requirement first. They need to hand in 21.5 percent of their margin deposits within two months from Sept 5, over three stages.

Smaller banks will turn over 19.5 percent of margin deposits over five months from Sept 15, in six stages.

The top five commercial banks in China are Industrial and Commercial Bank of China , China Construction Bank , Agricultural Bank of China , Bank of China and Bank of Communications .

WHAT DROVE THE MOVE?

In a word, inflation.

Though few market watchers see China's price rises getting out of hand, inflation hit a three-year high of 6.5 percent in July and is expected to stay elevated in coming months.

The latest move shows Beijing is still in tightening mode. But unlike a traditional increase in the reserve requirement ratio, it allows China to curtail shadow loans, or off-balance-sheet lending banks use to beat credit controls.

Chinese banks have lately been pumping out loans through bank acceptance bills, trust loans and designated loans, none of which show up on their balance sheets.

These loans accounted for 27 percent of China's total social financing -- a broad group of credit that includes on- and off-balance-sheet loans, and bond and equity issuance -- in the first half of 2011, up from 12 percent in 2008.

The shadow loans have made Beijing's credit curbs less effective and distort bank balance sheets by understating risks.

By refraining from publicly announcing its order to banks to lock up margin deposits, Beijing appears to be worried about roiling markets still skittish after Standard & Poor's historical downgrade of U.S. debt rating.

 

IS POLICY TIGHTENING ENDING?

Having raised interest rates five times and the reserve requirement ratio nine times since October, analysts think China is near the end of its tightening cycle.

Policymakers are eager to avoid a repeat of 2008, when Beijing was criticised for over-tightening policy before the global financial crisis struck.

But it is too early to declare a victory on inflation.

Speculative money flowing into China to chase its economic growth, relatively higher interest rates, and a rising yuan could fuel price pressures. Beijing also worries that a potential third round of U.S. quantitative easing would worsen matters.

Indeed, if inflation for August is higher than expected, analysts say China might raise interest rates once more.

Chinese policymakers have no intention of loosening monetary policy any time soon for fear of a further rise in property prices and the consumer price index, said Ting Lu, an economist at Bank of America-Merrill Lynch.

 

HOW ARE BANKS AFFECTED?

Even though smaller banks will turn over a smaller proportion of their margin deposits, they will be hit harder.

Margin deposits comprised nearly 12 percent of their total deposits in 2010, compared with just 4 percent for China's top banks, according to Deutsche Bank.

Deutsche Bank said the new rule would shave 1.4 basis points off the net interest margins of China's four biggest banks in 2011, and dent their net profit after tax by 0.8 percent.

But the impact on smaller banks could be three times bigger, with net interest margins narrowing by 3.6 basis points in 2011, and net profits after tax shrinking by 2.3 percent.

China's Big Four banks reported record six-month profits in recent weeks, with double-digit earnings increases, amid better pricing power for loans and fast-rising fee income. [ID:nL4E7JP22E} ($1 = 6.387 Chinese Yuan)