China's increases in bank reserve requirement ratios (RRR) have become a key part of its arsenal in managing massive fund flows and investors should not be concerned that such policy tightening will choke growth.

International investors who may have been spooked by the Shanghai composite's 3 percent fall on Monday and volatility in commodities prices after Beijing lifted RRRs for a seventh time in the past year should be heartened that such policy moves are not aimed at cooling the country's economy.

RRR rises instead are being employed to do the job that central bank selling of short-term debt used to do: managing the amount of money sloshing around China's financial system.

The People's Bank of China announced a 50-basis point rise in RRR for all banks after Chinese markets closed on Friday, which will take effect on Thursday and drain an estimated 360 billion yuan ($55 billion) from the market.

But because of maturing PBOC bills and repos, the central bank will automatically inject 229 billion yuan into the market this week and another 110 billion yuan next week.

The PBOC then said on Monday, without explanation, that it would temporarily suspend bill sales this week and refrained from using bond repurchase agreements to drain money on Tuesday.

Although the central bank did not say RRR changes would replace bill sales, Friday's hike is set to drain most of the money from maturing bills and repos in the coming two weeks.

The PBOC sent two signals by the latest RRR hike, said economist Wang Haoyu at First Capital Securities in Shenzhen.

The most important is that this RRR hike is a replacement of open market bill sales instead of a monetary policy tightening. On top of that, the PBOC hopes to tell the market that banks have lent too much at the the start of this year.


Changes in how Beijing manages the massive liquidity in its financial system and capital inflows chasing yuan appreciation mean that the People's Bank of China (PBOC) is increasingly making RRR its weapon of choice for fund drains.

As bill sales in the open market have become either symbolic or have been occasionally suspended since November, overall liquidity drains have not increased much despite the RRR hike.

The PBOC has conducted a slew of tightening moves, including two unexpected interest rate rises, since mid-October to fight consumer inflation that jumped to a 28-month high of 5.1 percent in November. December data will be announced this week.

Investors are therefore nervous of further rapid fire PBOC policy tightening measures and that has pushed secondary market yields of the central bank's bills sharply higher.

Without Friday's RRR hike, the market would be awash with cash, though. The PBOC is reluctant to let its bill auction yields be hijacked by higher secondary market yields so that it is unable to sell large quantities of bills.

More importantly, the central bank appears to be capitalising on the opportunity to launch long-awaited reforms in China's rigid interest rate system.

Market watchers say the central bank may be slowly shifting to use bill sale yields at auctions to signal its future interest rate intentions, a step toward transparency in an otherwise murky and centralised financial system.

Along these lines, the central bank has also signalled that it would usher in reforms in China's bank reserve requirement system by introducing a dynamic RRR system.

Under the proposed changes, the PBOC may judge how much a bank can lend by looking at its capital adequacy ratio, liquidity conditions and provisions for bad loans.

Last week, the market expected the PBOC to use selected rises in RRR for some banks to help clamp down on excessive early-year lending.

For now though the PBOC is either not sufficiently prepared to launch the dynamic system or bank lending has not reached levels deserving regulatory penalties, traders said.

Chinese banks doled out 500 billion yuan ($76 billion) in new loans in the first week of January in a customary lending frenzy at the start of the year, putting pressure on the PBOC to tighten policy to cap inflation, although the central bank has not yet signalled when it will raise rates again. ($1=6.6 Yuan)