Further hikes in the RRR (reserve requirement ratio) and interest rates are expected in the first half of this year on the mainland after the People's Bank of China's (PBoC) latest monetary tightening move on last Friday.

Judging by the tone and recent actions of the central government, I believe more restrictive measures will be put in place in the coming months, including two more rate hikes of 25 basis points (bp) each - one in early March and the other in early May. There are also likely to be two more RRR hikes of 50 bp each in late March and late April.

The central bank announced that RRR for all banks would be raised by 50 bp, effective Feb 24, raising the rate to 19.5 percent for the larger banks. This is the second RRR hike this year following the move on Jan 14 (effective Jan 20), and the fifth RRR hike since last November when the PBoC began its current policy tightening cycle.

Flows of liquidity into the banking system at the close of the lunar new year holidays provide the strongest rationale for the additional RRR hike this month close on the heels of the rate hike on Feb 9. Expiration of the PBoC notes has also contributed to rising liquidity. The PBoC's recent sterilization exercise is intended to manage flows of liquidity into the economy.

In terms of the impact on banks' ability to lend, Friday's action has had a similar effect to the 50 bp hike earlier in January, removing around 360 billion yuan of base money from the banking system. With surging inflationary pressure reflected by the January CPI inflation rate of 4.9 percent and above-target January M2 growth of 17.2 percent, controlling liquidity in the banking system is critical if the PBoC is to tame inflation.

The central government will continue to use the "three rates" -interest rate hikes, RRR hikes and yuan appreciation - to control inflation. As the government has already invoked two of the three rates - yuan appreciation and an interest rate hike on the first day of work after the lunar new year holidays, the market was not surprised to see the PBoC call upon a RRR hike to further control liquidity within the banking system as a counter to inflation.

The RRR hike is still an effective monetary tool. A report issued by the State Administration of Foreign Exchange stated that in 2010, China had inflows amounting to $35.5 billion of "hot money". This marked the first time China had ever released an official estimate of short-term speculative capital inflow to the public. The dilemma in using interest rate hikes to curb liquidity is that their use attracts liquidity from abroad due to the low-interest-rate environment in developed countries. RRR hikes are the final recourse in the battle against soaring inflation, representing the weapon of choice in the PBoC's multi-pronged approach to managing speculative capital inflows.

The author is an associate director and economist at CCB International Securities Ltd. The opinions expressed here are entirely his own.

(HK Edition 02/22/2011 page2)