* Raising bank reserve ratio is clearest China tightening yet
* China hopes to tighten softly, avoid draconian steps later
* Monetary conditions very loose, need to be managed
* Gradual tightening likely unless prices spike
* Inflation will determine pace and level of tightening
By Simon Rabinovitch and Aileen Wang
BEIJING, Jan 13 (Reuters) - Global markets were rattled by China's surprise increase of banks' required reserves, but investors should be thankful that Beijing is not asleep at the wheel of a very fast-moving car.
On the contrary, China is trying to prolong its cycle of strong growth and steer clear of a boom-bust scenario.
The 50-basis-point rise in the reserve requirement ratio (RRR) announced late on Tuesday is, first and foremost, a tool for the central bank to manage cash sloshing about the Chinese economy, locking up about 300 billion yuan ($44 billion) that banks would otherwise be able to lend.
But its greater significance is that it is China's most unambiguous tightening of monetary policy since the world's third-largest economy shot back towards double-digit growth from a near standstill in late 2008.
Hence the fears that Beijing is about to launch a cycle of aggressive tightening that will weigh on the Chinese economy and, by extension, the China-powered global recovery.
Further tightening steps -- more bank reserve increases, higher interest rates and even allowing some appreciation of the yuan -- are widely expected to come. Lost in the market panic, though, are two essential points.
First, Chinese monetary conditions remain quite loose and officials have repeatedly insisted that they are not about to choke off a recovery that they fret is still not on solid ground.
Second, by taking pre-emptive steps now to nip overheating, inflation and asset bubbles in the bud, Beijing is hoping to avoid draconian tightening down the road.
"We see this adjustment as a positive step given the rapidly increasing inflationary pressures in the economy," said Yu Song, an economist at Goldman Sachs in Hong Kong. "It highlights that the government is well aware of the inflationary pressures in the economy and is very flexible in changing its policy stance."
Although the reserve requirement increase caught global investors' attention, China had already made a series of smaller moves. The central bank also raised one-year bill yields on Tuesday and drained a record 200 billion yuan ($29.3 billion) via 28-day repurchase agreements.
WHY NOW?
Nevertheless, Beijing raised required reserves earlier than the market expected, setting off speculation about what pushed it to act so soon. Several factors probably worked together.
Chinese banks reportedly issued 600 billion yuan in new loans in the first week of the year, about double their monthly average in the last half of 2009. By freezing more of their deposits as required reserves, Beijing was making clear that it does not want a repeat of their unprecedented lending surge a year ago.
There is also reason to believe that inflows from abroad have been picking up, generating more liquidity above and beyond that from the banks' nearly 10 trillion yuan in lending last year.
"With exports recovering and RMB appreciation expectations rising, FX inflows will only get larger, requiring increased sterilisation efforts by the People's Bank of China," Wang Tao, China economist at UBS, said in a note. "In other words, the central bank has to keep running to stand still."
Inflation figures for December, likely to be published next week, may also contain a nasty surprise, which could have cemented China's will to act now.
Consumer prices rose 0.6 percent in the year to November after spending much of 2009 in deflation. Analysts polled by Reuters forecast that the December reading jumped to 1.5 percent.
"The increase in required reserves is mainly targeted at curbing inflation expectations," said Nie Wen, an economist at Fortune Trust in Shanghai. "I don't think the central bank will take aggressive tightening action until more figures in the coming months show steep inflation growth and a sustainable improvement in exports."
STILL LOOSE
Expectations that more tightening steps will follow are, of course, predicated on the view that monetary conditions in China are still very loose.
The government is believed to be targetting about 7.5 trillion yuan in new lending this year. With as much as 1.5 trillion yuan of last year's loans still sitting unused in corporate bank accounts, credit in the economy should remain ample throughout this year.
It is also important not to overstate the power of reserve requirements. In China's last tightening cycle, from mid-2006 to mid-2008, the central bank raised the ratio 18 times. That did not stop the stock market from soaring until late 2007 and inflation from climbing to a decade-high in early 2008.
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Moreover, commercial lenders' excess reserves at the central bank stand at more than 3 percent. The required reserve ratio, which is 16 percent for big banks after Tuesday's increase, could be lifted further without unduly crimping lending abilities.
In tamping down on the money supply, Beijing is of course also trying to take moderate rising asset prices.
But it has already done well in keeping the stock market range-bound since August by approving a flood of new listings. And while sky-high property prices remain a worry, a series of tax and land-use measures have started to bite with transaction volumes falling in recent weeks.
So it is consumer price inflation that will be the key determinant of whether China becomes more aggressive, said Dong Xian'an, chief economist at Industrial Securities in Shanghai.
"If consumer prices go up strongly in the coming months, we cannot rule out the possibility that the central bank will adopt more severe tightening measures," he said.
"But I think the overall price level throughout most of 2010 will be controllable, leading the central bank only to take gradual and relatively mild steps." ($1=6.826 Yuan) (Editing by Ken Wills & Kim Coghill)