Forcing banks to lock up more cash is China's most viable policy option for now as it battles inflation, though that won't shut the door on higher interest rates and faster rises in the yuan.

At the heart of China's latest inflation headache is an economy overflowing with money from booming exports, foreign investment and speculative funds looking for returns, all of which are fuelling a lending binge the government is struggling to contain.

But analysts say China's central bank is hard-pressed for choices as it looks for ways to drain the economy of all the excess cash.

It wants to raise interest rates, but cannot raise them as sharply or as quickly as it needs to because too drastic a move will draw in more hot money and add to the surfeit of cash.

Higher rates also could hurt indebted local governments, something Beijing loathes to see as it is the implied guarantor of some of that debt.

Open market operations, traditionally used by the central bank to drain excess money from the system, have flopped due to tepid demand for central bank bills.

Likewise, the yuan, which can curb imported inflation if it rises, cannot climb fast enough as official fear that sharp appreciation could cripple China's export machine.

That leaves the People's Bank of China with bank reserve requirements, which analysts say could be a fast and direct way of draining money from the Chinese economy, if it is used boldly enough.

It's an effective tool. Compared with interest rate rises, the impact of reserve requirement ratio hikes is more immediate on liquidity, said Dongming Xie, an economist at OCBC Bank in Singapore.

The central bank appears to agree. It ordered banks on Friday for the fourth time in over two months, or the seventh time in a year, to lock more deposits in reserves.

With the central bank vowing to priorities inflation-fighting this year, analysts say the reserve requirement ratio can go as high as 23 percent by December, from a record 19.5 percent now.

IT WORKS, BUT CAN BE BETTER

With global commodity prices tearing higher and record domestic property prices showing no signs of cooling, there is little doubt China needs more forceful policy tightening.

Inflation eased in December from its highest in 28 months in November, but price pressures stayed elevated.

Qu Hongbin, an economist at HSBC, argues the reserve requirement ratio is the most powerful tool as it curbs bank lending, which is key to taming China's inflation.

This is especially since excess reserves kept by commercial banks are at a 15-month low of 1.7 percent, Qu said, in a sign that banks may be holding less reserves to maximize lending.

Every 50-basis-point rise in the reserve requirement ratio forces banks to put 350 billion yuan ($53 billion) of deposits into reserves.

While stricter reserve requirements in the past year did not forestall a ritual lending surge among China's banks this month, analysts say that is due to banks trying to push forward lending in anticipation of tougher official clampdowns later this year.

That banks are holding their breath for stiffer requirements is not a surprise since analysts say the reserve ratio can keep rising so long as it does not hurt bank profits.

And there are few signs of that happening anytime soon, said Stanley Li, a bank analyst at Mirae Asset Management. He said profits at big banks dip just 0.2 percent for each 50 bps rise in the reserve requirement ratio.

The central bank, for its part, is trying to reduce the risk of imposing a one-size-fits-all reserve requirement on banks. It wants to tailor requirements based on the size of a bank, its capital ratio and loan growth, but has not given further details.

Smaller banks face liquidity pressures if they continue to raise requirement reserve ratio across the board, so they are considering introducing differentiated reserve requirement ratios, said Tang Jianwei, an analyst at Bank of Communications.

Compared with other emerging economy giants, China's present reserve requirement regime is less discriminating.

In India, banks need to hold 6 percent of deposits in cash and 24 percent in approved government securities such as bonds, which pay better returns than interest earned on reserves.

In Brazil, requirements are differentiated depending on whether deposits are demand or time deposits.

NOT THE ONLY TOOL

Problems with open market operations in recent weeks further argue for the use of bank reserves.

The central bank's attempts to sterilize capital inflows by selling bills have flopped because banks would rather hold out for possible rises in benchmark rates than buy low-yielding bills.

Sales floundered so badly that instead of draining cash, the central bank ended up adding cash to the economy in every week since November 15, to a total sum of 375 billion yuan.

Dariusz Kowalczyk, a senior economist and strategist at Credit Agricole CIB, noted that the central bank pays 1.62 percent for cash held in reserves, compared to yields of 2.7 percent in its sales of one-year bills.

They can withdraw liquidity with reserve requirement hikes or money market operations. But money market operations are sold at yields below market rates, so they are unable to drain money, said Kowalczyk.

It's cheaper to do reserve requirements hikes and it will continue.

To be sure, few believe the Chinese central bank should ignore other policy tools, such as gradual rises in interest rates and the value of the yuan.

With one-year deposit rates at 2.75 percent, below the 2011 inflation target of 4 percent, benchmark interest rates still need to climb to anchor inflation expectations, analysts say.

It's a relatively effective tool, But the reserve ratio requirement has limits and it does not help to eliminate the negative real interest rate, said Dong Tao, chief economist for non-Japan at Credit Suisse.

China needs more than just quantitative tightening.

(Editing by Kim Coghill)

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