China was Grinch-like in raising interest rates on Christmas Day, but in fact investors have good reasons to be grateful.

The government provided much-needed reassurance that it was determined to rein in price pressures -- and a salutary reminder that more yuan appreciation than the market expects could be in the offing.

The key take-away from the rate increase, China's second in just over two months, is that Beijing is softly, softly pulling every tightening lever within its reach.

The central bank will only raise rates in small and steady increments in the coming months, said E Yongjian, an analyst at Bank of Communications in Shanghai.

The yuan will also steadily climb next year, serving as one tool to alleviate the inflationary pressure, he said.

Ba Shusong, an economist with the Development Research Center, a think-tank under the cabinet, provided a neat summary of the government's strategy for taming consumer prices, which rose 5.1 percent in the year to November, a 28-month high.

The rhythm of policies will become regular, something we call the simultaneous implementation of the three rates: banks' required reserve ratios, interest rates and the exchange rate, he said in comments published in the Economic Information Daily, a Chinese-language newspaper, on Monday.

Even as a move on Christmas Day was a surprise, the 25-basis point increase in benchmark one-year interest rates announced on Saturday was in line with a majority view in a Reuters poll earlier this month. Most economists had predicted that China would raise rates by the end of this year and the consensus was for two more increases in the first half of 2011.

Normally apprehensive of tightening, investors had begun to worry about the opposite in China -- that the government was delaying the inevitable for too long and that the ultimate reckoning with inflation would be more painful as a result.

As long as tightening is not too much lagged behind the curve, market sentiment should improve gradually in the first half of 2011, Shen Minggao, an economist with Citigroup, said in a research note.

APPRECIATION NOW?

Shen echoed Ba in saying that faster yuan appreciation would play a bigger role in the campaign against inflation.

That view has been notable by its absence in financial markets of late. Investors are pricing in just a 2.4 percent rise in the yuan versus the dollar over the next year, according to offshore forwards. In 2007-08, when China was last battling inflation, the government let the currency climb more than 7 percent in six months.

Although price pressures are less serious now, it would not be surprising to see a mini burst of yuan appreciation in the coming months.

In fact, an informal poll of onshore currency dealers over the last week, showed many of them expect the yuan to gain roughly 6 percent over the next year, hitting 6.25 per dollar by the end of 2011.

Some traders thought the central bank hinted at this on Monday by nudging the yuan up against the dollar.

Letting the yuan rise right after a monetary tightening step is a rare phenomenon, as the government typically hopes to curb speculation of yuan appreciation right after such a step, said a senior trader at a major Asian bank in Shanghai.

The government appears thus to be giving a signal that it will use both interest rates and the exchange rate to fight inflation, including imported inflation.

In its gradual tightening over the past year, the central bank has made little use of currency appreciation and interest rates, relying mainly on quantitative controls. It has restricted commercial lending and officially increased banks' required reserves six times.

SHIFT IN FOCUS

Now, both the currency and interest rates may be about to get somewhat greater prominence.

Required reserves are already at a record high of 19 percent for big banks and can only go up so much higher. Moreover, the central bank has struggled to sell bills in regular open-market operations in recent weeks because of rising yields.

Inflationary pressure is high and the scope for other measures is limited, so it's normal for them to raise interest rates, said Wang Hu, an economist at Guotai Junan Securities in Shanghai. Raising rates will help curb inflation expectations. If the central bank resists raising rates, more bank deposits will flow into asset markets, he said.

Whatever the method of tightening, the implementation is sure to conform to the gradualism that has been the hallmark of China's policy setting over the past three decades.

Although it has threatened to impose price controls if necessary, the government is increasingly confident of its chances against inflation. Food prices, the root of the problem, have ebbed in recent weeks.

Premier Wen Jiabao said on Sunday that Beijing would be able to keep inflation in check, as steps taken in the past month, including curbs against speculation and monetary tightening, had started to produce results.

(Additional reporting by Aileen Wang and Lu Jianxin; Editing by Tomasz Janowski)

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