China took its strongest step toward tightening monetary policy on Tuesday as the world's third-largest economy roars ahead, surprising investors with an increase in banks' required reserves that rocked global financial markets.

The move came just days after China reported robust trade figures and was the first time that the central bank had adjusted the ratio since a cut in December 2008, when it was loosening policy to cushion the economy from the global financial crisis.

The sudden move by the People's Bank of China to boost required reserves came earlier than investors had expected and appeared prompted by concerns that a renewed surge in bank lending was flooding the economy with too much cash, risking overheating and a surge in inflation.

This is exactly what happens with Chinese policy. They say fine tuning. It never happens that way. It's always nothing or boom, Ken Peng, an analyst with Citigroup in Beijing said. When they reach a consensus, it happens very quickly.

The PBOC said it will increase commercial lenders' reserve requirement ratios (RRR) by 50 basis points as of Jan 18, making China one of the largest economies to start rolling back the emergency policies used to combat the crisis fallout.

It caught the market by surprise, Lin Songli, an economist with Guosen Securities in Beijing, said. The action is primarily targeted at curbing bank lending.

China helped pull the global economy out of recession last year, with its double-digit growth giving a lift to Asia and countries that have been able to feed its voracious appetite for commodities from iron ore to metals and crude oil.

Fears that Chinese tightening could take some of the fizz out of the global economic recovery shook financial markets, denting stocks, higher-yielding currencies and commodities.

Britain's top share index shed 1.1 percent by midday as commodity issues and banks dropped sharply. Commodity-linked currencies, including the Australian, New Zealand and Canadian dollars, hit session lows against the U.S. dollar, following a sell-off in gold.

The PBOC announcement underlined the risk tied to those currencies which, along with commodities, rallied for much of 2009 on the view that the global economy was on a recovery path.

The U.S. dollar was given a lift by developments in China, said Camilla Sutton, a currency strategist at ScotiaCapital in Toronto.

Chinese bonds and stocks were expected to take a hit when markets open on Wednesday.

Analysts said the central bank, still cautious about hitting the brakes on the economy too hard, may be hoping that the boost in required reserves will give it some breathing room to wait before raising policy rates.

China is expected to nudge up interest rates midway through 2010, and a Reuters poll last week forecast minimal yuan appreciation over the year.

MANAGING LIQUIDITY

A Chinese central bank official sought to downplay the significance of the bank reserve move, saying it was intended to manage liquidity and ensure stable bank lending.

Our monetary policy stance is still reasonably accommodative and the move is aimed at using quantitative tools to fine-tune flexibly, the official, speaking on the condition of anonymity, told Reuters.

China has long used required reserves for mopping up excess cash in the economy generated by its yawning trade surplus and speculative inflows. As such, it is an important weapon in its arsenal for curbing inflation, which analysts expect to climb to more than 3 percent this year after the country spent much of last year in deflation.

Shi Lei, an analyst at Bank of China in Beijing, said there could be two or three more required reserve increases before June.

The reserve ratio hike is a strong signal the central bank is stepping up efforts to absorb excessive liquidity, Shi said. The hike may drain about 200-300 billion yuan ($29-$43 billion) from the market but it really needs to drain about 700-800 billion yuan.

The RRR increase also followed two other tightening steps taken by the central bank on Tuesday.

The central bank raised the yield on its regular sale of one-year bills by about 8 basis points, the first increase in 20 auctions and higher than forecasts for a rise of 4 basis points.

It also drained a record 200 billion yuan via 28-day bond repurchase agreements, ensuring it will draw net funds from the market this week.

NOTHING, THEN BOOM

Chinese leaders from Premier Wen Jiabao to central bank governor Zhou Xiaochuan have insisted in recent weeks that the country is sticking to its active fiscal and appropriately loose monetary policies.

Few, however, believed that Beijing would allow a repeat of last year's credit boom, when banks answered the government's call to open the floodgates to boost the economy and issued a record of nearly 10 trillion yuan ($1.5 trillion) in new loans.

The RRR increase followed reports that loans surged in the first week of the year to 600 billion yuan, nearly double the monthly average in the second half of last year and standing in sharp contrast to the government's repeated pronouncements that banks need to better control lending.

We have forecast that the government will exit from stimulus policies earlier than scheduled. But this move came much earlier, said Zhu Jianfang, chief economist of Citic Securities in Beijing.

With China's exports growing again and investment inflows also on the rise, he noted that the country was again starting to accumulate more foreign exchange, only adding to the pool of cash sloshing about the economy.

It's hard to tell whether this is the beginning of more tightening steps. But one thing is sure. If forex reserves keep swelling, more will come, Zhu said.

(Editing by Eric Burroughs & Kim Coghill; Additional reporting by Eadie Chen, Kevin Plumberg and Michael Wei)

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