A newly constructed complex stands tall in Hefei, capital of Anhui Province. Like many other Chinese cities, house prices in Hefei surged in the first quarter this year.

The People's Bank of China, the central bank, on May 10 raised the deposit reserve requirement ratio for large commercial banks again—by 0.5 percentage points.

This is the third time this year the central bank raised the ratio, and is expected to freeze liquidity of more than 300 billion yuan ($44 billion).

After the adjustment, large financial institutions will be required to put 17 percent of their deposits on reserve, bringing the ratio ever closer to the peak of 17.5 percent in 2008.

Given the buoyant growth in the first quarter, China is showing signs of overheating, said Li Daokui, an advisor to the central bank's monetary policy committee and Director of the Center for China in the World Economy at Tsinghua University. Curbing excessive liquidity and calming down the overheated economy has since become regulators' priority, said Li.

The Chinese economy grew a robust 11.9 percent in the first quarter, accelerating from 10.7 percent in the last quarter of 2009.

Liu Yuhui, a senior researcher at the Chinese Academy of Social Sciences, told Xinhua News Agency that the economy is growing at a faster-than-expected rate, allowing asset bubbles to form.

To prevent a dangerous bubble bust, tightening monetary policies and mopping up excess liquidity have become urgent tasks, said Liu.

Guo Tianyong, Director of the Institute of China's Banking Industry at the Central University of Finance and Economics, said the liquidity management will continue throughout this year to offset the impact of the significant lending spree in 2009.

Siphoning excess liquidity

The central bank's intention is to control the liquidity increase and slow down money supply to maintain stable economic growth and ease the pressures of price hikes and price expectations, said Zhao Xijun, Deputy Director of the Institute of Finance and Securities at Renmin University of China.

Bank lending in the first quarter saw rapid growth. Central bank figures show that new renminbi loans totaled 2.6 trillion yuan ($380.67 billion) in the first quarter. If such growth continues throughout the rest of the year, total loans in 2010 would far exceed the government-set target of 7.5 trillion yuan ($1.1 trillion).

By the end of March, the broad money supply (M2) grew at 22.5 percent year on year—still higher than the normal speed of 17 percent, though the index had slowed for four consecutive months since the end of December 2009.

Moreover, the renminbi counterpart of foreign exchange reserves increased 749.1 billion yuan ($109.68 billion), 2.1 times the added amount as the same period last year. The ratio hike is closely related to the surging counterpart funds, said Lian Ping, chief economist of the Bank of Communications Co. Ltd.

Lu Zhengwei, chief economist at Industrial Bank Co. Ltd., agreed with Lian. The central bank wants to offset money supply increases in circulation brought about by foreign exchange inflows, including the trade surplus, foreign direct investment and international hot money, Lu said. Hot money, in particular, is pouring in, leveraging a risk-free source of profit from an expected rise in the Chinese currency, added Lu.

With China's economy bouncing back, inflation is no longer a theoretical side-effect of the lending surge so far, but a practical concern that needs to be tackled before it spirals out of control.

The consumer price index (CPI), a main gauge for inflation, grew a mild 2.2 percent from a year earlier in the first quarter. "But food prices, a major element of CPI, are braced for a run-up in the upcoming months due to buoyant demands and the drought in south China," said Guo Tianyong.

Meanwhile, the producer price index (PPI) has grown much faster. The PPI, a barometer for inflation at the wholesale level, rose 5.2 percent year on year in the first quarter of 2010. It will only take three to six months for the fast-growing PPI to ripple through consumer prices, so the policymakers need to take preemptive measures against inflationary risks, Guo said.

Dampening the property market

The ratio hike will also give a heavy blow to the white-hot property market. National Bureau of Statistics' data show house prices in 70 large and medium-sized cities surged a record 11.7 percent in March.

The past few weeks have seen the government take every measure possible to squeeze speculators out of the market. Among the most overwhelming policies were tighter mortgage rules, higher requirements for down payments and a stringent clampdown on financing for property developers. The avalanche of new policies is yielding results. The sales volume in April fell as buyers held off on purchasing houses in anticipation of price declines.

By striking the banks' ability to lend, the spike in required bank reserves will further drain life from the property fever, said Chen Guoqiang, Director of the Research Institute of the Real Estate Industry at Peking University.

The psychological impact on homebuyers, in particular, will be overwhelming, and expectations for price declines will take hold, said Chen. In the wake of a government clampdown on the real estate sector, most property developers have held onto peak prices or delayed sales of new houses, with a close watch over market situations. But the ratio hike will only prompt them to take actions to lure buyers either by lowering prices or stepping up promotional offers, added Chen.

Zhao Xijun agreed. Together with several previous austerity measures, the latest ratio adjustment will leave commercial banks little room for lending to property developers, and force the developers to lower prices, he said.

Interest rate hike?

Ba Shusong, a senior researcher at the Development Research Center of the State Council, said the latest ratio hike shows the central bank has no intention to raise the interest rate in the short term.

The central bank has preferred quantitative measures so far this year like open market operations and reserve requirement ratio adjustments, and is hesitant to move on the interest rate and currency exchange rate, said Ba.

"Policymakers will not take their foot off the accelerator since the woes of many crisis-stricken enterprises still need time to heal," said Lian Ping.

Moreover, an early interest rate hike ahead of Western countries could accelerate hot money inflow and disrupt domestic financial stability, he added.

But some experts consider an interest rate hike necessary.

"China still prefers to fine-tune credit conditions and the property market rather than using blunt instruments that impact the entire economy," said Brian Jackson, a Hong Kong-based strategist at the Royal Bank of Canada, in a recent report. "The danger is that the approach will not be enough to keep these price pressures under control, which would then force policymakers to tighten more aggressively later on."

Li Huiyong, an analyst with the Shanghai-based Shenyin & Wanguo Securities Co. Ltd., said a move from gentle tightening to actual interest rate increases will largely depend on whether inflationary expectations become inflationary realities.

Calming down the overheated economy would eventually require serious monetary tightening measures, such as interest rate hikes, said Li.