China's central bank said last Friday it would raise the share of deposits banks must hold in reserve by half a percentage point.

The increase, effective March 25, is the third this year. The central bank upped the rate, which affects all Chinese depository financial institutions, previously on January 20 and February 18. This latest hike is part of an ongoing campaign by the central bank to fight inflation. The bank raised the ratio eight times last year.

The new effective reserve ratio for Chinese financial institutions will be 20 percent, a ten-year record high and only slightly lower than the rate's historical high in 1984. At the same time, this move indicates the Chinese central bank has less and less wiggle room to engage in quantitative easing measures, because the deposit reserve ratio forces banks to bear higher costs. At 20 percent, the stiff reserve requirement effectively shrinks banks' profit margins.

It is worth noting that even in the wake of turmoil in global financial markets caused by the recent Japanese earthquake, the Chinese central bank has still chosen a contractionary monetary policy. This decision to some degree reflects the bank's "long term perspective" with respect to monetary policy. Moreover, the rate hike shows the Chinese central bank's determination to suppress inflation and manage inflation expectations.

In fact, inflation indicators show Chinese inflation is still in an upward cycle. This is reflected in continually high CPI figures and consecutive months of year-on-year inflation rate growth. The PPI has climbed to its highest level since October 2008, while consumer confidence has tumbled to its lowest point since 1999. Housing data released last week, meanwhile, showed housing prices are continuing their ascent.

The effect on the market of this week's reserve ratio hike can be summed up as follows:

1) The short-term market interest rate may rise. This reserve rate increase will take some 350 billion yuan of market capital out of circulation. Equally notably, the March 25 payment day for this new reserve ratio comes near the end of both the quarter and the month. The combined effect of these factors may lead to a sharp rise of the market RMB interest rate in the short run. The market should pay special attention to the effect of this short term interest rate increase. During this period, market volatility will increase substantially.

2) Bulk commodities and commodity money may suffer shocks. Against the backdrop of G7 foreign exchange market intervention, the Chinese central bank's decision to increase the reserve ratio indicates it does not want to participate in G7 efforts to slow the appreciation of the Japanese Yen. Clearly, the sole starting point for Chinese monetary policy formation remains the domestic economy and inflation rate. Under these circumstances, bulk commodities could continue to depreciate, and commodity money will also lose value.

Similarly, one should note that as part of this campaign against inflation, the use of quantitative tools seems too frequent and inappropriate. As such, the central bank should make greater use of interest and exchange rates to control upward inflationary pressure. Note that the interest rate on one-year Chinese central bank bonds is about 20 basis points higher than the interest rate for one-year fixed savings deposits. This gap probably indicates the central bank is already preparing to increase the interest rate soon. In this contractionary environment, related economic activity may see some deceleration. The RMB's accelerated appreciation will help control imported inflation. Related research shows that if the RMB appreciates 5 percent in 2011, China will save at least 100 billion yuan on purchases of imported iron ore, crude oil and soy beans.

The author is ANZ head of China Economic Research.

(This article was written in Chinese and translated by Matt Velker.)

Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.