More moves to mop up liquidity are expected on the mainland in its fight against surging inflation, as the central bank's latest tightening move last week sent forth a signal that the country's "prudent" monetary policy hasn't changed in the wake of the disruptive events in Japan.

The People's Bank of China (PBoC) announced last Friday that the required reserve ratio (RRR) for all commercial banks would be raised by 50 basis points (bps), effective March 25. This will be the sixth RRR hike since October 2010 and the third this year, raising the RRR to 20 percent for the larger banks and to 18 percent for other banks.

The surprise RRR hike (instead of a rate hike) came on concerns over liquidity flows after the disastrous earthquake in Japan. I had previously forecast a rate hike of 25bps and a RRR hike of 50bps in March, with the rate hike preceding the RRR hike.

The PBoC is concerned that the Bank of Japan's huge spending on post-earthquake reconstruction may lead to massive amounts of liquidity pouring into China's banking system. In my view, a RRR hike of 50bps is an appropriate monetary tool to stave off possible inflows of liquidity.

The underlying objective of draining liquidity is to avoid surging inflation. The move to raise the RRR by 50bps will soak up excess liquidity of around 350 billion yuan. Higher-than-expected February CPI inflation of 4.9 percent tells us that inflation remains a threat to the economy. I expect the CPI to peak at 5 percent in the second quarter. So controlling liquidity in the banking system is critical if the PBoC is to tame inflation.

Will Japan's earthquake affect China's "prudent" monetary policy? The answer is "no". China followed India in tightening its monetary policy last week despite the fact that the earthquake hit global financial markets and disrupted supply chains. As Premier Wen Jiabao has identified taming inflation as a top economic priority, I do believe the tragic events in Japan will not do much to change the course of China's "prudent" monetary policy in 2011.

The RRR remains an effective monetary tool. As a massive amount of central bank bills are due in March and over the next several months, acceleration in the sale of sterilization debt and RRR hikes will help prevent excess liquidity in the banking system. I believe RRR hike remains the government's policy tool of choice for controlling liquidity; moreover, I expect it to be used alternatively with interest rate hikes to control inflation.

Further RRR hikes and rate hikes are expected in the first half of this year. Judging by the tone and recent actions of the central government, I believe further tightening measures will be brought to bear in the first half of the year. I expect two more rate hikes of 25bps each - one in early April and another in May. There is also likely to be one more RRR hike of 50bps in late April.

The author is an associate director and economist at CCB International Securities Ltd. The opinions expressed here are entirely his own.

(HK Edition 03/22/2011 page2)