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China reserve move could stoke yuan expectations

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China reserve move could stoke yuan expectations
Sun May 2, 2010 6:52pm IST

By Jason Subler and Lu Jianxin

SHANGHAI (Reuters) - China's central bank said on Sunday it would raise banks' reserve requirement ratios by half a percentage point from May 10, the third such move this year, as it seeks to fend off property and consumer inflation.

Following are potential market implications from the move, including for expectations that the People's Bank of China (PBOC) could act soon to let the yuan start strengthening again against the dollar:

* The fact that the central bank has chosen another reserve requirement increase to drain cash from the financial system could suggest that it intends to hold off raising interest rates, even as it faces signs of overheating.

* Even though the move is mainly about managing liquidity, it could feed into expectations that the PBOC is likely to let the yuan start appreciating again before it raises interest rates, as it is not expected to employ both tightening steps around the same time.

* Offshore forwards could therefore price in greater expectations of yuan appreciation. The forwards -- used to hedge against and speculate on yuan moves in offshore markets -- implied on Friday that the yuan would appreciate by 3.23 percent against the dollar over the next 12 months.

* Chinese markets will have to wait until Tuesday to respond to the news, as the country is observing the May Day holiday on Monday.

* When it reopens, the stock market could come under further pressure, as the reserve requirement rise shows authorities' determination to keep asset and consumer prices from getting out of hand. The main stock index fell 7.7 percent in April, largely on falls in bank and property shares, because of the government's barrage of measures to contain property speculation.

* Hong Kong shares, particularly of Chinese banks, could also come under pressure on concerns over lower lending.

* The reserve requirement increase will likely take the domestic bond market by surprise, as many had expected the central bank to continue to drain liquidity through its regular open market operations. The middle range of the yield curve could rise, though expectations that interest rate rises could be postponed could mean the long end of the curve will remain flat.

* Commodity and energy markets, which responded strongly to the reserve requirement rises earlier in the year, could experience jitters again after this ratcheting up of tightening measures by China. The backdrop of the Greek debt crisis adds further uncertainty to the market outlook.

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