China Pulls Back on Stimulus Effort

By JAMES T. AREDDY

Bloomberg

A customer uses an ATM at a branch of the Agricultural Bank of China in Beijing.

SHANGHAI -- China backed off its giant stimulus effort Tuesday by reducing the amount of cash banks have available to lend, in the clearest signal yet that the government is worried that the nation's credit binge now risks igniting inflation.

China's stimulus program, led by a government order to banks in late 2008 to flood the economy with cash, helped to carry China through global financial turmoil. The Chinese economy has rebounded strongly, with property prices sizzling in major cities, a recovery in exports and, recently, a rush of inward investment. The economy is now poised to surge past Japan this year as the world's second-largest economy after the U.S.

But deflecting inflation has become a growing priority for Beijing. Tuesday's move by the People's Bank of China, the country's central bank, appeared to economists as a significant, sooner-than-expected step away from the policies that have encouraged easy bank credit.

Starting Monday, most commercial banks will be required to put 16% of their deposits on reserve and not lend the money, an increase of a half percentage point. In recent years, the reserve requirement rate has emerged as a primary tool for the central bank to fine-tune monetary policy.

Also Tuesday, the central bank raised the yield it pays on its one-year bills, a move also designed to siphon cash out of the financial system by making the debt securities more attractive for banks to buy.

The change potentially sets China on a path for other bigger adjustments, including official interest-rate increases later in the year. "The reserve requirement often seems to function as a leading indicator, partly because it's a good signaling point to the markets," said Mark Williams, senior China economist at Capital Economics Ltd. in London. "From that perspective, it's a turning point."

The move rattled global markets, sending investors to safer-seeming assets as they worried that China's economy might not be as robust as expected this year. The dollar rose against riskier-but-higher-yielding currencies such as the South African rand, and U.S. government Treasurys also rallied. Stock prices in Europe fell in the wake of China's announcement, which came after Chinese markets closed.

As it orders banks to lock up more cash, Beijing is demonstrating it is on guard against asset bubbles that can accompany inflation. The initial impact may be to knock back China's stock market, which gained 80% last year, as shown by the Shanghai Composite Index. The market appeared not to expect the reserve-ratio increase, jumping 1.9% Tuesday.

A sharp spike in bank lending starting in late 2008 was the central element to Beijing's effort to escape the global financial crisis. The forceful policy allowed companies to gorge on easy credit and speculate on properties and stocks. It may have also encouraged wasteful spending: The government recently said that over 106,000 officials were punished last year for misconduct, including abuse of economic-stimulus money.

Economists estimate that the Chinese economy galloped ahead at close to 10% in the latter part of 2009 and will prove to have exceeded the 8% growth target for the year that appeared questionable early in the year. While China's early recovery underpinned the global economy, it is now facing the fallout from its success earlier than other major economies.

News in recent days that China overtook Germany as the world's largest exporter in 2009 has sharpened political calls for Beijing to lift the value of its currency, a move that would make its exports more expensive while making goods from other countries more competitive. China now faces mounting protectionist pressures.

By tapping on the monetary brakes, Beijing has underscored how its biggest challenge is to rein in its massive banks, which traditionally make most of their loans in the early part of the year.

When the new reserve-requirement rate takes effect Monday, it will effectively lock up 300 billion yuan, or around $44 billion, that might otherwise have been lent, according to Stone & McCarthy Research Associates China analyst Tom Orlik.

In a note, Mr. Orlik said the move is a particularly "powerful signal" of the central government's determination to tighten monetary policy. He said Beijing may have acted earlier than expected due to signs that local banks were rushing out loans in the first days of January in anticipation that the government would tighten lending.

China last changed the reserve requirement and official lending rates in late December 2008. But those moves were to lower the rates as part of broad credit-easing program that included sharp drops in official interest rates. The last increase in reserve requirements took place in June 2008.

With an economy that is led largely by investment, China faces a balancing act in bringing down lending without choking off growth. Analysts predict official interest rate increases won't occur until much later in the year, although Tuesday's move led them to move up estimates of when the first increase will occur.

Bankers expect Chinese authorities to target roughly an 18% increase in bank loans this year, slowing from the 30%-plus surge in 2009, with total new lending of around 7.5 trillion yuan compared with more than nine trillion yuan last year.

The reserve requirement increase follows a number of less clear indications that the easy monetary policy was being reconsidered. In recent days and weeks, China began removing certain incentives for property buyers: in a rare press interview, Premier Wen Jiabao referred to "quickly" rising real-estate prices and fresh inflation expectations; and the central bank permitted yields on its debt instruments to notch higher.

None of the recent moves appears to erase Beijing's contention that the global economy remains too fragile for it to completely remove stimulus policies. Paul Cavey, a Macquarie analyst, said Tuesday's changes mark "stage one of China's exit from the emergency policies" of late 2008.

At this point, inflation is under control, although the consumer-price index turned positive for the first time in November and the December number is expected to show a jump -- an expectation fed by the latest sign of official concern about inflation.

Economists say headline inflation rates in China are likely to rise rapidly in the next few months, even if only because current prices are being compared with the extremely depressed levels of early 2009.

—Andrew Batson and Victoria Ruan contributed to this article.

Write to James T. Areddy at james.areddy@wsj.com