China takes aim at volume, not price, of money

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BEIJING, Nov 20 (Reuters) The prospect of further weakness in the dollar and of more U.S. interest rate cuts has triggered a tactical shift in the way China is tightening monetary policy.

After strong economic data for October, markets last Friday were confidently forecasting the sixth interest rate rise this year to brake growth and tame inflationary expectations.

Higher rates are still on the cards before the end of the year, economists say. But, after comments by central bank governor Zhou Xiaochuan and Premier Wen Jiabao, they now expect the People's Bank of China (PBOC) to tighten policy in the near term mainly by reducing the amount of money in the banking system rather than increasing its price.

''They've changed their tune a little bit,'' said Dwyfor Evans with State Street Global Markets in Hong Kong.

''What we're seeing here is probably a move towards currency appreciation and towards administrative measures and a move away from interest rates.'' Raising Chinese rates at a time of falling U.S. rates would increase the cost to the PBOC of mopping up the torrent of cash pouring in from China's huge trade surplus; it would also make it more attractive for international investors to find ways to sidestep China's capital controls and park money in the yuan.

Tao Wang, chief economist at Bank of America in Beijing, said she was surprised at the recent failure to increase rates.

''My guess is that the reluctance to raise rates -- and they know better than anyone else that it's not an effective tool to control lending -- is that it has negative side effects,'' she said. ''That could be a key concern.'' RATE RISE ON HOLD Speaking in Cape Town, Zhou ruled out a rate rise ''next week'' but said there was still plenty of room to increase required reserves; banks must already tie up a record 13.5 percent of their deposits with the central bank instead of lending them out.

In parallel, the authorities are cracking down on the extension of net new bank loans for the rest of 2007, a step that economists say will be much more effective in choking off credit than raising interest rates by the usual 0.27 percentage point.

At 7.29 percent for one-year loans, borrowing costs are low compared with China's 15 percent nominal gross domestic product growth and near 40 percent profit growth.

Tim Condon, head of Asian research with ING in Singapore, said that news of the lending crackdown had muddied the rates outlook in the near term; at the end of last week he, too, had seen an imminent rate rise as probable.

''To the extent that they're worried about accelerating growth in the monetary and credit aggregates, it's going to diminish that worry,'' he said, referring to the lending squeeze.

''And if that's why they were raising rates, well, then they're not going to have to raise rates,'' he said.

As well as lengthening shadows over the U.S. economy, which China's Ministry of Commerce fears could hit exporters hard, Frank Gong with JP Morgan said recent softness in the stock market had also diminished the urgency of raising rates.

Zhou and other central bank officials had been stressing the need to lift real interest rates out of negative territory to discourage depositors from taking their money out of the bank and punt in the stock market. One-year certificates of deposit earn 3.89 percent, well below October's 6.5 percent inflation rate.

However, the main index of domestically listed A-shares has dropped over 13 percent since Oct. 16.

''While concerned about the risk of an A-share bubble, authorities would not want to see them tumble either,'' Gong said.

TIGHTENING STILL NEEDED Evans with State Street said he did not think Beijing was necessarily targetting levels in the equity or real estate markets.

''But I think they're concerned that continued dollar weakness, continued FX reserve accumulation and the impact that has on money supply growth and liquidity is potentially increasing issues in 2008 regarding domestically generated inflation,'' he said.

Zhou signalled that Beijing was not too worried about inflation for now, saying it was mainly food-driven and that there were signs it would ease next year.

However, Yiping Huang, chief Asia economist at Citigroup in Hong Kong, said the PBOC remained primarily concerned with keeping the real deposit rate positive in principle, containing inflation and reining in the trade surplus.

Further, even with the stock market experiencing a mild correction, the authorities still had to be vigilant about rises in the prices of other assets, especially property, as investors looked for other places to park their money.

That concern was underlined on Monday by Premier Wen, who in a speech in Singapore said that the biggest worry he had in terms of residents' lives was rising housing prices.

''Monetary tightening is still needed, going forward,'' Citi's Huang said. ''If a correction happens in one place, the money can still flow somewhere else. So overall, you still need to manage the liquidity conditions and the cost of capital.'' REUTERS BJR ht1447

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