China Money: PBOC signals bank reserve rise, not rate hike

* C.bank pulls back on draining via open market operations

* C.bank appears to prefer quantitative to pricing tools

* That should help ease market jitters of imminent rate hike

* 50-bp bank reserve hike possible soon

* Rate rises more effective anti-inflation tool in long term

By Lu Jianxin and Jason Subler

SHANGHAI, Dec 9 (Reuters) - The Chinese central bank's actions in its open market operations in the last few weeks suggest it could be due for another increase in banks' reserve requirement ratios soon -- and investors should not fret too much about the impact that will have.

The People's Bank of China (PBOC) has all but put its regular money market operations on hold, selling very small volumes of sterilisation paper and thus allowing a net 230 billion yuan ($34.5 billion) in cash to flow back into the system in the form of maturing bills and bond repurchase agreements in the last four weeks.

That stems in part from the difficulty the central bank has had in attracting demand for its bills, as the yields it offers for them at auction have lagged behind the cost of money in the secondary market, where investors have priced in expectations of further interest rate rises.

However, the very fact that the PBOC has held off from increasing bill yields in order to attract more demand suggests that it may be reluctant to raise interest rates at the moment and could instead turn to another tool for draining cash: raising banks' required reserves for the sixth time this year.

Should the PBOC indeed raise required reserves, it should be of some comfort to many investors, because that would crimp banks' ability to lend somewhat but would not have as significant an impact on capital markets and the economy as a rate rise would have.

"The PBOC appears to have used its open market operations to give some indications of the next tightening move," said a senior trader at a major Chinese state-owned bank.

"It apparently doesn't want to be cornered by the market to raise interest rates, but prefers quantitative tools for now."

For an analysis of China's money market [ID:nTOE6B101E]

SHUNNING THREE-YEAR BILLS

The strongest indication from the open market operations that the PBOC might next reach for the tool of required reserves was that it skipped the sale of three-year bills on Thursday, analysts said. [CN/MMT]

The PBOC suspended the sale of three-year bills for the first time since resuming the use of that tenor in April, as market players refused to buy the bills at the low auction yields the central bank insisted on.

Local media, including the official Shanghai Securities News, interpreted that step as meaning reserve ratio increases would become the PBOC's preferred monetary policy tool in the near term, saying the central bank appeared reluctant to raise yields so as to avoid fanning speculation over another rate hike.

In a further sign another reserve requirement rise may be in sight, former deputy PBOC governor Wu Xiaoling said in remarks published on Thursday that the central bank needed to further raise banks' reserves and issue bills to mop up excessive liquidity. [ID:nTOE6B8018]

An approaching flood of cash means that any move by the central bank to force banks to tie up a higher proportion of their deposits as reserves will be mainly meant to prevent liquidity conditions from becoming too loose.

Traders reported decent liquidity in the money market and calculated that around 1.5 trillion yuan in cash would flow into the market in the next several weeks.

That includes cash from maturing PBOC products and around 1 trillion yuan in finance ministry subsidies to provinces and major firms that are typically released at the end of the year.

RATE RISE STILL A POSSIBILITY

"The situation now is that the PBOC must drain a good part of excessive liquidity from the market as early as this week," said Liu Junyu, analyst at China Merchants Bank in Shenzhen.

"As its open market operations have largely lost the function to drain money from the market, it has to use other tools."

Money markets might barely flinch from such a move.

At around 2.5 percent, the weighted average seven-day bond repurchase rate , the key measure of short-term liquidity, has already priced in another 25 basis-point interest rate rise and another 50 bp rise in required reserves, some traders say. [CN/]

Still, the PBOC's need to keep an eye on inflation will mean that another interest rate rise is always a possibility, particularly if November consumer inflation figures to be released on Saturday were to be eye-popping.

Consumer price inflation in November is likely to reach 4.7 percent from a year earlier, topping October's 25-month-high of 4.4 percent, according to a Reuters poll of 36 economists. The official Securities Times, however, said it might be only "a bit" higher than the October reading. [ID:nTOE6B203E] [ID:nTOE6B800G]

Higher inflation has kept real interest rates in negative territory since February, with the one-year fixed deposit rate now at 2.5 percent despite the PBOC's surprise 25-basis-point rate hike on Oct. 19, putting pressure on authorities to ensure depositors' money is not eroded too much.

To Merchants Bank's Liu, that means another rate rise will still probably happen around early next year, though perhaps not imminently.

"Any quantitative tightening will only be an expediency. In this inflationary environment, only interest rate hikes can effectively offset consumer price pressures," he said. ($1=6.66 Yuan)

(Editing by Ken Wills)