CHINA'S recent directive to banks to expand the base of deposits they keep as reserves boosts the fight against inflation and capital risk, but economists said the unexpected move may spark the end of the current tightening stance.

The People's Bank of China, the central bank, has ordered commercial banks to include margin deposits related to bank acceptance bills, letters of credit and letters of guarantee, as part of their reserve requirement, according to its circular. Previously these items were exempt.

The new order is expected to take effect today.

Margin deposits are deposits required by banks in return for issuing credit instructions and providing guarantees for clients.

"The new measures, to some extent, caught the market unexpectedly," said Tommy Xie, an OCBC Bank economist. "China's liquidity has turned neutral to tight recently from the previously ample level after more than one year of tightening measures."

China's top six banks - Industrial and Commercial Bank of China, Bank of China, China Construction Bank, Agricultural Bank of China, Bank of Communications and Postal Savings Bank of China - have been ordered to meet the latest reserve directive in three installments in each of the next three months. The other banks will be allowed to meet the directive in six installments in the next six months. (See charts)

According to PBOC data, outstanding margin deposits as of July totaled 4.4 trillion yuan (US$688 billion).

China has raised the reserve requirement ratio on banks 12 times since January 2010, with six increases this year alone. Big banks now face a record reserve-requirement ratio of 21.5 percent while smaller lenders have to put aside 19.5 percent of their deposits with the central bank.

A quick calculation based on the size of margin deposits and the reserve ratio shows the PBOC's latest directive will withdraw about 900 billion yuan of liquidity from the capital markets. Economists said the impact will be most severe on small- and medium-sized banks, where margin deposits account for nearly 14 percent of total deposits. That compares to less than 4 percent for the big banks.

The smaller banks are the main financing channel for smaller businesses that form the backbone of employment in China.

"The banks' cost of providing credit to small and medium enterprises will increase," said Shen Minggao, a Citibank economist. "That will most likely be passed on to small companies under a tighter credit environment."

Banks may also choose to scale back loans to small businesses, he added.

China has also kept the reins on liquidity by raising the cost of borrowing. The central bank has lifted benchmark interest rates five times since last October. The benchmark one-year lending rate is now 6.56 percent.

The drip-drip-drip of disappointing economic and financial news from around the world has triggered a new round of investment jitters about the health of the global recovery, and that has renewed concerns about China's export-dependent economy.

Iron fist

Some question why China chose to keep an iron fist on liquidity against such a backdrop. Economists attribute the tight policy to central government fears about runaway inflation and the off-balance sheet risks of the banking sector.

"We think those are the reasons China is tightening the reserve requirement rule on off-balance sheet activities," OCBC Bank's Xie said.

Credit instruments like bankers' acceptances, a form of time draft, are widely used in China trade and have been gaining in popularity.

Because these instruments are treated as off-balance sheet items, they have allowed banks to sidestep loan quotas.

The use of margin deposits has increased rapidly this year because they were exempt from the reserve requirement previously and they could be used to meet required loan-to-deposit ratios, set at less than 75 percent.

For companies, bankers' acceptances have been the key source of short-term funding when more traditional credit lines were squeezed by government controls.

"It was a win-win situation for both banks and companies to be involved in those off-balance-sheet activities," Xie said. "However, that may have come at the expense of a stable financial system."

Charlene Chu, Fitch's head of China Financial Institutions, said the increase in off-balance-sheet exposure masks the extent of banking activities.

For instance, Guangdong Development Bank's credit grew 49.8 percent in 2010. However, if acceptances were included, credit actually rose 91.5 percent, according to data from Fitch.

"Off-balance-sheet activity has poured fuel to the credit boom and provided banks with new channels of window-dressing," Chu said.

Acceptances, guarantees, letters of credit and commitments are all deemed standard off-balance-sheet items.

New channels, like informal securitization and wealth management, are also on the rise.

Credit-driven inflation has been a major side effect of China's economic stimulus measures in the wake of the global financial crisis.

"Combating inflation is still the central bank's top priority," said Qu Hongbin, HSBC's chief economist in China. "This latest move will help the central bank mop up excess liquidity in the markets."

China's inflation accelerated to a 37-month high in July on surging food costs. The Consumer Price Index, a broad measure of inflation, soared 6.5 percent in July from a year earlier, the National Bureau of Statistics said.

In the first seven months, inflation rose an annual 5.5 percent, exceeding the government's target of 4 percent for this year.

But given the slowdown in China's economic growth and nervousness about the possibility of another global recession, authorities may shy away from further tightening.

"This is likely to be the last meaningful step towards credit tightening," HSBC's Qu said.

He said the central bank may even start to inject liquidity through open market operations or even by moderately lowering the reserve requirement if needed.

OCBC's Xie shared a similar sentiment.

"Given rising global economic uncertainties, we do not expect further reserve requirement hikes for the rest of year," Xie said. "We also see the probability of further interest rate increases as low."