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Last week, policymakers in Beijing, concluding an annual Central Economic Work Conference, decided to shift their monetary policy stance from “prudent” to “tight” next year. In line with the new policy stance, China’s central bank raised its reserve ratio requirement to 14.5%, a 1% increase and a 20-year high. Previous increases in the ratio had been much smaller, usually 0.5%. We would expect that a rise in lending rates is not far behind. China’s moves come just as the U.S. is expected to continue to loosen its monetary policy, with the Federal Reserve Board meeting today and most market watchers forecasting a further decline in the fed funds rate.

What are the implications of this? For one, it does seem that China’s policymakers are getting more serious about preventing overheating of the Chinese economy. They aim to bring China’s rate of economic expansion down to sustainable levels over the medium-term rather than risking a burst of short-term growth, followed by collapse. With tighter economic policy, we would expect money supply growth, including bank lending, to slow and, with that slowing, the potential for asset price growth also slows.

As a result, a cooling in the hot stock and property markets is likely although this may simply mean a slower rate of growth rather than a decline - at least for property. Inflation is also more likely to come under control, a positive outcome, and one of the major risks currently facing the Chinese economy.

Finally, a tighter monetary policy in China, while the U.S. continues to loosen its monetary policy, suggests that the Renminbi may come under even more pressure to rise. Presumably, China’s policymakers fully understand this and we would expect further measures to release the pressure on the Renminbi – either more appreciation of the Renminbi or a further relaxation of capital controls, allowing more Chinese to invest their money abroad.

Will it all work? The one major risk seems to be a slowing U.S. economy. The monetary policy tightening could prove to be superfluous if export growth to the U.S. slows enough to do the job all by itself. In this case, the monetary policy tightening could prove to be excessive.

Source: China's Overheating Prospects Brought Under Control - Unless U.S. Falters