Why China Keeps On Hiking

 Last Friday, just when everyone was getting ready for the weekend, the People's Bank of China (PBOC) raised its reserve requirements by 50 basis points. Boy, does China know how to pull off a surprise!

There are a few smarty pants who say that they had seen it coming though. According to them, with liquidity increasing by around 500 billion CNY when central bank bills and repos expire, another RRR hike was only a matter of timing.

Let's not forget that inflation is also starting to be a real pain in the hiney for the Chinese economy. Note that food prices surged by 11.7% in November and led the 5.1% annual increase in China's CPI. And so, in an effort to tame inflation, the central bank resorted to setting higher minimum reserve requirements. What this basically means that there will be less money being available for lending.

Of course this is all part of China's grand master plan of shifting to a prudent monetary policy stance. Recall that last year, the Chinese government announced that it plans to implement more rate hikes in 2011 to combat inflation and to keep liquidity in check. Because of that, economic seers forecast four more interest rate hikes and a bunch of reserve ratio increases.

Check out how China put the "Ayt!" in "tightening" over the past few months:

October 14, 2010 - PBoC raises the RRR by 50 basis points
October 19, 2010 - China hikes interest rates by 25 basis points
December 10, 2010 - Reserve ratio increases by 0.50%
December 25, 2010 - PBoC raise interest rates by 0.25% 
January 14, 2011 - 50 basis point hike in reserve requirement

From this timeline, you've probably noticed that a reserve requirement hike is often followed by an increase in the actual interest rate. Word on the street is that if China sticks to its routine, we may just hear a holler to bring the official cash rate up by another 25 basis points before the end of the month!

Now, some of you might be wondering, "Why the heck should I care about China and the PBoC? China basically controls the value of the yuan and it's not even a major currency!"

Ah, but you see, everybody's who's anybody has his or her eyes on China nowadays. China is a global power house, being a major player in trade. Changes in monetary policy affect Chinese demand and trade will have an effect on the currencies of China's major trading partners.

Take for example Australia and Japan. With China booming over the past decade, Australia has relied on Chinese demand for raw materials and minerals to boost their export industries. If China continues to make moves to counter rising inflation, Australian exporters would be hard pressed to find someone else to make up for the slowing demand.

Meanwhile, Japanese officials are also worried about tightening Chinese policy because it could lead to yet another headache. Japan's export industries have found the rising yen (which is near 15-year highs) to be a major thorn in their sides. With China being Japan's biggest trade partner, any moves to curb inflation (and in turn, demand), could be a big Danny Laruso Flying Goose kick to the Japan's economic recovery plans.

And if you took your School of Pipsology classes seriously, you'd know that a weak outlook for a particular economy is usually bearish for their currency. If that sounds like hogwash to you, we're sending you back to Kindergarten!