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China’s Surprises on Timing, But Not Action

February 12th, 2010 Michael McDonough

Judging by the market’s reaction, investors were blinded sided today when Chinese officials increase their reserve requirement ratio for the second time during its renewed tightening cycle.  But, really the only surprise was that the hike occurred just prior to the Chinese New Year, which is a week long holiday.  I have been stating for weeks, and I believe the market has widely anticipated that that another RRR hike was imminent, so today’s strong sell-off on the news comes as a bit of a surprise to me, and highlights the fragility to markets and their sensitivity to negative news, even if anticipated.  I should note this action came right after Chinese data pointed to lower than expected consumer inflation.

To help put things into perspective magnitude of this RRR will be far smaller than the country’s open market operations in removing liquidity from the market–so far this year open market operation have likely removed over 4x the liquidity than this move will total.  The market can anticipate additional RRR hikes over the months ahead.  The RRR presently stands at 16.5%, versus a historical high of 17.5%.  I also anticipate the central bank will continue to remove additional liquidity through open market operations via additional issuance and higher yields on its 1Y paper.  Keep in mind so long as China’s reference rate remains at 2.25%, 1Y yields can not move above this level; regular auctions are held on Tuesday and Thursday.

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