After months of open market fine-tuning, it is now considering a tool that has been shelved for years - raising the legal reserve ratio or the amount of commercial banks' deposits that they must redeposit at the central bank.

In a pronounced sign of concern and one not seen for some time, the People's Bank of China said in its monetary policy report for May - where it clearly indicated its intention for the move "at a proper time" - that: "Overall, the growth of money supply at present is on the fast side."

M2, the broad measure for money supply that covers cash in circulation and all deposits, jumped by 20.2 percent on a year-on-year basis to 19.95 trillion yuan (US$2.4 trillion) at the end of last month, the fastest since August 1997.

It was 2 percentage points faster than its full-year target and was despite increasingly strong contractive open market operations that started as early as last year.

There have long been fears within the central bank about inflation. But some economists are now worried that its unfolding campaign, including a recent circular ordering banks to restrict property loans, may lead to an unwanted sharp decline in money supply growth and further undermine economic growth.

"It's understandable that the banks are worried about credit risks, an overheating in the economy and inflationary pressure," said Wang Yuanhong, a senior analyst with the State Information Center (SIC). "But we are worrying about a (possible) abrupt braking."

If banks go too far in restricting their property loans to prevent bad loan risks and a higher legal reserve ratio substantially constraining loans, the pace of money supply increases, which are primarily driven by loans, may slip below 18 percent, a pace Wang said is necessary for economic growth at a time when the fiscal policy has little room to maneuvour.

A 20 percent money supply growth rate, which the central bank noted as outstripping the sum of China's gross domestic product (GDP) growth and consumer price index (CPI) rise in May, is actually nothing to worry about, argued Yuan Gangming, a senior economist with the Chinese Academy of Social Sciences.

In Japan, where the money supply growth outpaced the sum of GDP and CPI rates by a far broader margin, noted Yuan, the government went ahead last year to loosen money supply and "apparently eased its deflation, and economic growth came back positive."

Analysts say banks should, instead, focus on readjusting their credit structure to lend more to small and medium-sized enterprises and private businesses that are still hungry for funding, and be more cautious with sectors showing signs of overheating.

The government is reportedly considering similar ways to cool down other fast-growing sectors like autos and high-end consumer durables.

The SIC's Wang said: "The key is the credit structure, but we are worried the overall size (of loan increases) would also slide."

And the prospect looks possible considering a likely rise in the legal reserve ratio, a tool Yuan said few countries are still using as it tends to cause "multiple contraction" in lendings.

Ma Junsheng, a senior manager with the Industrial and Commercial Bank of China (ICBC), said: "This is a very tough move. In the event it's raised, all the deposit-taking institutions will have a big chunk of funds frozen. The impact on liquidity is measurable."

Chinese commercial banks are currently required to put 6 percent of their deposits with the central bank.

They also often set aside additional reserves to meet their daily needs, which averaged 5.12 percent of total deposits at the end of March, at the central bank for a 1.89 percent annual interest rate.

Insiders said only a handful of the bigger banks now have relatively sufficient additional reserves to offset a 0.5 percentage point rise in the legal reserve ratio and most of the smaller banks will likely feel the pain.

Interbank market participants reacted to the news in unison.

The yield on a one-year bond offer by the China Development Bank on Wednesday came out on par with comparable issues in the secondary market.

But primary market yields are typically 8 to 10 basis points lower than the secondary market, said the ICBC's Ma.

"That means most people were expecting a rise," he said.

Ma predicts a 0.5 to 1 percentage point rise in the ratio will come in one to three months.

In spite of assertions by other economists that money supply growth rates faster than 18 percent will make it difficult to keep inflation within a theoretically desirable 0 to 1 percent range, Yuan said deflationary pressures still outweighed inflationary risks despite a 0.5 percent rise in the CPI in the first quarter.

The CPI rise was primarily driven by domestic oil prices, which soared by a rarely seen 40 percent in the first quarter due to the war in Iraq, he said, and not as a result of domestic demand.

"Taking that off, we are still far away from inflation," he said.

China's retail sales growth, which Yuan said better reflects real consumption trends, slowed down to a little above 4 percent in May, even lower than in 1999 when deflationary worries were strong enough to force the government to take countermeasures.

(China Daily June 23, 2003)