Source: Reuters

China sprung a surprise on global markets on the eve of its New Year's holiday with an increase in banks' reserve requirements, a move that can slow bank lending and tamp down on rising inflation.

Although investors had been expecting the People's Bank of China to push the reserve requirement ratio higher after an increase last month, few thought the second rise would come so soon.

Markets were rattled by fears that the pace of monetary tightening in China would be more aggressive than had been reckoned on, potentially denting global growth.

Investors pulled back from riskier assets, buoying the dollar which rose 0.7 percent against a basket of currencies. Stocks fell, while European and U.S. bonds jumped.

"The central bank is sending clear messages to banks that it wants more reasonable bank lending and it is paying close attention to inflation," Xie Xuecheng, an economist with Southwest Securities in Beijing, said.

The 50 basis point increase comes into force on February 25.

The surprise was all the greater since China on Thursday had reported an unexpected slowdown in consumer price inflation in January to 1.5 percent.

Analysts had cautioned that the dip in inflation was only likely to be temporary because of seasonal factors, but markets had still interpreted it as a sign that the central bank could proceed more gradually with its normalization of monetary conditions after last year's ultra-loose pro-growth policies.

But the January data also showed that, for all the government's insistence that banks control their pace of lending, Beijing was still struggling to rein in credit. Banks lent 1.39 trillion yuan ($203.4 billion), the third-largest monthly total on record.

After Friday's reserve requirement increase, China's biggest banks will now have to put 16.5 percent of their deposits on hold at the central bank, crimping their ability to lend.

"Even though the inflation threat is mild, the central bank has huge pressures to mop up excessive funds from commercial banks to reduce their urge to extend corporate loans," Shi Lei, an analyst at Bank of China in Beijing, said.

"But the hike will still not fundamentally tighten liquidity too much and there will be more reserve ratio hikes upcoming," Shi said.

Each reserve increase drains about 300 billion yuan ($43.9 billion) of liquidity. The Chinese economy remains awash in cash after a record surge of 9.6 trillion yuan in bank lending last year.

($1=6.832 Yuan)

(Additional reporting by Beijing and Shanghai reporters; Editing by Tomasz Janowski)