The People's Bank of China (PBOC), the nation's central bank, knows this only too well: Too much money too soon can cause problems.

The bank, as the economy's excess liquidity has been accumulating rapidly, has finally raised lenders' reserve requirements to fend off inflation and cool down the ongoing investment fever.

PBOC officials announced last week the ratio of deposits, which commercial banks must place with the central bank, will be lifted from 6 per cent to 7 per cent beginning on September 21.

"This is to guarantee a stable monetary and financial environment for the economy," said a PBOC spokesman.

The reserve increase will not cover rural co-operatives, as it could affect the ongoing reforms within those institutions, the spokesman said.

PBOC's decision came after the central bank issued, since April, 445 billion yuan (US$53.6 billion) in commercial bills to drain money circulation through open market operations.

The move, PBOC officials hope, will freeze about 150 billion yuan (US$16 billion) worth of deposits with banking firms and, subsequently, will contain the ballooning cash supply.

Money supply surged 20.8 per cent by the end of July compared with a year ago, although PBOC's official target for this year's growth is 18 per cent.

The excessive growth has been fuelled by commercial banks' credit expansion and international hot money, or speculative funds, which has managed to enter the system.

The increase of bank loans this year, by the end of July, reached 1.89 trillion yuan (US$228.4 billion), even more than last year's total loan increase of 1.85 trillion yuan (US$223.6 billion).

"Bank loans will continue to grow if there is no interference," said PBOC's spokesman.

"The relentless growth would harm the economic health and cause some structural imbalance in the system."

Ma Kai, minister of the National Development and Reform Commission, also warned last week relentless growth in bank loans would "easily lead to new non-performing loans."

Earlier, several official reports confirmed many of these loans flowed into government-sponsored construction projects and sectors showing signs of oversupply.

Bank loans have financed exceptionally high growth in the automobile, real estate and steel-production sectors, experts said.

Nationwide automobile manufacturing capacity, in the year's first half, reached 5.5 million units, including 2.5 million units of sedans, which far exceeded the market's demand, indicates a recent report by the State Information Centre.

Investments in real estate during the same period increased by about 30 per cent, the report said.

The growth of China's steel output reached 21 per cent - the world's highest - in the year's first half, doubling analysts earlier predictions.

PBOC since June has tightened loans to property developers and buyers of second homes and/or luxury apartments.

Inflows of foreign currency have added to banks' lending capacity and the cash in circulation.

A recent report by investment bank Credit Suisse First Boston (CSFB) indicates, despite Chinese authorities' tight foreign exchange control, up to US$25 billion in short-term speculative funds have sneaked into the country.

It could be traced by examining the gap between the increase of China's foreign reserves and the country's trade surplus in the year's first half, said Tao Dong, a Hong Kong-based analyst with CSFB.

China's foreign exchange reserves reached US$356.5 billion at the end of July, Ma said.

While speculators have bet on possible sharp appreciation of the renmenbi, China's currency, PBOC has released cash reserves to keep the currency's exchange rate stable.

The renminbi has since 1994 been kept in a narrow band around 8.28 yuan to the US dollar.

Chinese officials have reiterated - despite mounting pressure from Japan, the European Union and the United States - they have no plans to revalue the yuan.

PBOC, meanwhile, fearing increasing interest rates would heighten speculative purchases of the renminbi, has promised lending and deposit rates will remain for the rest of the year.

This, however, has left the central bank with few options - by using monetary policies - to fight inflation, experts said.

China's concerns about inflation come after the domestic consumer price index (CPI) rose, for the seventh consecutive month, 0.5 per cent in July.

The CPI had fallen 14 straight months before it finally picked up early this year.

China's retail sales, another gauge of consumption, soared 8.3 per cent in the year's first seven months compared with a year earlier.

However, government-led investments jumped 32.7 per cent in the same period.

PBOC Governor Zhou Xiaochuan expressed concern last week that "expansionary monetary and fiscal policies have led to growth in the savings rate, but not in consumption."

Overheating in parts of the economy might not mean an immediate threat of inflation, but could still harms China's long-term growth, experts said.

"Since food-related products still dominate CPI, they have reduced the index' sensitivity as a whole," Tao said.

"Economic overheating could lead to a market glut in a few years, and could erode companies' profits."

Last week's reserve hike prompted fears among financial institutions the stricter obligations would cause a short-term drain of money on the Shanghai-based interbank market.

PBOC, days later, issued seven-day repurchase agreements, or repos, in open market operations, injecting 60 billion yuan (US$7.25 billion) into the market.

This marked the central bank's first injection of cash over the past eight months.

Commercial banks have scrambled for the subscription, and pushed up annual rates for the benchmark seven-day repo rate 0.75 percentage points.

China said last Tuesday it will examine foreign exchange deals by some banks in a bid to halt illegal foreign currency inflows.

The State Administration of Foreign Exchange will conduct special checks on the trading of foreign exchange at banks.

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