The PBOC sold its forex assets by a net amount of RMB25bn (or USD4bn) in October, indicating a net outflow of capital which tends to tighten liquidity conditions in the banking system and may force the central bank to cut the RRR earlier than expected. We see several interesting points from this data release:

1) The net purchase of forex by the PBOC turned negative for the first time in four years. In the early parts of this year past few years the PBOC's net purchase of forex per month amounted to about USD40bn.

2) Given that China's October trade surplus amounted to USD17bn and inward FDI amounted to USD8bn, the size of outflow of capital (which includes authorized outward FDI, portfolio outflow, private sector purchase of forex, as well as hot money outflows, among others) was substantial. It obviously reflected the expectation of RMB depreciation by some market participants.

3) The negative net forex purchase by the PBOC leads to a contraction of RMB liquidity in the banking system, initially by the amount PBOC forex sales, and over a period of time this contractionary effect will be multiplied by the money multiplier (3.7x time). This exacerbates the downward pressure on the deposit base in the banking system and makes it more difficult for banks to fund their lending activities.

4) The likelihood of a RRR cut is further increased by the contractionary impact of PBOC's net sale of forex reserves. Without a RRR cut, it would be difficult for the banking system to achieve a modest increase in net lending to RMB600bn in November and RMB700bn in December. We believe net lending numbers are needed to fulfill the government's objective of "fine tuning" monetary policy.

5) A RRR cut should be modestly positive for the market, but unlikely to drive a sharp rally in our view. This is because the RRR cut will be used partly to offset the liquidity contraction by the PBOC's net sale of forex and other factors (such as the rise in the cash-deposit ratio). The market will eventually understand that the net increase in monthly lending will be modest despite the RRR cuts.

• [Editor:editor]