The sell-off yesterday was little short of a rout. After the People's Bank of China announced late on Tuesday that it would increase the proportion of mainland banks'deposits that they must set aside as reserves, Hong Kong's stock market took fright. Interpreting the move as the first step in an aggressive round of monetary tightening designed to rein in runaway bank lending, investors began to bail out of Hong Kong and China stocks. The Hang Seng Index slumped 2.6 per cent during yesterday's session, with the H-share index sliding 3.7 per cent. Both falls were steep enough to wipe out all the gains made so far this year (see the first chart below). Among the worst hit were commodity companies, property developers and banks. Maanshan Iron & Steel tumbled 8 per cent. Henderson Land Development dropped 6.5 per cent. And China Construction Bank slipped 3.9 per cent on reports that the 0.5 percentage point increase in the required reserve ratio for large banks to 16 per cent meant the banking system would have 300 billion yuan (HK$340.77 billion) less available to lend. Taken by surprise, investors began to fret that Tuesday's move was the prelude to early interest rate increases. On reflection, however, it is likely many will conclude that yesterday's sell-off was a panicky overreaction. It is true that the PBOC is edging towards tightening mode. As we warned last Friday, 'given the magnitude of last year's monetary expansion, the mainland authorities are deeply concerned about the level of price rises they may find themselves grappling with in a year's time should they fail to act soon.' It is also true that raising reserve requirements fires a shot across the bows of China's banks and sends a powerful signal to the markets. But despite the fears of many investors, Tuesday's increase in reserve requirements will have little or no short-term impact on banks' ability to lend money. For one thing, China's banks are sitting on excess reserves. At the end of September, banks had reserves worth about 17.5 per cent of customer deposits, a proportion likely to have risen since. So increasing the reserve requirement from 15.5 per cent to 16 per cent has no immediate impact. Secondly, increasing required reserves has little effect on lending anyway. That's because the requirement is set as a percentage of customer deposits. And counter-intuitive as it may seem, deposits are driven by lending rather than the other way around, as borrowers tend immediately to place the funds they receive back on deposit at their bank. Increasing the required reserve ratio does reduce the multiplier effect of new loans, eventually restricting the capacity to lend, but that is a slower process. In the short term, it will do little to curb loans. If you don't believe that, take a look at the second chart below. Between mid-2006 and mid-2007, the PBOC more than doubled reserve requirements. But as the chart shows, there was no discernible effect on new lending. In reality, the PBOC uses required reserves not so much to guide bank lending as to mop up hot money flowing into the banking system from abroad. In recent weeks the central bank has been struggling to sterilise inflows by selling short-term bills, nudging yields higher in an attempt to attract buyers.So although Tuesday's increase in reserve requirements undoubtedly reflects a shift towards a tightening stance by the PBOC, it is a move aimed more at managing surplus liquidity than at drastically cutting the supply of cheap credit to Chinese companies. Although new loan levels will fall compared with last year's, bank lending will remain strong over the coming months in order to support stimulus projects begun last year. And while lending rates may well be nudged higher later in the year, any increases will be modest for fear of undermining the recovery, especially in the property sector. All of which implies that yesterday's Hong Kong stock market sell-off was an overreaction, and that the market is likely to recover once investors have got over their initial fright.