China's record Rmb9,210bn ($1,349bn) in lending in the first 11 months of 2009 and the Rmb4,000bn stimulus package drove an economic rebound following the global financial crisis. With exports returning to positive territory in December following a fall of about 16 per cent in 2009, we think it is logical for Beijing to reduce gradually the amount of stimulus to pre-empt the risk of overheating and were not surprised when, on January 12, the government raised the banks' reserve requirement ratio (RRR) by 0.5 per cent to 16 per cent. As China is recovering much faster than anticipated, the latest adjustment in the RRR signalled that authorities are confident to start the process of fine tuning stimulus measures.

Steps are also being taken to reform and develop China's capital markets, which have grown tremendously over the past 10 years. The launch of stock index futures, margin financing and short selling of mainland-listed A shares which had been delayed by about three years due to market volatility and system trials, has now been approved. This will give investors more trading tools and flexibility by allowing long-short, event-driven and other forms of market-neutral strategies. The introduction of the short-selling mechanism will pave the way for the smooth launch of index futures and other equity derivatives such as warrants and options.

The first stock index futures, based on China's CSI 300 index, which tracks the 300 biggest stocks traded in Shanghai and Shenzhen, could begin trading in three months following the completion of preparations, such as structure, pricing and margin requirements. Short-selling and index futures are intended initially to help institutional investors better manage their portfolios rather than for retail participation due to the relatively high risk of these instruments. According to the initial rules, the minimum investment requirement has been set at a relatively high level of Rmb500,000.

Over the longer term, we could see a gradual narrowing in the premium of A shares over H shares as qualified domestic institutional investors (QDII), domestic institutional investors authorised by the government to invest in overseas capital markets under the foreign exchange control system, may begin to short sell A shares and go long H shares. A shares are trading at a premium of about 37 per cent over H shares. In October 2009, the State Administration for Foreign Exchange (Safe) resumed approval of QDII quotas after a 17-month moratorium. The approval of more QDII quotas should drive market liquidity and help reduce the valuation gap between A and H shares.

The stock market's initial reaction to the increase in the RRR was negative as investors feared a start to interest rate hikes. We believe, however, that this is an opportunity to buy quality stocks on weakness.

David Fuller's view I think investors overreacted to the RRR hike for banks but we live in nervous times. My medium-term concern has been the heavy supply of IPOs which we have seen since last August. Nevertheless these have improved valuations, as Richard Wong points out.

What about the technical picture?

This appears to be a 'moment of truth' in terms of medium-term prospects. Those of us who are not citizens of the PRC mainly invest via the H-Shares. Their Index (HSCEI) (weekly & daily) lost upside momentum, broke the progression of higher reaction lows and has now moved slightly below the rising 200-day moving average. This has created another oversold condition and the Index has lost downside momentum recently. However, a strong rebound is now required to repair recent technical damage, including an eventual upside break through the progression of lower rally highs evident since December.

A medium-term pause in H-Shares is certainly not unreasonable given the strong recovery between October 2008 and November 2009 but until we see some upside dynamics, we will know that China remains temporarily confined to the status of a 'wall flower' in the global beauty contest. The Hang Seng Index (weekly & daily) shows a similar pattern and is at the psychologically interesting 20,000 level.