* Central bank surprises with bad cop, good cop strategy
* Pushes yuan lower while relaxing grip on money markets
* Market divided over how long trend will last
* Could be designed to relieve market pressure ahead of NPC
* May be aimed at deterring hot money inflows
SHANGHAI, Feb 28 (Reuters) - China's central bank delivered two major surprises to investors this week: it engineered a sharp decline in the yuan against the dollar and at the same time relaxed its tight grip on money markets that had kept interest rates firm.
In effect, the central bank was playing bad cop with speculators in the foreign exchange market to try to shake out one-way appreciation bets, while making nice with money market traders.
That was a marked change from December and January when the regulator appeared deaf to howls of pain emerging from China's money market as interbank lending rates spiked, rattling both domestic and global investors.
"The PBOC has suddenly become surprisingly soothing, and that has resulted in a great improvement in money market sentiment," said a trader at a Chinese commercial bank in Shanghai, although he questioned how long the new environment would last.
The central bank's action was unusual because traders had expected the authority to mop up the extra yuan entering markets as a result of its intervention in order to prevent interest rates from easing. It did drain funds, but not to the extent that the market had expected.
Traders and analysts are divided over what the central bank is trying to achieve.
Some argue the looser rates could be designed to provide a further deterrent to hot money inflows as its tries to battle against speculation that the yuan is a one-way appreciation bet.
Others suspect the change of heart may be designed to offer relief to equities and real estate markets, both of which have shown signs of strain under the tighter credit environment in place since last year. That could boost sentiment during the annual session of parliament that begins next week.
But the relaxation also complicates the central bank's efforts to maintain pressure on risky shadow banking and encourage heavily indebted Chinese corporations to cut their debt burden.
"The central bank has a difficult task in trying to prevent growth from sliding sharply and avoid a financial crisis, while taming the credit bubble and deleveraging the economy," wrote Barclays economist Jian Chang in a research note on Friday.
THE NEW "NEW NORMAL"
The PBOC has remained rhetorically committed to maintaining adequate liquidity for growth, but in practice that has meant different things at different times.
During dramatic cash crunches in Chinese markets in June, December and January, the central bank declined to act to ease the pressure and instead insisted liquidity was in fact "ample".
On Wednesday, however, the PBOC announced it had no plans to change monetary policy, adding that stock market investors in particular should not worry about liquidity supply.
Traders usually discount such talk - especially rhetorical attempts to juice stock markets - and instead watch what the central bank actually does. In this case, the central bank put its money where its mouth was by allowing rates to ease.
The average rate for the seven-day bond repurchase contract, considered the most reliable indicator of China's real-time liquidity conditions, was already easing before Wednesday's announcement by the PBOC. One transaction was done as low as 1.6 percent on Feb. 21, the lowest rate for that instrument since late 2010.
Market participants who believed the PBOC wanted to keep rates in elevated territory widely expected the PBOC to conduct a major drain of funds during open market operations. While the central bank did indeed drain funds to the tune of 160 billion yuan ($26 billion) for the week, the amount was much less than had been expected.
During the comparable week of 2013, the PBOC pulled a massive 351 billion yuan out of the financial system.
Some traders argue the central bank is only allowing rates to ease in the run-up to the annual meeting of the National People's Congress starting next Wednesday - hoping to deliver a liquidity-driven stock market rally to give an optimistic backdrop to the event.
However, others wonder if Beijing has lost its will to keep up the pressure on money markets following a run of weak economic indicators.
China's official manufacturing purchasing managers' index (PMI) is forecast to slip to 50.1, which would be the lowest level since June last year, a Reuters poll shows. The data is due to be released on Saturday.
PBOC data shows it has been largely successful in its attempts to isolate the money market from its intervention in the currency market, supporting the thesis that the decline in rates is deliberate and not an unintentional side effect of currency meddling.
Bank of America Merrill Lynch economist Lu Ting argued that the combination of falling money rates and a falling yuan shows the PBOC is trying to solve a policy conundrum produced by its campaign to push up money rates, launched in mid-2013.
The rising rates attracted hot money, which in turn put one-way upward pressure on the yuan, which in turn attracted even more hot money.
"The PBOC has been under tremendous pressure to deliver solutions to this dilemma since late 2013, and it has been persistently requesting co-ordination from other government agencies," he wrote, and argued that it is at long last getting support from other regulators.
"We did not simplistically call the rising rates in 2H13 as the PBOC's tightening, and we won't simplistically call the PBOC's current action as easing."
(Editing by Kim Coghill)