China's central bank drained funds from the market on Tuesday as it strengthened its money management strategy after unexpectedly strong credit growth in January put downward pressure on rates.
The People's Bank of China (PBOC) is trying to engineer a gradual upward shift in the cost of money to encourage firms to de-leverage and discourage high-risk shadow banking activity.
(Read more: Get ready for moreChina shadow-banking defaults)
But strong credit growth early in the year only poured money back into the system and loosened supply. That pushed the weighted average of the benchmark seven-day bond repurchase agreement to end at 3.84 percent on Monday, its lowest point since November.
The central bank issued cash-draining forward bond repurchase agreements on Tuesday, sucking 48 billion yuan ($7.92 billion) out of the system, traders told Reuters. The central bank has not used forward repos since June, relying entirely on reverse repos to inject short-term funds for short periods of time, then letting the money flow back out when they mature over the course of a few weeks.
For example, last week maturing reverse repos issued to get banks over the week-long Lunar New Year hump in late January-early February passively drained 450 billion yuan from the system.
But that did not get rates back into the 4 percent-plus range traders believe the central bank seeks to maintain.
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"The January credit figures came in higher than expected and the 7-day repo rate declined to below 4 percent yesterday, which could have triggered a liquidity withdrawal from the central bank," said Zhao Hao, economist at ANZ in Shanghai, said in a research note.
"Generally speaking, it seems that the central bank tends to maintain a generally tight liquidity condition."
The central bank said this weekend that Chinese banks disbursed 1.32 trillion yuan in new loans in January, the largest amount lent in a single month in four years, far exceeding expectations for 1.1 trillion yuan.
Total social financing (TSF), a broad measure of liquidity and credit in the economy, hit a record monthly high of 2.58 trillion yuan in January, toppling the previous record of 2.55 trillion yuan hit in March 2013.
Seasonality is always an issue at the start of the year, both because banks tend to front-load their lending and because of distortions resulting from the Lunar New Year holiday.
(Read more: China January lending soars to 4-year high)
Even so, traders said the all-time high TSF figure was particularly unsettling.
"Tuesday's forward repos business was of a small scale, but it nevertheless sent a strong signal to the markets that the central bank is not letting liquidity ease," said a trader at a Chinese commercial bank in Shanghai.
"If money market conditions remain sloppy, the central bank could even step up efforts to mop up excess."
Successive record high TSF readings in the first quarter of last year -- driven largely by explosive growth in shadow banking activity -- prompted the PBOC to strike back through the interbank market, engineering repeated cash crunches that saw short-term rates reach as high as 30 percent on some days.
(Read more: China central bank urges proper risk management)
Thanks to the PBOC's hawkish stance, many traders predict the seven-day repo rate's 250-day moving average will rise by a further 50 basis points to 4.5 percent in the first half of the year, up from around 4.0 percent in late 2013 and 3.5 percent in mid-2013.
"Since 2013, interest rates in financial markets have generally risen with sharper volatility...reflecting a 'conflict' between excessively strong demand for liquidity and appropriate supply," the PBOC said in its latest quarterly monetary policy report published in February.
"In the next stage, the central bank will further improve its liquidity management models with a combination of quantity and pricing tools and prudent macroeconomic policy."