SHANGHAI (Jan 24): China's central bank raised interest rates on a key funding tool, the medium-term lending facility (MLF), on Tuesday in its latest bid to cut debt levels and bolster financial stability.

Policymakers are trying to keep the world's second-largest economy sufficiently greased to counter an economic slowdown while also managing risks created by an explosive growth in debt that has fueled a housing boom.

China's benchmark bond futures prices fell at the end of the trading day on the higher rates, as the People's Bank of China (PBOC) also rolled over maturing MLF loans.

The central bank raised the interest rate for one-year and six-month MLFs by 10 basis points each to 3.1% and 2.95%, respectively.

The move was designed "to maintain basic stability in the banking system", the PBOC said in a statement.

Analysts suspected this increase in the cost of one of the main money market funding avenues for banks was in line with the central bank's broader objective of reining in speculative investment in the economy.

The MLF is a supplementary policy tool the central bank uses to manage liquidity conditions and medium-term interest rates in the banking system and money markets.

Tuesday's move was the first rate rise in years, catching many market participants off guard.

Xia Haojie, a bond futures analyst at Guosen Futures, said higher MLF rates were intended to encourage deleveraging.

"Low interbank yields don't reflect real borrowing costs in the real economy and have to trend higher, otherwise easy funding would only be used by financial institutions to make speculative arbitrage," Xia said." Meanwhile, yuan depreciation pressure also puts upward pressure on Chinese yields."

TIGHT LIQUIDITY

A trader at a Chinese bank in Shanghai was surprised about the timing, given the generally tight liquidity conditions ahead of the week-long holiday.

"I have no idea why the bank released such bad news ahead of the holiday. The purpose of raising the interest rates on MLFs is still to cut leverage at financial institutions," said the trader, who could not be identified by name because she was not authorised to speak to the media.

The authorities have been tweaking policy settings to discourage excessive borrowing and deter capital outflows, including last year's introduction of longer tenor open market funding operations and increased reporting requirements for overseas cash transfers.

The last time the PBOC adjusted interest rates on MLF loans was February 2016, when it lowered offered rates for six-month and one-year tenors. And the last explicit policy tightening was in 2011, when the central bank raised benchmark lending rates.

But Tommy Xie, a Singapore-based economist at OCBC Bank, said it might be too early to conclude that China had embarked upon a fresh tightening cycle.

"The next important thing to monitor is the interest rate for open market operations. Our forecast for 2017 benchmark lending and deposit rates remains unchanged for now," he wrote in a report.

On Tuesday, the PBOC said it lent 245.5 billion yuan (US$35.8 billion) to 22 financial institutions via MLFs.

The central bank sent queries to banks last week on the demand for the MLF loans when it did not announce any new issue of these loans as two batches totaling 216.5 billion yuan came due.

The PBOC usually pumps more funds into money markets at the Lunar New Year, China's biggest holiday, when demand for cash surges. But some traders said its injections have barely been keeping up with heavier demand this year.

Ten-year treasury bond futures prices for June delivery slumped just before the end of trade, closing at 94.900 yuan from as high as 95.075 yuan earlier in the day.

Some 435.5 billion yuan worth of MLF loans are due to mature in January, and an additional 205 billion yuan will mature in February, according to Reuters calculations.