THE central bank can take some measure of success from its attempts to force small banks to reduce their reliance on risky short-term borrowing, but uncomfortable memories of a 2013 cash crunch that spooked global markets is keeping traders on edge.

    Three years ago, the People’s Bank of China (PBOC) engineered a cash squeeze that saw some short-term rates spike as high as 30 percent. Financial markets interpreted the manoeuvre as a PBOC warning to banks to curb risky lending practices, but the jump in rates also sparked fears of a banking crisis.

    Worried that banks are again too reliant on short-term loans, the central bank has changed tack by forcing banks away from overnight and seven-day repurchase agreements (repos) and into 14-day and 28-day instruments, while at the same time injecting cash into the financial system to avoid a cash crunch.

    But the delicate balancing act still pushed the benchmark overnight lending rate up to 2.15 percent Wednesday, its highest level in more than a year. Other money market benchmarks, including the volume weighted average seven-day bond repo agreement rate, have also risen sharply. China’s markets were closed on Thursday and Friday for a public holiday.

    “It’s been incredibly tense these past few days,” said a money-market trader at a mid-sized Chinese commercial bank in Shanghai.

    The risk for small and mid-tier banks, which unlike big banks can’t rely on a large deposit base for funding, is that interbank funding exposes them to any market disruptions — such as a sustained rise in interest rates, Moody’s Investors Service said.

    If the small banks are faced with a liquidity crisis, the problem would reverberate across a banking system already concerned with the highest level of nonperforming loans since the global financial crisis and a deterioration in asset quality.

    But half way through September, the volume of trade is running at a slower pace than in August, suggesting the PBOC’s measures have to a degree curbed banks’ appetite for short-term repos — a form of lending with an agreed repayment deadline and price.

    China Foreign Exchange Trading System figures show that 21.3 trillion yuan of one-day repos had been traded as of Sept. 14, or about 40 percent of the record high volume in August. The volume of seven-day repos was less than 40 percent of the August figure.

    The use of repos is critical for many bank operations, but the central bank is concerned that many banks are using them to help fund trading strategies that contain too many layers of borrowing, or leverage.

    Typically, a bank money manager can boost returns by using deposits invested in the bank’s wealth management products to buy bonds. They would then use those bonds as collateral to raise short-term funds from the repo market, which in turn are used to buy more bonds. In theory, this cycle can continue but the tactic is fraught with risk.

    As long as bond prices keep rising, the banks can profit before the repos fall due and provide the returns that attract investors to deposit funds in the wealth management products.

    Since the middle of this year, China’s bond market has been rallying, so the practice has largely paid off but the central bank’s money-market intervention is a sign that it is worried a bond market bubble could be forming, traders said.

    It has clamped down as the broader economy appears to be levelling off following worries earlier this year that economic expansion was slipping too quickly.

    “As (economic) growth has stabilized, it appears that Chinese authorities have turned the focus to ‘risk control,’” Zhou Hao, senior emerging markets economist at Commerzbank wrote in a research note.(SD-Agencies)