By Rachel Rosenthal

Chinese government bond yields are approaching their highest level since September 2015, after authorities overnight tightened a key rate on loans to financial institutions.

The yield on China's benchmark 10-year government bond climbed to 3.336% on Wednesday compared with 3.296% late Tuesday, approaching a recent peak in mid-December when yields hit 3.383%.

Late Tuesday, China raised rates on an important tool that the central bank uses to manage liquidity, called the medium-term lending facility. Some analysts are interpreting the move as an effective interest-rate increase, which would be the first such step since 2011.

The decision is the latest evidence of Beijing fiddling with the dials of monetary policy to tamp down rampant credit growth, while simultaneously keeping enough liquidity in the financial system for banks to meet funding needs and prevent market panic.

"Undoubtedly this is a tightening signal," said Pin Ru Tan, director of Asia-Pacific rates strategy at HSBC Holdings PLC in Singapore. "One of China's top priorities this year is to reduce financial leverage, prevent asset bubbles and avoid a systemic crisis."

Last week, the People's Bank of China pumped 1.13 trillion yuan (roughly $165 billion)--a weekly record--into domestic money markets ahead of the Lunar New Year holiday, when Chinese traditionally give gifts of cash in red envelopes. The rush of cash withdrawals tends to tighten liquidity this time of year, particularly because markets will be closed from Jan. 27 through Feb. 2.

Chinese officials have put deleveraging at the top of their agenda for 2017, after a flood of cheap, post-financial-crisis money pushed up prices of financial assets from real estate and corporate bonds to iron ore and soybean-meal futures. China's money supply has more than quadrupled since 2007, sending more cash after a shrinking pool of appealing investment options, just as capital controls keep money coursing through Chinese assets rather than those abroad.

The build-up of credit in the bond market began in 2015, when the central bank started holding short-term borrowing rates at very low, stable levels to boost growth. By the summer of 2016, roughly 90% of interbank borrowing was in the overnight market, the shortest and cheapest form of funding.

Many investors used the cheap cash to buy bonds and other financial products, and then used those securities as collateral to invest even more. Much of this borrowing was done through off-balance sheet products, adding layers of leverage and financial risk beyond regulators' view.

Officials started to crack down on this pattern in August, by pushing borrowers to longer-term maturities, which elevates short-term funding costs. The impact of this gradual tightening campaign combined with a more hawkish U.S. Federal Reserve and default scares triggered a deep selloff in the onshore bond market in mid-December.

At that point, China halted trading in some bond futures contracts for the first time, after 10-year and five-year futures fell 2% and 1.2%, respectively. Currently, 10-year bond futures are down 0.90% and five-year bond futures are down 0.50%.

Officials' deleveraging efforts have shown some signs of success: The daily volume of overnight transactions has fallen to 1.96 trillion yuan from a peak of nearly 4 trillion yuan over the summer, according to BNP Paribas. Now, roughly 70% of interbank borrowing is in the overnight market.

China's decision to raise rates on medium-term lending facilities by 0.1 percentage point--to 2.95% for the six-month and 3.10% for the one-year tenor--isn't terribly dramatic. More important, for market watchers, is the affirmation that officials' tighter stance is here to stay.

"While the size of the rate increase is modest, the signal seems clear that the PBOC has stepped up the tightening bias," wrote economists at Goldman Sachs in a note.

Despite temporary bouts of volatility, there are some signs that the long-term view on China's bond market is nevertheless optimistic.

On Wednesday, Bloomberg announced that it would create two new indexes, set to launch March 1, that will include China's onshore government and policy bank bonds.

The move could accelerate inclusion into other closely tracked international bond indexes, such as J.P. Morgan's emerging-market government bond index, and accelerate foreign participation in China's onshore bond market, said Becky Liu, a China macro strategist at Standard Chartered. Foreigners currently own less than 2% of China's onshore bond market.

Index providers have been charting China's progress in opening up its financial markets as a condition for inclusion. Deutsche Bank estimates that China's addition to some indexes could help boost foreign investment inflows into China to $700 billion-$800 billion over the next five years.

Write to Rachel Rosenthal at Rachel.Rosenthal@wsj.com

(END) Dow Jones Newswires

January 25, 2017 02:13 ET (07:13 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.