By Shen Hong

SHANGHAI--China's central bank has stepped up efforts to drain cash from the country's financial system in the past week, as it seeks to curb excessive borrowing and tame frothy markets.

The cost for banks to borrow from each other, measured by the so-called seven-day repo rate, rose to 3.49% this week--a 19-month high--from 2.92% on Monday. The surge followed the People's Bank of China's withdrawal of a net 130 billion yuan ($18.85 billion) from China's money markets over the four trading days until Tuesday this week, which has been partially reversed.

At the same time, the PBOC has been guiding major state-owned banks to restrict their short-term lending to otherfinancial institutions, according to market participants.

The scarcity of funds and sharp rise in borrowing costs has contributed to a selloff in China's domestic bond markets, which had thrived in recent months on an abundance of cheap funds available to investors. The yield on 10-year Chinese government bonds rose as high as 3.00% on Friday, its highest point since mid-June. Bond yields rise as their prices fall.

Analysts say the central bank could also be seeking to relieve the recent downward pressure on the yuan by raising domestic interest rates.

"It's all part of the government's broader deleveraging campaign that seeks to put China's high debt level under control. The message is clear: the days of easy money are over," said Suan Teck Kin, an economist at United Overseas Bank in Singapore.

Market participants say the PBOC's move to reduce the amount of cash in China's financial system was a surprise, in part, due to its timing.

"It was totally unexpected because we are talking about the month end, a period when banks need lots of cash to meet all kinds of capital requirements and so the PBOC would typically provide more funds to quench the thirst," a Shanghai-based head of money market trading at an Asian bank said.

The overnight repo, the most popular tool for speculators to access borrowed funds, has also surged to a 19-month-high of 2.60% from 2.36% on Monday.

Short-term loans, in the form of overnight and seven-day reverse repos, are typically used by financial institutions to meet their daily cash needs. However, in recent years, Chinese banks have channeled some of that money to investors, who have been able borrow it at cheap rates to plow into assets such as bonds.

The PBOC made a similar attempt in September to crack down on speculative investment behavior by artificially raising interbank interest rates via tighter supplyof short-dated funds. However, the campaign lasted for just a few days, after signs of panic in markets forced the central bank to soothe investors with the resumption of large cash injections.

"They to want to manage expectations so that people will accept the new normal of more expensive funding costs but they don't want to let rates rise too fast either," said Mr. Suan.

PBOC officials couldn't immediately be reached for comment.

The current tight funding conditions in China could last until the Lunar New Year in late January, analysts say, if the central bank takes no further action to inject more cash into the financial system.

"If the PBOC just relies on its routine money market operations to inject more liquidity, it will only solve the difficulty of funding access but not the problem of high funding costs," said Liu Dongliang, a senior analyst at China Merchants Bank.

Write to Shen Hong at Dow Jones Newswires

December 01, 2016 23:02 ET (04:02 GMT)

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