UPDATE 1-China cash squeeze eases after c.bank injects funds
* Key money market rate falls sharply
* C.bank injects 29 bln yuan through open market operations
* Impact of injection mainly psychological - traders
* Rates remain elevated, could spike again (Adds market reaction, trader quote)
SHANGHAI, Dec 24 (Reuters) - China's interbank cash crunch eased on Tuesday after the central bank injected funds through normal channels for the first time in three weeks, but traders warned that conditions remained tense.
The People's Bank of China on Tuesday morning added 29 billion yuan ($4.8 billion) in short-term cash into the banking system through seven-day reverse repos, after it had suspended such injections since Dec. 3.
The central bank had largely stood passive over the last week as the interest rates banks charge for lending to each other rose to six-month highs due to strong demand for cash at the year-end.
The benchmark seven-day bond repurchase rate was 6.56 percent on a weighted-average basis, the lowest level in a week and down sharply from 8.93 percent on Monday. But traders cautioned that the impact was mainly psychological.
"The PBOC's open market injection also helped soothe sentiment, but the amount is too small to have real impact on market rates," a trader said.
Market watchers are divided about whether China's second cash crunch in six months is due to intentional action by a central bank concerned about rampant credit growth and stubbornly high house prices or the result of an unexpected shortage of liquidity from other sources.
Those who believe the central bank engineered the squeeze say authorities want to curb the use of interbank borrowing to fund risky off-balance-sheet loans to property developers and local governments.
Those who say the rate spike was unintentional point to an unexpected slowdown in government spending at the end of the year.
The transfer of so-called fiscal deposits from the central bank to commercial banks is typically an important source of liquidity at year-end, when governments disburse subsidies and spend money on events near the end of the year.
"The pace of fiscal spending this year had been much slower than past years due to the anti-luxury spending stance of the Chinese government," Shen Mingao, head of China research for Citibank in Hong Kong, wrote in a note to clients on Tuesday.
Even if the central bank didn't intentionally engineer the crunch, authorities declined to aid the market with extra cash when fiscal deposits failed to enter the system as expected.
Traders have interpreted this to mean that the central bank will not rush to the aid of banks who are overly reliant on short-term borrowing to remain liquid.
"Money market conditions will remain volatile in coming weeks, with the yields likely to fluctuate sharply from time to time," the money market trader said.
($1 = 6.0702 Chinese yuan) (Additional reporting by Lu Jianxin; Editing by Jacqueline Wong)
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