* Cash crunches seen as PBOC signal for banks to deleverage
* Next squeeze may occur as soon as in late January
* Risk rises as banks build huge interbank positions
* Banks' cash management weakens after tighter liquidity since 2010
* Fed's QE taper adds to liquidity supply uncertainties
By Lu Jianxin and Pete Sweeney
SHANGHAI, Jan 8 China's interbank market dealers are braced for a rocky ride in 2014 as it becomes increasingly clear that Beijing will tolerate extreme short-term liquidity squeezes to deter sloppy lending by domestic banks.
The People's Bank of China (PBOC) confounded the market in December when it allowed a second dramatic rise in short-term money rates. Previously, many economists had suggested that a crunch that roiled domestic and global markets in June was a one-off and the PBOC was unlikely to allow another.
But that theory went out the window when the central bank again deliberately held back from injecting enough money to satisfy market demand, and banks saw themselves pay record-high rates for cash or see their ATMs run dry.
Dealers are now asking if these lessons will get banks to fall into line on improving their liquidity management.
"Twice-bitten banks should have gotten the message from the PBOC that they have to deleverage to better manage their cash flows," said a trader at a Chinese commercial bank in Shanghai.
"But it takes time for banks to carry this out, so periodic market squeezes will repeat time and again in 2014."
Defending themselves against accusations of irresponsibility in the aftermath of the mini-credit crises, central bankers have said there is plenty of liquidity in the system - banks are just misallocating it.
Traders say the next crunch could come as soon as later this month, when seasonal demand for cash will jump for the Spring Festival, or Lunar New Year, but expect spikes to occur regularly at the end of financial quarters.
Traders also warn that the resumption of initial public offerings in China this month could put cyclical pressure on short-term liquidity as subscriptions to new issues typically temporarily lock up huge amounts of cash.
The PBOC has provided more detail on its concerns about the mounting risk brewing in the shadow banking market in its latest quarterly report published in November.
It said the proportion of money created by the interbank market had exceeded capital inflows and securities investment during some periods of 2013, becoming the second biggest liquidity creator in the economy only after bank loans.
"The economy may have to experience a process of de-leveraging and removal of overcapacity for a quite long period," it said, marking the first time the word "de-leveraging" has appeared in its high profile monetary policy reports.
The interbank market in the world's second-largest economy rarely attracted attention until the squeezes began in June, but since then both domestic and global stock markets have proven sensitive to signs of liquidity shocks in China.
The PBOC's 2013 China financial stability report published in May revealed rapid growth in banks' interbank business.
Their interbank deposits reached 12.2 trillion yuan ($2 trillion) by the end of 2012, a 30.29 percent jump from a year earlier, while interbank assets reached a high 15.13 percent of their total assets, up 1.8 percent.
"The rapid increase in interbank business will to some extent enable banks to bypass restrictions on loan quotas, go around interest rate controls and cause distortions of regulatory indicators," the stability report said.
"Some interbank funds are circulating inside the market itself, weakening the ability of financial institutions to serve the real economy."
The PBOC has steadily tried to tighten liquidity since 2010 in the face of persistent inflation, especially of food and housing prices. That included 12 consecutive increases to banks' reserve requirement ratios (RRR) over a period of less than two years up to late 2011.
Consequently, banks' ability to handle seasonal demand has been greatly weakened, traders say, with the RRR for major banks now remaining at 20 percent of their total deposits, near a record high of 21.5 percent.
In 2014, cash flows in China's interbank market will become even more volatile as the U.S. Federal Reserve winds down its quantitative easing (QE) policy over time.
"Still, the PBOC is likely to adopt a stance to only offer limited cash in cases of acute shortfalls while sitting aside in most cases to force banks to shift money back into core operations," said a senior trader at a major Chinese state-owned bank in Beijing. ($1 = 6.05 Chinese yuan) (Editing by Jacqueline Wong)