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UPDATE 1-China's short-term money rates jump to pre-COVID levels on tighter cash conditions

(Writes through; adds details, comments and background)

SHANGHAI, Jan 26 (Reuters) - Short-term borrowing costs in China jumped to their pre-COVID 19 levels on Tuesday, pressured by the combination of the central bank’s extended net drain of cash from the financial system and higher holiday demand.

The week-long Lunar New Year holiday - one of the most important festivals in China - starts on Feb. 11 this year, and traditionally drives a surge in cash demand as households splurge on gifts and celebrations, and companies pay bonuses.

In response, the People’s Bank of China (PBOC) usually uses various liquidity tools, including reserve requirement ratio (RRR) cuts in 2019 and 2020, to inject funds into the financial system. But so far this year, the central bank has drained a net 64.5 billion yuan ($9.96 billion).

That has driven up the volume-weighted average rate of China’s benchmark overnight repo to 2.7366% as of noon Tuesday, the highest level since October 2019.

Other tenors also followed the trend, with the volume-weighted average of the seven-day tenor rising to a one-year high.

Signs of liquidity stress in the money market led to a spillover effect, driving yuan forwards higher and supporting exchange rate.

Traders said investors were struggling to interpret the official monetary policy stance as the PBOC has kept injecting a minimal daily 2 billion yuan this week, causing a huge cash drain on a net basis.

“The 2 billion yuan of cash injection could not even fulfil demand at a medium-sized commercial bank,” said a trader at a Chinese bank.

Some investors speculate that the PBOC’s moves might be a precursor to adopting a tightening bias especially as a few senior central bank officials have recently signalled they were considering scaling back the stimulus.

PBOC Governor Yi Gang said on Monday the central bank will adjust to new economic developments in a timely manner.

Some traders expect the PBOC could soon revive the contingent reserve arrangement (CRA), while avoiding sending a strong easing signal to the market. The CRA, introduced before the holiday in 2018, lets banks dip into reserves to make up for liquidity shortfalls.

“No matter whether the CRA is implemented or not, I think there’s a switch in official stance,” said a second trader at a Chinese bank.

China lowered lending benchmark rate twice and offered hundreds of billion dollars worth of liquidity in the early days of the COVID-19 outbreak in 2020.

$1 = 6.4733 Chinese yuan Reporting by Winni Zhou and Andrew Galbraith Editing by Shri Navaratnam

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