By Winni Zhou and Elias Glenn
SHANGHAI (Reuters) - China's central bank surprised financial markets on Friday by raising short-term interest rates on the first day back from a long holiday, in a further sign of policy tightening as the economy shows signs of steadying.
While the rate increases were modest, they reinforced views that Chinese authorities are intent on both containing capital outflows and reining in risks to the financial system created by years of debt-fueled stimulus.
Higher interest rates could prod debt-laden firms into deleveraging, though at the risk of stunting growth.
"It appears to be an intent to control a real estate bubble. It could also be aimed at arresting the yuan's depreciation, although it is on the reverse repo they touched upon and the impact remains to be seen," said Naoto Saito, chief economic researcher at the Daiwa Institute of Research In Tokyo.
"All in all, it comes across as a move to tweak interest rate levels to accompany a broader monetary policy shift."
The People's Bank of China (PBOC) raised the interest rate on open market operation reverse repurchase agreements (repos) by 10 basis points, effective on Feb. 3.
It also raised the lending rates on its standing lending facility (SLF) short-term loans.
PBOC assistant governor Zhang Xiaohui said later on Friday that monetary policy will be kept generally prudent and stable, while also avoiding either a rapid slowdown in economic growth or excessive liquidity injections.
Zhang also said China will keep the yuan basically stable and will avoid large volatility in interest rates and foreign exchange rates. The comments were made in an essay published by China Finance, a PBOC-affiliated magazine, through the messaging service WeChat.
Analysts said the tightening of primarily money market rates suggested the PBOC wanted to retain policy flexibility as it balances the need to keep the economy from slowing again.
Other moves in recent months had signaled that Beijing was eyeing a gradual shift from its loose policy stance.
In late January, the PBOC raised rates on its medium-term loan facility (MLF) for the first time since it debuted the liquidity tool in 2014. It was the first time it has raised one of its policy interest rates since July 2011.
Analysts expect any further steps to be gradual as policymakers weigh their impact on economic growth, and believe the PBOC will be in no hurry to raise the policy lending rate for now. The one-year policy lending rate was last cut in October 2015 to 4.35 percent.
"China's economic recovery is still shaky, while the global economic situation is unstable, so raising open market rates is more appropriate than raising benchmark rates," said Li Huiyong, chief economist at Shenwan Hongyuan Securities.
"It's a flexible tool, which can be easily reversed if China's economy shows signs weakness again."
The world's second-largest economy grew 6.7 percent last year - roughly in the middle of the government's target range.
But heavy policy stimulus - evident in record lending from mostly state-owned banks and increased government spending - has fueled worries about the risks of high debt levels and an overheating housing market that could threaten financial stability if not addressed.
China's debt to GDP ratio rose to 277 percent at the end of 2016 from 254 percent the previous year, with an increasing share of new credit being used to pay debt servicing costs, UBS analysts said in a note.
A DIFFERENT TYPE OF TIGHTENING
Asian stock markets extended modest early losses after the rate rise, while China bond futures fell as much as 1.5 percent at one point. Most Chinese and global metal prices also fell on fears that higher rates will sap demand.
The PBOC raised the seven-day open market operations rate -- its unofficial policy rate -- to 2.35 percent from 2.25 percent, while also lifting rates for SLF loans. The SLF rate acts as a de facto ceiling for interbank lending, analysts said.
(For details on other rate moves, see)
China's central bank also injected funds through 7-day, 14-day and 28-day repos on Friday, although there was a net drain of funds for the day owing to maturing open market operations.
"It's not a good kick off of the Lunar New Year. It is a clear sign that the central bank has switched to tighten its monetary policy," said a trader at a Chinese bank in Shanghai.
China's economy has seen a broad-based pickup in recent months, due largely to a strong housing market and higher government spending on infrastructure projects.
At the same time, however, capital flight from the tightly managed economy has been strong, fueled by expectations that the yuan currency <CNY=CFXS> will depreciate further after sliding to more than eight-year lows against the dollar.
The yuan <CNY=CFXS> fell nearly 7 percent last year, its biggest loss against the dollar since 1994, on worries about shaky growth early in the year and amid a surge in the dollar.
Bearish yuan views have persisted despite a slew of moves in recent months aimed at making it more difficult for Chinese individuals and companies to send money abroad.
China's currency reserves fell by a tenth last year and, at $3.011 trillion, are close to falling below psychologically significant levels.
“The signal is very clear," said Zhou Hao, senior Asian emerging market economist at Commerzbank in Singapore, referring to the latest rate move.
Hao said this time the tightening was more targeted compared with China's previous tightening cycle that ended in 2013.
"Inflation at that time was rising very rapidly and at this time inflation is not really an issue. Secondly, the yuan was under pressure to appreciate at that time."
"Right now it’s totally different. If you have capital outflows, that’s already tightening. And then you tighten further, which is a double-whammy.”
(Reporting by Shanghai and Beijing newsrooms; Writing by Vidya Ranganathan; Editing by Kim Coghill)