CHINA'S central bank withdrew cash from the financial system, suggesting it views Tuesday's (Oct 31) abrupt surge in short-term borrowing costs as a one-off disruption.

The People's Bank of China drained a net 109 billion yuan (S$20.4 billion) from money markets on Wednesday by doling out a smaller amount of new short-term loans than were maturing.

The withdrawal came even as funding conditions tightened sharply in recent days due to month-end demand, tax payments and large government bond sales. Still, the overnight rate had surged to as high as 50 per cent in isolated transactions on Tuesday, according to a trader, who asked not to be identified. That sparked concern over potential stress in the financial system.

"The PBOC likely viewed the incident yesterday as a temporary mismatch, not a structural issue," said Bruce Pang, chief economist for Greater China at Jones Lang LaSalle. But, the need for liquidity to support bond issuance going forward means the PBOC will still likely cut banks' reserve requirement ratio (RRR) within three months, with a possible move as early as in November, he added.

The weighted average rate of overnight repurchase agreements, a key gauge of interbank borrowing costs, fell as much as 15 basis points on Wednesday, another indication that liquidity stress has declined. It had gained 18 basis points on Tuesday, the biggest increase since Sept 28, Bloomberg-compiled data show.

The PBOC typically withdraws cash via its daily open-market operation at the beginning of each month, as liquidity usually eases due to a decline in financing demand. It tends to inject cash on a net basis toward the end of the month as banks boost their liquid assets to meet regulatory requirements.

State broadcaster China Central Television blamed unidentified financial institutions for disrupting the market on Tuesday. "Some institutions, with the aim of maximising profits, depend too much on rolling-over financing, borrowing short and investing long – creating their own liquidity risks, which disturbs the market and creates a tense mood," CCTV said in a report.

The jump in overnight borrowing costs was seen mostly in over-the-counter borrowing by non-banks, traders said, asking not to be identified as they aren't authorised to speak publicly. Those loans aren't captured in public data.

Liquidity remained relatively tight in the morning as large banks offered limited funding, according to two traders. Banks borrowed overnight funds at around the weighted average rate, while non-banking institutions transacted at higher borrowing costs at about 2.5 per cent, they said.

China's financial system has been under strain in recent months as the government sought to support a faltering economy with debt-fuelled stimulus, spurring intense scrutiny over its money market operations.

Liquidity is expected to tighten after Beijing said last week it's raising the fiscal deficit ratio and authorising the sale of 1 trillion yuan of debt in the remaining months of the year.

"The PBOC may not target to address brief liquidity tightness among some market participants," said Frances Cheung, a rates strategist at Oversea-Chinese Banking Corp. "Rather, we expect liquidity injection to buffer the broader liquidity demand arising from bond issuances."

Money market rates will likely retreat toward the rates used in the central bank's open market operations from Wednesday, according to a person close to the central bank, who asked not to be identified. Liquidity in the banking system is relatively abundant, the person added on Tuesday.

The central bank cut lenders' reserve requirement ratio in March and September by 25 basis points each. It also delivered moderate reductions to the rate of the medium-term lending facility in June and August, respectively, to support the slowing economy. The PBOC also stepped up cash injection in October as funding costs climbed.

A total of 850 billion yuan worth of MLF funds will mature this month, the most in a year, providing another reason for the PBOC to step up liquidity support. Some economists expect the PBOC to cut the RRR by 25 basis points in the next two weeks amid a bonanza bond sale.

"The net withdrawal today is in line with the tradition for the beginning of a month," said Zhaopeng Xing, senior China strategist at Australia & New Zealand Banking Group. "The PBOC intends to keep the overnight rates not too low, extending its operation style since October." BLOOMBERG