* Abrupt rate rise prompts central bank to inject cash
* PBOC telegraphs injection, suggests better market signalling
* Cash crunch risks undermining IPO resumption
* Regulators creating pilot to help small banks directly
By Pete Sweeney
SHANGHAI, Jan 21 (Reuters) - China's central bank moved to head off another destabilising cash squeeze on Tuesday with a big injection of cash - flagged in advance in a surprising act of transparency to relieve anxious markets.
Faced with an abrupt rise in benchmark interest rates on Monday, which saw the benchmark seven-day repo rate quoted as high as 10 percent at one point, the People's Bank of China (PBOC) announced it had provided an unspecified amount of emergency cash directly to some banks through its short-term lending facility (SLF).
It also committed to injecting money into the financial system during regularly scheduled open market operations on Tuesday - an unusual behavioural change for the central bank, which usually remains cagey about such plans.
As good as its word, the PBOC dumped 255 billion yuan ($42 billion) into the interbank market, the first injection since Dec. 24 and the largest amount in one day in 11 months.
The central bank also set up a lending facility specifically for smaller banks, who often complain they are squeezed out of the interbank market by bigger players.
"We think these are significant steps by the PBOC," said Zhang Zhiwei, China economist at Nomura in Hong Kong.
"These announcements suggest that the central bank is very concerned about potential liquidity risk in the interbank market leading into the Lunar New Year holiday period, as well as the financial risks in small banks," he wrote in a research note.
Following the central bank actions, benchmark rates eased sharply on Tuesday and several bond auctions by the China Development Bank went smoothly, pricing below expectations.
Stock markets were also relieved, with the benchmark CSI300 Index closing up nearly 1 percent on the day.
But money dealers remained cautious. They said cash withdrawals as Chinese prepare for the Lunar New Year holidays in the first week of February and planned initial public offerings (IPOs), which require potential investors to lock up cash, could apply upward pressure to rates in the absence of fresh fund injections by the PBOC.
Markets are also jittery over whether a 3 billion yuan mining trust loan, underwritten by China Credit Trust, will be allowed to default at the end of the month.
Chinese regulators want to move the country away from a credit-intensive growth model without putting short-term economic stability at risk, but volatility in the interbank lending markets show the difficulty they have in striking a balance.
"The PBOC is committed to deleveraging and reform but it has to tread cautiously," said a former central bank researcher, who spoke on condition of anonymity.
"Tightening money and credit conditions could put more pressures on the economy, and higher borrowing costs could erode profit margins of manufacturers and hurt the real economy."
By refraining from injecting cash into the country's interbank market - the funding pool commercial banks often use to cover risky credit bets - the PBOC has effectively engineered a sustained rise in short-term interest rates.
But by doing so, it has also set off a series of panic attacks in the market.
Last June, short-term rates jumped as high as 30 percent as domestic media circulated reports of panicking bankers and cash machines running dry. A less dramatic rise in rates occured in December.
The cash crunches hit Chinese stock markets, which are particularly sensitive to liquidity conditions, creating a headache for the China Securities Regulatory Commission (CSRC), which is trying to restore investor confidence in stock markets to serve as a viable alternative to bank lending.
The January rate rise was of particular concern because it risked setting off a stock market slide just as the long-frozen IPO market was being revived.
The PBOC was publicly criticised during the cash crunches in 2013 for not clearly communicating with the market, causing retail investors to overreact. Monday's announcement telegraphing its intention to inject funds appears to have been a small step in addressing that criticism.
However, central bankers have repeatedly and publicly defended their behavior by arguing that there is plenty of liquidity available in the system. If banks managed their cash supply better, that money would be available, they said.
Some traders said Monday's announcement was a step away from this hard-line position, pointing to the PBOC's commitment that it would create regional SLF centres around China to directly deliver cash to smaller stressed banks.
This would address a common complaint from traders at smaller banks that the big four state-owned banks abuse their mass and market influence to bully smaller entities into paying exortionate rates for short-term cash, even when they have plenty of cash to hand.
"It appears the central bank feels major banks have not done a good job in offering funds to smaller rivals, so it now wants to do itself," said a trader at a joint-stock bank in Shanghai.
On the other hand, economists point out that the smaller banks, which are particularly hungry for profits, tend to be far more deeply engaged in the kind of speculative lending, or shadow banking, that the PBOC is trying to suppress or redirect.
Industrial Bank, Minsheng Bank , and Ping An Bank are the most vulnerable to rising interbank rates due to their heavy reliance on short-term interbank borrowing, Michael Werner, China banks analyst for Bernstein Research, wrote in a note to clients in November.