The benchmark seven-day weighted-average bond repurchase rate rose to 4.1240 percent at midday from Thursday's close of 3.9832 percent.

The shortest overnight repo rate rose to 3.6038 percent from 3.5666 percent but tenors above 14-days fell on expectations that liquidity conditions may improve after July 5, traders said.

The market has recently suffered a liquidity crunch. It stemmed from the need by banks for more money to meet half-year regulatory requirements, such as loan-to-deposit ratios, and a large initial public offering that froze 31 billion yuan ($4.9 billion) from the market this week.

Also, Chinese banks are required to adjust their deposit reserves on the 5th, 15th and 25th of each month.

Traders said deposits recently have been rising sharply as banks are succeeding in attracting more savers to enhance their half-year financial statements. Higher deposits will increase the amount that banks must set aside as reserve payments on July 5, they said.

"Even major banks appear to have limited money to lend, keeping short-term funding costs at high levels," said a dealer at a Chinese commercial bank in Shanghai.

"But the central bank is acting to help the market, and the market expects it to cut bank reserve requirements in July," the dealer added.

WINDOW OPEN

The People's Bank of China (PBOC) injected a net 198 billion yuan into the market via regular open market operations this week, up sharply from a net injection of 55 billion yuan last week.

Facing a worse-than-expected economic slowdown, the PBOC has cut reserve requirement ratios (RRR) twice this year, in February and May, and it reduced benchmark interest rates once, in June.

The moves were made partly because the slowdown has hit capital inflows into China and reduced money supply in the system.

The PBOC said earlier this month that it and Chinese financial institutions bought a net 23.4 billion yuan worth of foreign exchange in May, following a net sale of 60.6 billion yuan in April.

Average monthly net forex purchases in the first five months of 2012 was just 50.7 billion yuan, down sharply from 2011's average of 231.6 billion yuan a month and the 2010's average of 272.4 billion yuan.

For about a decade, the PBOC's injection of base money into the system via its purchase of foreign currencies flowing into the country to keep the yuan stable was the single main source of base money supply in China's financial system.

The PBOC may await June's economic data, to be announced in mid-July, to decide the timing of another RRR cut, traders said.

"Judging from the acute liquidity shortfall in the market, an RRR cut in July appears to be inevitable, and the PBOC may just want to choose a right time," said a dealer at an Asian bank.

(Editing by Richard Borsuk)

• A Permanent Economic Emergency