June 25 Tuesday 11:10 GMT
SHANGHAI (Reuters) - China's central bank on Tuesday said it will not turn the screws too hard on banks in its drive to curb easy credit, seeking to allay fears of a banking crisis that had driven shares to their lowest in nearly 4-1/2 years on Tuesday.
The People's Bank of China (PBOC) wants to curtail the diversion of funds to a vast informal loan market as it seeks to shore up growth in the world's second-largest economy, but its tough stance has raised fears of a lasting credit crunch.
"Currently, the liquidity risk in the banking system is under control," said Ling Tao, vice governor of the Shanghai branch of the People's Bank of China told a media conference.
"We will stabilize market expectations and guide market interest rates to reasonable levels."
Ling spoke after local financial markets had closed. Anticipation of what he would say had earlier helped spark a remarkable turnaround in the stock market as rattled investors hoped for some respite from the central bank.
The CSI300 .CSI300 of the leading Shanghai and Shenzhen listings ended down just 0.3 percent, having fallen as much as 6 percent to its lowest since January 2009 during the day. The market had fallen 6.3 percent on Monday.
Reports of outages at cash machines of some banks added to the nervousness of a panicky market, with the index of financial stocks on the Shanghai exchange falling 7 percent at one point before recovering to close down a mere 0.1 percent.
It was not immediately clear whether Ling's comments would be enough to keep markets calm on Wednesday, but money traders welcomed a more accommodating tone.
"The PBOC appears to soften its position slightly by saying that it will adjust liquidity in line with market conditions and by suspending bill issuance today," one money trader at a Chinese commercial bank in Shanghai said. "It appears the peak of the market squeeze is over."
Money market rates soared last week after authorities allowed cash market conditions to tighten, and even though short-term rates have come down this week, bank stocks had tumbled on concerns tight funding would hurt earnings and the economy.
Overnight and 7-day rates eased again on Tuesday after the central bank did not drain funds from money markets, but weighted-average rates of over 5.8 percent and 7.4 percent respectively were still well above long-run levels.
Underscoring the tight conditions, there were spikes to 15 percent and higher for some deals during the day.
RISK WORTH TAKING
In addition to worries about banks, investors are also concerned that funding for many companies may dry up if credit conditions stay tight, forcing the world's second-largest economy to slow more than expected.
Several economists, however, praised the authorities saying it was a risk worth taking in order to steer the world's second-largest economy away from debt-fueled investment in infrastructure and property to a more sustainable path.
"The liquidity squeeze is the first real economic test for China's new leaders, to prove their willingness to overcome tough economic issues not with words, but by their actions," Zhiwei Zhang, a China economist for Nomura in Hong Kong, said in a research note.
"If the new leaders maintain their current approach, we believe it will add downside risk to growth in 2013, but in our opinion this would help reduce systemic financial risks, supporting long-term sustainable growth."
For decades China's rapid ascendancy has been powered by heavy investment fuelled by cheap, readily available credit, including massive spending in 2008 and 2009 that was credited with helping the global economy avoid a severe depression.
But with most analysts estimating China's total non-financial debt at around 200 percent of economic output and increasing amounts of it being funneled to the shadow system of wealth management products and trust funds, the new leadership of President Xi Jinping has been trying to cool lending down.
Market turbulence of the past week and violent and nervous investor reaction, however, highlighted the risks of Beijing's new approach to its debt headache.
"We believe the biggest risk comes from the PBOC potentially mishandling the situation," Bank of America Merrill Lynch analysts said in a note.
"In our view, dealing with banks in breach of regulations should be done by improving prudential regulations rather than engineering an interbank credit crunch which could potentially backfire should banks lose mutual trust."
(Additional reporting by Lu Jianxin, David Lin, Langi Chiang, Xiaoyi Shao, Aileen Wang and Shanghai Newsroom; Writing by Tomasz Janowski; Editing by John Mair)