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China’s Credit Squeeze Deals Fresh Blow to Stocks

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China's beleaguered equity markets are not having a good year: first there were worries about weak data and now a credit squeeze that is making investors steer clear of Chinese stocks.

The benchmark Shanghai Composite stock index tumbled 5.3 percent on Monday to its lowest level since early December. The sell-off spilled over into Hong Kong, where the Hang Seng stock index hit its lowest level in more than nine months.

Analysts say that until the tight liquidity conditions facing Chinese lenders ease or economic data improve, equity markets closely related to China are likely to remain under pressure.

Shanghai Composite Year-to-Date

Shanghai and Hong Kong are Asia's worst performing major stock markets this year with losses of roughly 12 percent each, followed by South Korea's Kospi, which is down almost 9 percent.

(Read More: What's Really Behind China's Cash Crunch)

"We are seeing ongoing weakness in Chinese stocks because of the credit squeeze and worries about China's economic growth because recent data have disappointed," said Audrey Goh, investment strategist at Standard Chartered in Singapore.

"When will the market stabilize? That is an open question – we need to see the PBOC [People's Bank of China] inject more liquidity and better economic data," she added.

Data last week showing the HSBC Purchasing Manager's Index, a gauge of manufacturing activity, moved deeper into contraction territory in June has fueled concerns that China's economy is slowing faster than anticipated.

U.S. Investment bank Goldman Sachs on Monday became the latest house to downgrade its forecast for Chinese economic growth, citing the tighter liquidity conditions as a reason for the move.

China's money markets have been under severe strain, with the key seven-day repo rate hitting a record high above 10 percent last week. The country's central bank has deliberately avoided pumping significant amounts of cash into the system in a bid to force local lenders to rein in credit growth which has reached worrying levels.

(Read More: China Stocks Bear Brunt of Growth Fears)

On Monday the central bank said that there were sufficient funds in the market, but banks need to improve their cash management, Reuters reported.

"It's all good in the long-run but in the short-term it is creating volatility in the financial markets when you're trying to control financial sector risk," Steven Sun, head of China equity strategy at HSBC, said on CNBC Asia's "Squawk Box," referring to the Chinese central bank's strategy.

Chinese banks were among the most heavily sold stocks on Monday, with the smaller lenders viewed as more dependent on short-term interbank funding suffering the most. China Minsheng Bank for instance fell more than 9 percent in Shanghai, while Ping An Bank slumped more than 8 percent.

Equity strategists said that while they did not expect China's stock market to be poised for a crash - an unanticipated and sharp drop in stock prices - the outlook was not great.

(Read More: Hedge Fund Manager Sees Stock Market Crash in China)

"I don't understand why they [China's central bank] are doing this. If you look at the way markets are trading, banks are trading, there is lots of uncertainty," Clay Carter, head of international equities at Perennial Investment Partners, told CNBC Asia's "Cash Flow." "It is one reason to stay away from Chinese equities at the moment."

— By CNBC.Com's Dhara Ranasinghe, Follow her on Twitter: @DharaCNBC

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