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China’s shadow banking shrinks amid delicate policy dance

Amid a spate of default headlines, China's shadow banking sector is slowing, but loans overall continue to grow amid a delicate policy dance between economic growth and tightening credit.

"On the one hand, (regulators) try to control and taper down on the China shadow banking system side and on the other hand, they need to pump liquidity into the system to ensure the rates do not spike up too drastically," said David Poh, regional head of asset allocation at Societe Generale private banking. "This is like a fine balance between the two."

(Read more: Yuan weakness adds wrinkle to EM debt concerns)

The latest loan data seem to suggest fresh caution on lending. Total credit formation slipped to a four-month low of 938.7 billion yuan (around $153 billion) in February, up 17.1 percent on year, but slower than January's 17.4 percent rise, hurt by slowing property sales and as shadow lending slipped. January typically sees higher lending activity, in part due to the Lunar New Year holiday distortion.

Combined January and February shadow-banking credit fell 11.3 percent on year, according to data from Nomura. The decline followed news of several near and partial defaults on shadow banking products.

But even as regulators seek to rein in riskier shadow banking lending, especially to sectors suffering from overcapacity, such as coal and property, they have also surprised the market by pushing the currency lower.

"Rampant currency intervention by the People's Bank [of China] caused interbank interest rates to plummet towards the end of last month," Capital Economics said in a note. "If the People's Bank [of China] keeps this up, then looser monetary conditions are likely to support a rebound in credit growth in the 'shadow banking sector,'" it added, although it noted it expects the intention was to deter speculative inflows and that the yuan will strengthen again later.

(Read more: Get ready for more China shadow-banking defaults)

Poh also expects efforts to tamp down riskier credit may not be entirely successful as the liquidity used to keep bank loan rates under control is likely to end up directed toward higher yielding options.

"What they try to pump into the system to ease the monetary policy side will eventually flow into markets and sectors that require the most credit – the coal companies, the real-estate sector," Poh told CNBC. "These are the ones that have a shortage of cash currently. This will push the rates much higher from here."

(Read more: Will a weaker yuan heighten China's property risks?)

Others have also noted China's policy is struggling with conflicting goals.

"The government is trying to do two things at the same time. One is it's trying to contain credit growth," said Bruce Kasman, chief economist for global research at JPMorgan.

"At the same time, though, the steps they were taking to tighten credit was encouraging money to flow in. It was encouraging upward pressure on the currency and now they're trying to offset that by doing things to increase liquidity," Kasman told CNBC. "The question is can they do one without going against their goal on the other?"

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(Read more: What that China debt default means to the market)

He believes efforts to keep credit from overheating are further complicated by the government's economic growth target of 7.5 percent for the year.

"They're not really willing to sacrifice growth," he said. "There's still a strong desire to keep this job machine running, to keep this economy growing. I think the right question to ask is how long can you go without it hitting a wall and I think the answer is I don't know."

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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