How China Could Douse Optimism From the Fed

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Concerns about a liquidity crunch in the world's second largest economy, reflected by an unsuccessful bond auction last week and a spike in interbank lending rates, threaten to derail financial markets just as the U.S. Federal Reserve is expected to restore some calm this week.

China's Finance Ministry failed to sell all of the $2.45 billion worth of government bonds on offer at an auction on Friday – the first time it has not reached its target in almost two years – amid a strain in liquidity conditions.

Reflecting tightness in the money market, the 7-day repo rate - a key indicator of market liquidity - has risen to around 7 percent, compared with an average level of 3 percent over the past year, according to Australia and New Zealand (ANZ) Bank.

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"We should be very careful about the news flow in China and what's going on. A negative headline out of China related to the financial sector could undo some efforts of the Fed to keep markets calm," Richard Yetsenga, head of global markets research at ANZ told CNBC Asia's "Squawk Box" on Monday.

Expectations that the Fed could start to take back its aggressive monetary stimulus this year as the economy improves has led to a sharp sell-off in global markets in recent weeks and the U.S. central bank is expected to use this week's monetary policy meeting as an opportunity to calm the nerves.

But signs of trouble in China's financial system could give markets a reason to remain on edge.

While seasonal factors such as last week's three-day national holiday and corporate tax payments at the end of May have driven tightness in the money market, experts say overall financial stress in the economy is rising.

"The problem in China is that mounting bad debt is making it harder and harder to refinance all that bad debt while simultaneously funding ever-rising levels of investment which has been a major factor in fueling GDP [gross domestic product] growth," said Patrick Chovanec, chief strategist at Silvercrest Asset Management.

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"Even at alarmingly high levels of credit expansion, there just isn't enough liquidity to paper over past losses and drive growth. The failed auction is just one symptom of this liquidity crunch," Chovanec added.

Time to Step In?

If policymakers fail to act pre-emptively, the financial risk could become a macroeconomic risk, according to ANZ, which is advocating an interest rate cut by the People's Bank of China (PBOC).

Although the PBOC has tolerated China's tight liquidity conditions to send a signal to the market that it is determined to contain growth in liquidity, monetary easing could be imminent, analysts at ANZ said.

"We believe a strong currency, together with sluggish real economic activity and limited inflationary pressures, have set the right conditions for the PBOC to cut the policy rate by 25 basis points," they said in a note.

(Read More: Now, China Watchers See Growth Below 7%)

Chovanec at Silvercrest Asset Management, however, said while the central bank will likely be forced to step in to ease liquidity shortfalls in the banking system in order to prevent defaults, this is would just be a temporary fix.

"When it [eases liquidity conditions], the PBOC basically cedes control over monetary policy to temporarily slake the Chinese economy's insatiable thirst for more and more Ponzi financing," Chovanec said, referring to a scheme in which new investors' funds are used to pay earlier backers.

In a sign that concerns about financial stress in the Chinese economy are mounting, ratings agency Fitch Ratings warned at the weekend that the scale of credit is so extreme that China will find it hard to "grow its way out of the excesses," The Daily Telegraph newspaper reported.

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," Charlene Chu, senior director at Fitch Ratings, told the Daily Telegraph.