China Faces Off With Markets as Money Rates Soar

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China's central bank continued to test the resilience of local lenders to withstand a cash crunch on Thursday, as money market rates soared once again and short-term rates hit record highs.

The seven-day repo rate, which is seen as gauge of confidence to lend in the interbank market, rose to a record high above 10 percent. China's overnight repo rate jumped to as high as 30 percent, analysts said.

Chinese money markets have suffered a severe liquidity strain in the past week, due to seasonal factors and a sharp slowdown in foreign exchange inflows, raising concerns about the financial risks facing the world's second largest economy.

But to the surprise of many market participants, the central bank has held back from pumping cash into the market to ease the credit squeeze and analysts said a spike in the rates at which banks lend money to each other was also a concern.

"SHIBOR (Shanghai Interbank Offered Rate) at 25 percent basically means there is no functioning in the interbank market in China," Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York, tweeted.

"It's like money markets seizing up post-Lehman," he added, referring to the bankruptcy of U.S. investment bank Lehman Brothers in 2008.

Analysts say one explanation for the lack of intervention by the People's Bank of China (PBOC), the central bank, is that it wants to see how lenders operate under tight liquidity conditions.

(Read More: Why China's Central Bank Is Reluctant to Help Lenders)

Stress Test?

"One thing we know is that the PBOC has the tools to soothe out the liquidity issues but it has not done that, why? It shows that the PBOC's preference is to stress test the banks and the highly leveraged financial system," Barclays China Economist Jian Chang told CNBC Asia's "The Call."

Chris Weston, chief market strategist at trading firm IG Markets, added: "The inversion in the local yield curve [where yields on short-term bonds are higher than yields on long-term ones] is there for all to see and this is the PBOC's way of saying to the banks 'you've got yourself in this position, we are not going to help you out of it.'"

"This is a story about leverage and credit, with Fitch Ratings recently estimating that total credit has increased to 198 percent of GDP last year," Weston said in a note. "Money supply is rising at just under 16 percent, relative to the official target of 13 percent and now something has to give, the clean-up of the banking industry is underway and the PBOC is happy to forgo short-term growth and concentrate on financial stability."

Economists say that if money market rates remain high, that could lead to higher financing costs for business, harming growth at a time whenChina's economy is slowing. But that might be a risk Beijing's policymakers are willing to take as they introduce reforms aimed at putting China's economy on a more secure long-term footing.

Data released on Thursday showed a measure of manufacturing activity at a nine-month low in June, exacerbating a sell-off in Asian equity markets.

(Read More: More Gloom for China – PMI Falls to Nine-Month Low)

"They [policymakers] don't want a crisis but they do need to test the system every now and then and that means allowing bankruptcies and defaults to happen," said Barclays' Chang.

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