What's Really Behind China's Cash Crunch

Tomohiro Ohsumi | Bloomberg | Getty Images

When it comes to the economy, China's policy makers have often been criticized for a heavy-handed approach, stepping in at the first signs of trouble. That makes the reluctance by the central bank to pump in cash and alleviate a credit squeeze for local lenders highly significant, analysts say.

"There is a sea change taking place in China," said David Mann, the head of regional research for Asia at Standard Chartered Bank in Singapore. "The reluctance to intervene in the money markets, the tolerance of a lower rate of growth, it's all part of the same story of China trying to secure a better long-term outlook for the economy."

A credit squeeze among China's lenders took a turn for the worse on Thursday after overnight lending rates surged. 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, before easing back to around 8 percent on Friday.

The prospect of a liquidity drying up in world's second largest economy rattled markets inside and outside China, unnerving investors at a time when the U.S. Federal Reserve looks set to start unwinding some of monetary stimulus it has pumped into the economy in recent years.

"China is the biggest risk at the moment. We've got the interbank rate spike and a growing numbers of calls for a credit crunch in China," said Stan Shamu, market strategist at trading firm IG.

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For some time now, China watchers have argued that Beijing needs to do more to clamp down on the credit growth among local lenders as well as tolerate a slower level of growth to allow the economy to rebalance itself away from a dependence on manufacturing and investment towards consumption.

Recent noises from Beijing's policymakers have suggested that they are willing to tolerate a slower rate of growtheven as signs of weakness show up in data.

"The new government is not as concerned about growth or artificial growth as the old government was," said Shamu. "They have already emphasized they want to see good structural changes in the domestic economy as opposed to creating an artificial bubble."

The central bank is playing its role in trying to engineer long-term changes that will benefit the economy long-term, analysts say.

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While a sharp slowdown in foreign exchange inflows and seasonal factors have dried up liquidity, the central bank has not helped by draining funds from the market and deliberately stayed away in a bid to force local lenders to rein in credit growth which has reached worrying levels.

According to research from Credit Suisse, China's credit-to-GDP ratio surged to more than 170 percent last year from just over 110 percent in 2008. Ratings agency Fitch Ratings has warned that the scale of credit in the economy was so extreme that it would find it difficult to grow its way out of the excesses.

In addition to not helping local lenders by providing more liquidity, there has been growing talk that China's central bank will allow smaller lenders to default on their loans to other banks.

"Right now China is about to experience what that adjustment process looks like and those banks that at are at the margin in terms of risk are going to be in big trouble – it might be something like bank failures or need to merge them," Joel Stern, the chairman and CEO of consulting firm Stern Stewart & Co.

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China's economy grew at its slowest pace for 13 years in 2012 and so far this year and economic data has disappointed, prompting many economists to slash their growth forecasts.

"Smaller provincial banks are going to feel some stress and that could hurt some of the companies that are dependent on them," said Lorraine Tan, director of equity research at S&P Capital IQ, said on CNBC Asia's "Cash Flow." "The good news is that this [credit crunch] is likely to be contained in China."

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

- Additional reporting by Ansuya Harjani