Is China Right to Brush Aside Credit Squeeze?

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China's central bank is right to stand its ground even as its decision to tolerate a credit squeeze that raises the prospect of slower growth in the world's second biggest economy rattles markets, strategists told CNBC.

"We think the PBOC [People's Bank of China] is doing the right thing, to prick a bubble before it's too late," Kelvin Chan, head of country research at Euromonitor International told CNBC Asia's "Squawk Box."

Rampant credit growth is seen as one of the biggest risks facing China's economy. According to research from Credit Suisse, China's credit-to-gross domestic product (GDP) ratio surged to more than 170 percent last year from just over 110 percent in 2008.

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Ratings agency Fitch 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.

"There's always a risk in terms of miscalculation, but if China has any kind of real chance to fix its problems, and we all know that China is sick in its credit system, then they [policymakers] better do it now rather than later," Chan added.

Local lenders in China have faced a severe liquidity strain in recent weeks, with interbank lending rates hitting double digits last week, raising concern that efforts to rein in credit growth and steer the economy away from a dependence on credit-driven investment could go wrong.

The jitters have spilled over into China's stock market, which slumped more than 5 percent in its worst one-day sell-off in almost four years on Monday and extended its falls on Tuesday to its lowest levels in more than four years.

China's seven-day repo rate, a gauge of the availability of funds in the interbank market, remains high at around 7 percent on Tuesday although it has eased back from a record high hit last week above 10 percent.

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"At least we've had some pull back in money market rates and I suspect that they [central bankers] will be able to fine tune their policy in the next few months. For the most part the lending numbers have been strong this year, but I'm not panicking," said Sean Callow, senior currency strategist at Westpac Bank in Sydney.

According to Michael Ivanovitch, president of economic research firm MSI Global, "They've [PBOC] known for some time about the problems in the shadow banking system and have tried to remedy the problems. Obviously it's not an easy task. Financial markets are sensitive and the PBOC probably wanted to send a message -- we'll tolerate no nonsense any more, you guys are on your own."

China watchers added that the central bank, while keen to see banks gain a tighter control over credit growth, would not allow the tight liquidity conditions to develop into a banking crisis that could destabilize the economy.

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"The idea here is they don't want to see banks fail, they have the ability to step in above board or clandestinely and inject targeted liquidity into companies and into certain sectors, so they can manage this pretty well," said Leland Miller, president of U.S.-based China Beige Book International.

Euromonitor's Chan agreed, saying: "Right now we are confident that they can fix the problem. They still have a few tools that they can take out and use to ease liquidity conditions if they need to."

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