After the Fed, China Bears Return With Vengeance

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Less than a week after the U.S. Federal Reserve rattled global markets with talk about possibly easing its monetary stimulus this year, growing worries about a credit crunch in China suggest the risk appetite that was so strong just two months ago could take some time to return.

In fact, fears that tight liquidity conditions could harm the world's second largest economy kept stock markets firmly in negative territory on Tuesday.

The benchmark Shanghai Composite index led falls in Asian stocks with a decline of more than 5 percent to its lowest level in more than four years, putting the market in bear territory. The market, however, pared back its losses in late trade amid talk of a news conference later in the day involving the central bank to address the credit squeeze.

Japan's blue-chip Nikkei closed down 0.7 percent, setting a negative tone for European and U.S. markets.

"The volatility in global markets started with the [Fed chief] Ben Bernanke comments on tapering a month ago and now we are looking at this adjustment in liquidity in China," said George Boubouras, chief investment officer at Equity Trustees in Sydney. "It's not going to stop."

(Read More: US Data More Important Than Ever for Jittery Markets)

In an effort to get local lenders to clamp down on credit growth, China's central bank has shown a reluctance to step in aggressively and ease tight liquidity conditions. Analysts say that although that is good news for the economy long-term, the credit squeeze does suggests short-term pain for an economy that is already showing signs of weakness.

"The dragon economy now resembles a panda," Evan Lucas, a market strategist at trading firm IG said in a note. "It has been over a decade since China has experienced a cash squeeze like this."

China's economy grew at its slowest pace for 13 years in 2012 and recent disappointing data prompted a number of growth downgrades by major banks. Goldman Sachs on Monday for instance lowered its 2013 gross domestic product forecast to 7.4 percent from 7.7 percent.

(Read More: Goldman Joins Bandwagon, Downgrades China)

"The market has taken an extreme view of what's happening in China but we are going to have to wait for the dust to settle down now," said Michael McCarthy, chief market strategist at CMC Markets in Sydney, told CNBC's "Capital Connection."

Bad Timing?

Still, the money-market squeeze is bad timing for financial markets already grappling with the prospect of an unwinding in the Fed's massive stimulus program also known as quantitative easing.

Benchmark 10-year U.S. Treasury yields have spiked to about 2.7 percent this week, their highest level in almost two years, while U.S. stocks fell more than 1 percent overnight. Emerging markets, hit hard by the Fed jitters, have also been unnerved by worries about China.

The MSCI Emerging Market Index, which has fallen almost 15 percent in the past month, on Tuesday fell to its lowest level in just over a year.

(Read More: Why Fed Won't Trigger Messy Rerun of 1994 in Asia)

"Look at global markets in general. Here we are in June and it's like a mini-1994. We have risk-free bonds with a negative return and equity markets with a negative return," said Equity Trustees' Boubouras, referring to the aggressive monetary tightening by the Fed back in 1994 that sparked a sharp jump in U.S. bond yields.

"So you've got 1994, one year of pain, all in one month and the volatility doesn't look like it will wane any time soon," he said.

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