By Gabriel Wildau and Lu Jianxin
SHANGHAI (Reuters) - China's cash crunch eased further on Monday after the central bank moved to prevent the money market from seizing up, but bank stocks tanked as the authorities made clear that the days of unlimited cheap official funds are over.
Chinese shares suffered their biggest daily loss in nearly four years, with financial stocks dropping more than 7 percent after the People's Bank of China (PBOC) said banks needed to do a better job of managing their cash and lending.
Money market rates had soared last week when the central bank, relied on as a source of cheap cash used to finance China's vast "shadow banking" system, stood pat, letting a sharp drop in fund inflows into China and cash hoarding by some banks do the rest.
The sudden tightening of cash markets, which saw some banks paying a 25 percent interest rate for cash, fanned fears that Beijing's latest attempt to steer the world's second-biggest economy to more balanced growth less reliant on credit-driven investment could backfire.
Under the worst-case scenario money markets could freeze, driving weaker lenders into default in a repeat of what happened in the West after the Lehman Brothers collapse in 2008. That would hit China's overall economy, its top trading partners and the global economy at large.
On Monday, however, such a scenario appeared less likely, after short-term rates eased for the second straight day, though individual bank stocks fell out of favor.
In a statement published on its website on Monday, the PBOC sought to calm fears that smaller players might get cut off, by suggesting bigger institutions should play their part and keep providing funding for others.
"As financial institutions, especially big commercial banks, strengthen their own liquidity management, they should at the same time play to their strengths and complement the central bank in stabilizing the market."
The public statement echoed points the PBOC made directly to banks in a closed-door meeting last week, just before interbank rates first began to fall back from their peak.
The overnight repo rate, a key measure of funding costs in China's interbank market, fell by more than two percentage points to 6.64 percent on a weighted-average basis on Monday, its lowest since last Tuesday.
It had peaked near 12 percent last Thursday.
"Panic over a liquidity squeeze appears to be fading. We are lending more money out, but I did not hear about any central bank money injection into the market," said trader at a major state-owned bank in Shanghai.
SMALLER BANKS HIT
The monetary authority, which drew fire for keeping the market guessing about its intentions, also made a point of telling banks they could do a better job at managing cash and controlling lending.
The central bank's rebuke sent shares of medium-sized lenders, which rely heavily on interbank borrowing, reeling as investors realized that costs of funding would stay elevated.
"It's much easier to borrow money today, but costs remain high. Our business is apparently affected, but mainly on side business, such as wealth management," said a trader at a mid-sized commercial bank in Shanghai.
The Shanghai blue-chip CSI300 index <.CSI300> ended down 6.3 percent. [ID:nH9N0DD04R] and the financial sub-index <.SSEFN> fell 7.4 percent, its worst day since November 2008.
Beijing has long struggled to contain the growth in "shadow banking", where banks and other institutions can bypass controls on deposit and lending rates and other restrictions by offering so-called wealth-management products and other investment products.
Several observers have said the monetary authorities "benign neglect" could be the most effective way of curbing the dark side of China's borrowing spree, though recent market turbulence showed how easy it was to miscalculate its side effects.
The latest developments also prompted several economists to reconsider their views on how fast China's economy can grow.
Both Goldman Sachs and China International Capital Corp. (CICC) downgraded their growth forecasts for this year and next with Goldman Sachs trimming its 2013 forecast to 7.4 percent from 7.8 percent and 2014 to 7.7 percent from earlier 8.4 percent. CICC cut its full 2013 growth forecast to 7.4 percent from 7.7 percent.
While the adjustments are relatively small and such a rate of expansion remains within the long-term rates targeted by Beijing, market players are worried about further turbulence.
"We regard China's latest moves as credit positive for the health of the Chinese banking system overall," Moody's Investors Service said in a report. "However, the method the PBOC chose to keep the banking system short of liquidity entails risks that could have credit negative implications," it said.
"Persistent money market volatility similar to that of last week could result in lasting damage to confidence in the interbank market."
(Writing by Tomasz Janowski; Editing by John Mair)