China's liquidity crunch won't pose systemic risks to the world's second-largest economy, but the central bank needs to rethink its policy, said analysts.[Hong Kong company registration]

Willem Buiter, Citigroup Inc's chief economist, said recent cash tension is a "warning shot" from the People's Bank of China that it means to curb shadow banking activities instead of those of ordinary banks, which pose no systemic risk.

"But if you rely on a crunch (to target shadow banking), you'll succeed but with an economic recession," said Buiter.

Apart from an increase in funding costs, the government should introduce a policy mix involving increased market orientation for the banking sector and treat banks and shadow banking the same, Buiter said.

Shen Minggao, head of China research at Citigroup, said tight liquidity cannot be sustainable and the central bank should inject funds into the market before long. "A cut in the reserve requirement ratio cannot be ruled out."

The PBOC "should also work on improving its policy transparency, to better communicate with the market and guide investor expectations, otherwise it will lead to 'artificial' panic".

Analysts have said that the central bank's "punishment" of banks that fund investments in securities with funding from the interbank market will result in more prudent lending and liquidity management, [Set Up Company Hong Kong]which will hurt economic growth.

Citigroup has cut its forecast for China's GDP growth this year to 7.6 percent from the previous 7.8 percent. The rate will further ease to 7.3 percent in 2014, it said.

It is becoming clear that China's new economic leadership team is willing to accept some short-term pain for long-term gains, and the recent crunch in the interbank market is the most obvious evidence of the new stance, said Stephen Green, chief China economist at Standard Chartered Bank.

"China's current high interbank rates are the intended result of a PBOC campaign to force banks to better manage liquidity and deleverage from certain sectors.

"Comparisons with the Lehman-related freezing of interbank liquidity in the United States in 2008 are unhelpful. This is not a run on liquidity caused by a credit event. Instead, we believe it is a deliberate policy meant to de-risk the interbank system," he said.

Louis Kuijs, chief China economist at the Royal Bank of Scotland, said: "In our view it remains highly unlikely that pressures stemming from financial risks would become systemic enough to threaten China's financial stability or the overall economy."

He said containing non-bank lending and the associated risks is likely to have been a key consideration in the firming up of the monetary stance.

"We do not think the financial risks emanating from the non-bank financial system are large and systemic enough to overwhelm macroeconomic and financial stability in China."

Since June 13, interbank market interest rates have soared as liquidity conditions tightened.

The seven-day repurchase rate, an indicator of interbank funding availability, rose 270 basis points to 10.77 percent in Shanghai on Thursday, the highest level since March 2003, while the one-day [Hong Kong Company Formation]rate increased by 527 basis points to a record high of 12.85 percent.

Analysts have said several specific factors contributed to the tightness, including misunderstanding between the markets and the PBOC about the central bank's policy stance and implementation, a change in the timing of corporate tax payments, strong liquidity demand around a national holiday and the impact of measures taken in May to clamp down on capital inflows.

Turbulence in international capital markets after indications of a possible tapering off of a third round of quantitative easing in the US added uncertainty.

At the end of last week, the authorities took some steps to ease the problems. Media reported some emergency financing was arranged to one or two individual banks to ensure they could honor their contracts and the PBOC injected some modest amount of liquidity into the market.

Interbank market rates became a little less volatile last Friday afternoon and moved lower. The overnight rate ended the day at 8.7 percent, sharply off the highs.

The PBOC told the big banks at a meeting on Friday to stop hoarding liquidity and ordered them to improve liquidity management.

"We see the PBOC maintaining its bill issuance in small amounts as signaling its stance of no near-term easing. At least for now, this is still just a liquidity issue and the PBOC has full control of the situation," Green said.

He said a broad-based easing is unlikely, although emergency support to prevent systemic risk is still possible.

"Liquidity could start to ease more materially in the second week of July, but rates are likely to stabilize at levels above those seen from January to April."

The PBOC issued a statement on its second-quarter monetary policy committee meeting on Sunday evening, which said that the committee had agreed to "fine-tune policy when necessary".

It also said the central bank will "contain financial risks with more solid actions".

"The financial risks in the economy are not yet fully under control. Policy tightening only started in mid-March, and a shift of policy to an easing bias would exacerbate these financial risks," said Zhang Zhiwei, chief China economist at Nomura Holdings Inc.