China's central bank has stepped in to calm investor nerves, saying the liquidity risks in its financial markets were controllable and that the unprecedented spike in interbank lending rates would gradually fade.
Ling Tao, the deputy director of the Shanghai branch of the People's Bank of China, told a news briefing in Shanghai that it would closely monitor the money market and keep interbank rates - a key measure of liquidity in the banking system - at reasonable levels.
Chinese shares rebounded sharply in the closing hour of Tuesday's trade as news of the briefing turned around an intra-day fall of as much as 5.8 per cent.
The Shanghai Composite Index ended the day 0.2 per cent lower.
It followed a more than 5 per cent fall on Monday, the worst one-day loss in four years.
The central bank's reluctance to inject liquidity into the system is seen as one of the strongest signals yet that it is determined to clamp down on the runaway problem of wealth management products in its so-called "shadow banking" sector.
Signalling the hardline stance, a commentary published in the state-run People's Daily on Tuesday said the central bank would not play "wet nurse" to investors, and that "propping up and bailing out" investors would not help but in fact harm the market in the longer run.
But the government's brinksmanship in carrying out what effectively have been impromptu "stress tests" of its banking system have also sparked concern.
Moody's lowered its credit outlook on the Hong Kong banking system over concerns of its exposure to borrowers in China.
Fitch Ratings warned last week that China's banking system will struggle to cope with the demand for cash when 1.5 trillion yuan worth of loans attached to wealth management products fall due.
Non-performing loans at Chinese banks have risen for six straight quarters, the longest deterioration in at least nine years. Moody's said the increase in NPLs was likely to accelerate in coming months.
But Standard & Poor's said it saw "no scenario" of China bank failure at this stage, and agreed the current spike in interbank rates would gradually ease.
Key interbank rates in China have eased for three straight days since touching an unprecedented 13.91 per cent on Thursday, but the overnight repurchase rate, at 5.73 per cent, is almost double this year's average of 3.09 per cent.
"The PBoC's campaign appears to be focused on the smaller shareholding banks, which are particularly reliant on short-term inter-bank lending for their (large) long-term liquidity needs," Standard Chartered analyst Stephen Green said in a note to clients. "However, there are clearly risks - it appears banks have been relying on inter-bank liquidity to tide themselves over during periods between WMP redemptions and reissues."
The liquidity crunch has the potential to exacerbate an already weakening Chinese economy - prompting several economists to wonder if this government could become the first in 15 years to miss its annual economic growth target.
The average growth forecast by economists surveyed by Bloomberg has fallen to 7.7 per cent, down from 8.4 per cent a year ago.