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Cash crunch signals policy dilemma for China’s central bank

China's central bank looks set to risk another cash crunch at the end of January, barely a month after the last market squeeze, as policymakers press ahead with a crackdown on shadow financing and other risky bank lending.

The People's Bank of China (PBOC) is attempting a delicate balancing act to keep economic growth on track while avoiding a debt-induced financial crisis.

(Read more: China 'major' uncertainty facing global economy: Soros)

Periodic cash squeezes as banks scramble for fresh funds highlight the policy dilemma the PBOC faces in 2014, as it pushes financial reforms to help rebalance the world's second biggest economy away from the investment- and exports-led model that powered its rapid rise.

Spikes in June and December in the interest rates at which banks lend to each other signaled the central bank's determination to reduce alarming levels of debt. But it must try to do so without hurting growth by braking too hard on credit.

Adam Young | Flickr | Getty Images

"It's difficult for the central bank to implement monetary policy," said Liang Youcai, senior economist at the State Information Center, a top government think-tank in Beijing.

"Monetary policy may be slightly tight in 2014 but the central bank has to consider the impact on the real economy."

Demand for cash is strongest near the end of each quarter as banks rush to meet regulatory requirements, such as loan-to-deposit and reserve ratios, and pay out maturing financial products – a factor that fueled both episodes in 2013.

Analysts say the seasonal liquidity strain in money markets could re-emerge when demand for cash from firms and depositors spikes ahead of the Lunar New Year holiday at the end of January. Banks also tend to increase lending at the start of the year, while the resumption of IPOs after a year-long freeze could also increase demand for cash.

(Read more: Time to get picky on China stocks: HSBC)

Market volatility

The central bank mostly stood by as interbank lending rates grew more volatile in 2013, and was accused of worsening June's market turbulence by keeping the purse strings too tight.

Since then it has sought to improve its communication with the market – including by announcing its short-term liquidity operation (SLO), by which it injects funds into the banking system, via its new account on the microblogging platform Weibo.

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