China's central bank pledged to maintain loose monetary policy and use market tools, not quota-style controls, to ensure sustainable credit growth that will support economic recovery.

In a statement that analysts said was intended to calm skittish markets, the People's Bank of China Vice Governor Su Ning said the central bank will unswervingly continue to apply appropriately loose monetary policy and consolidate the economic recovery momentum.

The statement was posted on the bank's website after Wednesday's 5 percent fall in the Chinese stock market, its biggest daily drop in eight months, which was sparked in part by worries that Beijing will push banks to restrict their lending.

They are responding to an incorrect interpretation by the market, Ting Lu, economist with Merrill Lynch in Hong Kong, said.

Su's comments helped push the benchmark Shanghai stock index <.SSEC> up in early trade, but worries that a roughly eight month-long rally has run out of steam pushed it down 1.15 percent at the close of the morning session.

There will not be credit quotas this year, though there could be window guidance, Lu said, referring to more informal directions that Beijing gives banks to influence their decisions.

Local media reported on Wednesday that the country's two biggest banks had decided themselves to put a lid on their 2009 lending targets in a move that would significantly slow overall Chinese credit growth in the second half.

Industrial and Commercial Bank of China (ICBC) <1398.HK> and China Construction Bank (CCB) <0939.HK> both planned to grant loans in the second half that would be just about one-quarter of the total that they issued in the first half, Caijing magazine said.

CREDIT QUOTAS

Beijing has in the past used a quota system to control lending, telling banks not to exceed specific ceilings. This credit management was a key prong of China's monetary tightening in 2008 and it was subsequently blamed for contributing to the economy's marked slowdown in the fourth quarter.

Su's comments appeared to rule out an imminent return to a strict, central bank-directed quota system.

We will focus on market tools, not quantitative-style control methods, flexibly using many kinds of monetary policy instruments, he said.

We will guide appropriate monetary and credit growth, strengthen the sustainability and do what is necessary to drive the economic recovery and to ensure stable and quite fast economic growth, he said.

But Dong Xian'an, chief macro-economist with Industrial Securities in Shanghai, said firm lending quotas were still very much on the table, because they are a direct way to manage the underdeveloped and occasionally unruly Chinese financial system.

Credit quotas are still an effective, if not the ideal, way to control credit growth, he said, adding that moving to a more market-oriented system would take time.

Lu at Merrill Lynch said that while Beijing was unlikely to impose hard-and-fast loan caps on banks, the central bank could well use a blend of moral suasion and punitive bill issuance to coax them into lending less.

It has already started down that path. Earlier this month, the People's Bank of China told a group of banks that have been particularly aggressive in lending that they would be required to buy 100 billion yuan in one-year special bills.

The special bills will carry a punitive yield of 1.5 percent and the banks were ordered to buy them in September -- a clear move to stem lending bursts that tend to come at quarter-end.

Overall, Chinese banks made a whopping 7.37 trillion yuan ($1.08 trillion) in new loans in the first six months, easily topping the full-year figure of 4.91 trillion yuan in 2008 and igniting concern that excess liquidity was leading to stock and property market bubbles.

Chinese regulators have left banks largely unhindered in their rampant lending in the belief that the economy needs ample money to recover, but in recent weeks they have warned of mounting credit risks to the banks themselves and demanded that loans be put to use for productive purposes.

China's top leadership and the central bank last week both reaffirmed the country's active fiscal policy and appropriately loose monetary policy after meetings to discuss their priorities for the second half.

($1=6.831 Yuan)

(Additional reporting by Langi Chiang; Editing by Ken Wills and Tomasz Janowski)

China