By Gabriel Wildau
SHANGHAI (Reuters) - Chinese stocks extended losses to more than 10 percent this week as investors worried about banks' ability to access cash after a week-long squeeze in money markets, even as the central bank relaxed its tight grip to let interest rates fall.
Reports of outages at cash machines of some banks added to the sense of fear in markets, with the index of financial stocks on the Shanghai exchange falling more than 5 percent on Tuesday morning after a 7.3 percent plunge on Monday.
Money market interest rates continued a broad moderation that began last week, helped by the central bank's decision not to drain funds at its regular operations on Tuesday, although there were spikes to 15 percent and higher in late morning.
The sharp losses in bank stocks drove the CSI300 of the leading Shanghai and Shenzhen A-share listings nearly 5 percent, building on Monday's loss of more than 6 percent. The index is now down more than 20 percent this month.
Short-term cash rates had soared last week after the People's Bank of China (PBOC) allowed funding to tighten in an apparent effort to curb credit channeled into China's vast "shadow banking" system.
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The sudden squeeze, and the central bank's tough message that there was a reasonable amount of cash around and it was up to banks to manage it and control lending better, hit smaller banks that rely on central bank funding the hardest.
Rates in the money market, where banks cover their short-term funding needs, were mostly lower for a third consecutive day after the PBOC chose not to change the amount of cash in the market at its open market operations window on Tuesday.
"Overall, panic over a liquidity squeeze still lingers in the market, but market sentiment is slightly better than late last week," said a money market dealer at an Asian bank in Shanghai.
The weighted average for the overnight repo rate fell to 5.80 percent from 6.65 percent at Monday's close. It hit an all-time high of 11.74 percent last Thursday.
Though the market was likely hoping for a fund injection from the PBOC, the passive approach marked a slight softening from last week when the central bank had drained four billion yuan by issuing three-month central-bank bills.
While several observers have praised the "benign neglect" as possibly the most effective way of curbing the dark side of China's borrowing spree, the market turbulence showed how easy it is to miscalculate its side effects.
Banks are being hit the hardest now, but investors are also worried about the broader impact on China's economic growth, its top trading partners such as Japan and South Korea and the world economy at large.
(Additional reporting by Lu Jianxin; Writing by Tomasz Janowski; Editing by John Mair)