The authorities have been worried about asset price bubbles and funds being diverted from where they are needed.

Also, the PBOC has been urging banks to better manage liquidity, cut their off-balance-sheet loans and match the maturities of assets and liabilities.

"I think the PBOC keeps warning banks about using cheap official funds to finance the shadow banking sector," said Vivien Li, a money market trader with a midsized bank in Shanghai.

The central bank understands that the goal can't be achieved instantly, and it will make sure financial institutions don't run out of cash. But that's not the same as engineering an easing in funding conditions, Xu said.

During the squeeze in June, there were rumors that a Chinese bank had defaulted on a loan to another bank. Ahead of its recent initial public offering in Hong Kong, China Everbright Bank Co Ltd disclosed in its prospectus that two of its branches had failed to pay 6.5 billion yuan of interbank loans due on June 5. The payment was later made.

A just-released report from the Chinese Academy of Social Sciences said the debts of the nation's local governments may have reached almost 20 trillion yuan.

The official statement from the Central Economic Work Conference earlier this month defined "controlling and defusing" local government debt risks as "an important economic task".

However, that remains a tough task. Higher interest rates will contribute to slower growth because they "will damage investment, particularly for highly leveraged companies such as property developers" and local government financing vehicles, said Zhang Zhiwei, chief China economist at Nomura Holdings Inc.

The outcome also depends on whether the PBOC's current operations can achieve the goal of deleveraging, Chen with UBS Securities said.

"Medium- and long-term interest rates remain elevated in China's capital market. Some companies will be forced to cut leverage and eliminate capacity, but not the ones that are insensitive to the cost of capital," Chen said.

For example, some government-guaranteed programs may not be affected by tight credit at all.

The latest squeeze was a reminder of the stresses in China's financial sector.

"Chinese banks now rely more on the interbank market for funding because of increased competition for deposits — the result of bottom-up interest rate liberalization and pressure from rolling over nonperforming loans," Wang Tao, chief China economist with UBS AG, said in a recent note.

Based on the experience of other countries that have conducted interest rate liberalization, cash rates — especially short-term rates — often fluctuate violently in the early stages. And that's exactly what's happening in China, Chen said.

"I do not think any bank in China is short of cash. But at the current stage of interest rate liberalization, when the cost of capital is unstable, no one is sure how much money is ‘enough'," he added.

Seasonal factors, including tax payments, contributed to the market upheavals in June and December, but a more important factor may be capital outflows from saving accounts and into wealth management products, said Chen.

Commercial banks are changing their business models and pursuing high-yield businesses to boost efficiency, which is greatly increasing their capital risk and operating risk.

Certain high-yield "innovative" financial products are drawing capital out of the banking system, destabilizing the short-term dynamics of capital supply and demand.

Many high-yield wealth management products are draining traditional bank deposits.

These wealth management products are often timed to mature near the end of a quarter, so the funds flow back into on-balance-sheet deposits for regulatory reporting purposes.

Banks often borrow short-term funds to finance these payouts, since the loans, bonds and other assets underlying the products may not have matured.

"Duration mismatch risk in the money market is pushing short-term volatility to high levels," said Xu.

Duration mismatch refers to a situation where the values of assets and liabilities don't have the same sensitivity to changes in interest rates.

Most economists believe that the PBOC doesn't plan to loosen policy.

"By adopting a tighter monetary approach to the interbank market, China's central bank kept a tight leash on liquidity directed into the shadow banking system," Mike Werner, senior analyst at Sanford C. Bernstein & Co, said in a recent report.

Werner noted that China's shadow banking sector is growing at its slowest pace since 2011, when the nation shifted to a tight monetary policy to fight inflation.

Generally speaking, the era of loose liquidity has ended, said Chen.

The US Federal Reserve Board announced last week that it will taper its quantitative easing policy.

A "modest reduction" was announced in monthly asset purchases from $85 billion to $75 billion, with another $10 billion trimmed from mortgage-backed securities and Treasury bonds.

"The speed of scaling back is moderate and the impact on China will be limited," said Chen.

However, with the cost of capital going up globally, any cash crunch in China could be compounded, he added.