China's bank lending slowed more than expected in July to seven-month lows as Beijing kept a tight grip on monetary policy to quell near three-year-high inflation.

Money supply growth sank to six-year lows, but analysts predicted that tight monetary conditions may not hold in coming months as mounting risks of a global economic slowdown may prompt Beijing to loosen credit conditions.

The central bank could gently ease policy by keeping interbank rates low, or by encouraging banks to lend more to smaller-sized firms.

July's loan (data) is too low to be sustainable, said Xu Biao, an economist with China Merchants Bank in Shenzhen. Without a doubt, some kind of an easing in bank credit will take place in coming months.

Chinese banks made 492.6 billion yuan ($77 billion) of loans in July, the People's Bank of China said on its website, a pull-back from 634 billion yuan lent in June.

Economists had forecast lending of 550 billion yuan.

Bank lending is a focal point in China's monetary policy as it is controlled by Beijing through loan quotas to manage economic growth and control price pressures.

To quell inflation before it stirs social discord, China's central bank has been steadily tightening policy since October, when it kicked off the first of five interest rates rises.

However, worsening debt problems in the United States and Europe, China's two biggest export markets, have led Beijing to signal it is ready to pause its tightening campaign.

It seems they are preparing the ground for something called directed easing, said Stephen Green, an analyst at Standard Chartered Bank in Hong Kong. The ambition is more credit for small- and medium-sized enterprises.

Underlining the tightness in the banking system, China's broad M2 measure of money supply grew only 14.7 percent in July, the weakest pace of growth seen since April 2005, and again missing forecasts for a 15.8 percent growth.

Yuan loans outstanding at the end of July were 16.6 percent higher than a year earlier, roughly in line with forecasts for a 16.8 percent expansion.

And in a sign that banks may have artificially inflated their deposit bases in June to meet quarterly regulatory checks, data showed savers withdrew 669 billion yuan in deposits in July.

That comes after new yuan deposits ballooned to 1.91 trillion yuan in June, when banks had competed to attract deposits to meet a 75 percent loan-to-deposit ratio requirement.

SMALL FIRMS HURTING

To be sure, all signs suggest China's economy has endured months of tightening with remarkable resilience, and growth in the world's second-biggest economy is only easing slightly.

Most analysts still believe the Chinese economy will grow between 8-9 percent this year and is not facing a hard landing.

Data earlier this week showed China's value of exports hit record levels in July after U.S. and European shipments proved surprisingly buoyant. That helped to keep inflation elevated at 3-year highs of 3.5 percent in July.

That said, tighter policy has inflicted its share of pain on businesses. Smaller firms have bore the brunt of that as Chinese banks shut them out of the loan market to cut their lending risks.

This has forced some smaller businesses to fold. Others have complained of having to turn to an informal loan market that charges exorbitant rates of as high as 60 percent a year.

As firms are forced to look beyond banks for loans, a rising portion of lending is happening outside Chinese regulator's purview, through off-balance-sheet bank lending and informal loans offered by wealthy in the grey market.

That means monthly bank lending data is only a barometer for the amount of lending that is happening and does not paint a comprehensive picture.

The reaction in the real economy continues to argue for easing of monetary policy in the rest of the year, said Jun Ma, an analyst at Deutsche Bank. But by the fourth quarter we are likely to see some easing in credit.

The plight of China's small- and medium-sized firms is a concern for Beijing as they account for 80 percent of jobs in the country.

Green from Standard Chartered said although China would try to target its credit easing at small firms, it is unlikely that Beijing would succeed in pinpointing any relaxation in policy so completely.

Money is fungible. It moves where people want it to go or where people pay for it to go, he said. So any kind of effort to significantly ease credit conditions for small- and medium-sized enterprises is going to affect overall credit conditions. ($1 = 6.394 Chinese Yuan)

(Reporting by Zhou Xin, Koh Gui Qing and Beijing Newsroom; Editing by Ken Wills & Kim Coghill)

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