China has ordered a further clampdown on excessive bank lending to ensure credit has not illegally entered the stock or property markets as two surveys on Monday showed the mounting challenges faced by policymakers.

China made a strong start to the year, according to January purchasing manager indexes (PMIs) that showed the economy runs a greater risk of growing too quickly, not too slowly, with rising input and output prices pointing to greater inflationary pressures.

Worries that the government, emboldened by the robust growth and wary of price pressures, will act more aggressively to tighten monetary conditions weighed on the benchmark Shanghai Composite Index, which fell to its lowest close in more than three months.

If more forceful measures are not implemented to control credit expansion, we will likely see considerable upside risks, Yu Song and Helen Qiao, Goldman Sachs economists in Hong Kong, said in a note.

Authorities ordered banks to slow, and in some cases, to halt loan approvals for the rest of January to try to control unruly lenders which provided 1.1 trillion yuan in credit, or 15 percent of the full-year target, in the first two weeks of the month.

In the latest move, the China Banking Regulatory Commission (CBRC) ordered lenders to conduct checks on whether any loans had been used for improper purposes, a banking source told Reuters on Monday.

If so, the loans must be withdrawn within a certain period, said the source, who had seen the relevant notice from the regulator. He did not want to be identified.

But for all the tremors that the government's gradual tightening has provoked in global markets, China's two PMIs for January showed an economy that is growing strongly.

The official PMI eased from a 20-month high in December but remained firmly in expansionary territory, while an index derived from a companion poll by HSBC scaled an all-time high.

The reports, which are important leading indicators, both offered evidence of increasing cost pressures.

Industrial activity continues to accelerate, implying stronger GDP growth in the first quarter. But rising input and output prices also point to greater inflationary pressure, which will likely prompt more tightening measures in the coming months, said Qu Hongbin, chief economist for China at HSBC.

China might increase interest rates once consumer inflation exceeds the one-year benchmark deposit rate of 2.25 percent, Ba Shusong, a prominent government adviser, told Reuters. Consumer prices rose 1.9 percent in the year to December.

POLICY UNCERTAINTY

But in an illustration of the uncertainty surrounding Chinese policy at this juncture, a central bank researcher suggested that tightening could take the form of stiffer reserve requirements rather than higher interest rates.

A half-point increase in required reserves that took effect on January 18 locked up 300 billion yuan. World markets tumbled in response to the tightening, which occurred much earlier than investors had expected.

Whether China will increase interest rates or not will be decided by the price situation, and prices in the first quarter won't be too high, Jiao Jinpu, deputy head of the central bank's postgraduate school, told the official China Securities Journal.

In a sign of China's ability to also use more direct administrative controls, official media reported that there had been a sharp slowdown in lending in the last 10 days of January after regulators ordered banks to pull in their horns.

Banks loaned 1.1 trillion yuan in the first half of January, according to bankers familiar with the central bank; by January 19, the total had reached 1.45 trillion yuan, local media reported.

But for the whole of January net new lending was less than 1.6 trillion yuan ($234 billion), the official Economic Information Daily reported, without giving its source. The People's Bank of China releases official data next week.

Beijing's loan quota for all of 2010 is 7.5 trillion yuan.

Until recently, Chinese policymakers had bent all their efforts on pulling the world's third-largest economy out of a downturn induced by the global financial crisis.

The message from Monday's surveys of purchasing managers was that, with the economy now back at cruising speed after growing 10.7 percent in the fourth quarter from a year earlier, Beijing is now justified in paying more attention to rising prices.

Nevertheless, Fan Gang, an adviser on the central bank's monetary policy committee, sounded an optimistic note on inflation, saying that manufacturing over-capacity and an ample food supply would restrain price pressures.

I would say the real worry for the China economy now is asset bubbles, he said.

Export orders were also strong in both PMI reports, suggesting an improvement in global demand going into 2010.

HSBC's PMI rose to a record high of 57.4 in January from 56.1 in December, while China's official PMI fell to 55.8 from 56.6.

It was the first month-on-month deterioration in the official index since May 2009, but it remained firmly above the threshold of 50 that demarcates expansion from contraction.

($1=6.826 Yuan)

(Additional reporting by Victoria Bi, Farah Master, Simon Rabinovitch and Zhou Xin)

China Inflation HSBC