U.S. investors have been paralyzed by concerns about the Federal Reserve turning off the easy-money spigot, but Wall Street has started this week fretting about another central bank: China’s.

The credit crunch in China was brought to the forefront by the Shanghai Composite plummeting 5.3% overnight into bear-market territory after the People’s Bank of China refused to loosen monetary policy in response to country’s worsening liquidity squeeze.

After watching China’s total credit explode from $9 trillion in 2008 to about $23 trillion today, the new government in Beijing now seems ready to ease off the stimulus gas pedal.

“The signal being sent is they are willing to tolerate slower growth in the interest of reforming the system. Long term it’s good, but short term it’s very scary for the markets,” said Win Thin, global head of emerging market currency strategy at Brown Brothers Harriman.

The PBoC’s hawkish stance is akin to “telling a child you’re not going to give him any more sugar even though the sugar makes you feel better and gives you a sugar high,” Anthony Chan, chief economist at J.P. Morgan’s (JPM) Chase Private Client, told FOX Business. “It’s for your own good, but it doesn’t feel good.”

Liquidity Squeeze Fallout

It didn’t feel very good to be bullish on risky assets on Monday as the Shanghai Composite suffered the equivalent of an 800-point meltdown, its worst single day since August 2009. The steep selloff left China’s benchmark 20% below recent highs, or technically in a bear market.

The Chinese yuan took its biggest tumble in six weeks and the Dow Industrials lost as much as 248 points before rebounding, while the S&P 500 has retreated as much as 6.14% from its all-time high of 1687.

“Never has the interconnectedness of global markets been on more display,” Peter Kenny, chief market strategist at Knight Capital Group (KCG), wrote in a note to clients.

So what exactly is happening in China’s banking system and why do U.S. investors care?

Similar to the U.S. real-estate bubble that eventually popped in 2007-2008, China appears to now be working off the excesses of explosive credit growth.

Credit Bubble?

According to Barclays (BCS), total credit in China has skyrocketed to $23 trillion and credit-to-GDP levels have raced to 200% from 75%.

While China’s overall GDP has slowed below the 10%-12% range of recent years, credit continues to boom at about 20% year-over-year, Barclays said.

“Total social finance, which includes the shadow banking market, is growing way out of control,” said Chan.

In response, the PBoC has taken a much more hawkish position, refusing to inject as much liquidity as the banking system had gotten accustomed to.

At the same time, China has suffered from a drop of foreign-exchange inflows in recent weeks and months.

The credit crunch is best demonstrated by looking at China’s seven-day repo rate. This measure of short-term borrowing costs in the interbank market has surged to 12% as of June 20 from just 3% a month earlier, Barclays said, calling the move an “extraordinary spike.” The repo rate has retreated to 7.32% this week, but that is still seen as elevated.

“The distress in China’s fixed income markets is palpable,” Barclays said in a report released late last week. “The dilemma for policymakers is pretty clear -- while the interbank market is experiencing a credit crunch, the overall leverage ratio is probably already too high.”  

‘New Sheriff in Town’

Rather than come to the rescue of the banks, the PBoC on Sunday agreed to “fine-tune policy when necessary,” but did not announce any new measures and said it’s comfortable with liquidity levels.

The PBoC statement “suggests to us that the policy objectives have not changed,” Zhiwei Zhang, an economist at Nomura, wrote in a note. “The financial risks in the economy are not yet fully under control. Policy tightening only started in mid-March, and a shift of policy to an easing bias would exacerbate these financial risks.”

The hawkish tone underscores the new Chinese administration’s goal to reform the country’s economy into something that is more sustainable and market based.

“There is a new sheriff in town in China and for all the short term pain a crackdown on excess leverage will have, it is the proper long term strategy,” Peter Boockvar, lead portfolio manager at Morgan Stanley’s (MS) Excelsior Wealth Management, wrote in a note. “Unlike with the Fed, Chinese officials have had enough of the rampant credit growth that has so distorted their economy.”

Yet the tighter policy also comes on top of recent indicators revealing activity in the Chinese manufacturing sector shrank in June to a nine-month low.

“It’s quite startling that manufacturing actually contracted. The banking system is exacerbating the slowdown,” said Jeffrey Bergstrand, a finance professor at the University of Notre Dame.

Now What?

China’s willingness to stomach slower growth and a deleveraging process has spooked investors worried about the short-term impact on an increasingly interconnected global economy.

As the world’s second-largest economy and largest consumer or commodities, China plays an outsized role in the markets.

The metals sector of the commodities complex headed south on Monday, with copper slumping almost 2% and aluminum maker Alcoa (AA) retreating 2% to its lowest level since April 2009.

“The world’s second-largest economy was perhaps the last prop remaining to commodity bulls, but even this now seems lost to them,” Alastair McCaig, market analyst at IG, wrote in a note.

Barclays warned that some smaller Chinese banks that rely on the suddenly-tight interbank markets may eventually fail if rates remain high.

It also said the liquidity situation isn’t likely to improve in the coming weeks, barring a strong rebound of foreign-exchange inflows, which doesn’t seem likely.

Global investors will have to hope the Chinese economy is able to avoid the so-called “hard landing” that many have feared.

“The market will clear over time, but not before a significant level of deleveraging,” Brown Brothers Harriman analysts wrote.

Follow Matt Egan on Twitter @MattMEgan5