* Soaring market rates limit central bank's wiggle room
* Regulatory scrutiny on banks worsens liquidity squeeze
* Central bank has injected cash to calm markets
* Banks starting to pass on higher funding costs to firms
* Economic stability vital ahead of party meeting in autumn
By Kevin Yao
BEIJING, June 28 (Reuters) - China's central bank will hold off on further monetary policy tightening and could even slightly loosen its grip in coming months as a deleveraging drive threatens economic growth and job creation ahead of a leadership reshuffle, policy insiders said.
Higher short-term funding costs, driven by a regulatory crackdown on banks' riskier financing, have started to spill over into the real economy, a risk to economic stability ahead of this year's Communist Party Congress, when President Xi Jinping is expected to consolidate his control.
The challenge is to counter the risks from excessive debt and shadow banking without endangering a growth target of around 6.5 percent – and previous experience suggests growth will be the priority.
"The leadership favours stability this year. We don't want to boost growth aggressively but we cannot allow growth to slow too sharply," said a policy adviser.
"Many companies face difficulties and higher interest rates will push up borrowing costs, which will be unfavourable for economic growth."
The sources are involved in internal policy discussions and offer advice to policymakers but are not part of the final decision-making process.
The People's Bank of China (PBOC) did not respond to a Reuters request for comment.
The weighted average lending rate of China's non-financial firms rose by 26 basis points in the first quarter to 5.53 percent, the PBOC has said.
Officials were tightening prudential requirements for banks during that period to try to tame risks from soaring property prices and debt.
The PBOC also guided market rates higher during the first quarter, including immediately after the Federal Reserve raised rates in March, in what analysts saw partly as an effort to counter pressure on the yuan from capital outflows.
Many analysts expect borrowing costs to have risen further in the second quarter, although the central bank has injected substantial liquidity to avoid an end-June cash crunch and did not follow this month's increases in U.S. interest rates.
The official China Securities Journal reported earlier in June that commercial banks have started to raise mortgage rates and even preferential rates for state-owned companies.
Authorities are expected to maintain a tighter regulatory environment given the focus on whittling down the large build-up of debt, but some of the insiders said that smaller banks could get some relief on the policy front to support activity.
One option to ease funding difficulties for those banks would be to cut the reserve requirement ratio (RRR), which sets the amount of cash that must be held against loans.
"Cutting RRR across the board is unlikely, but a targeted RRR cut cannot be ruled out in the second half," said one of the advisers.
The sources said top leaders are likely to meet in the summer, ahead of the Congress expected in the fourth quarter, to assess the economy and set the agenda for the rest of the year.
"They could step up policy support if economic growth slows in the second quarter and third quarter," said another policy adviser.
China's ruling Communist Party holds a Congress every five years to select a leadership team and set a broad direction for economic and social policy.
Although the world's second-largest economy is on track to hit its growth target for 2017, the tighter monetary policy, cooling housing market and slowing investment has reinforced views it will lose momentum.
Broad M2 money supply growth fell to 9.6 percent in May, its slowest in more two decades, due to the impact from cooling interbank and asset management businesses, as well as the clampdown on shadow financing activities, the central bank said.
Combined trust loans, entrusted loans and undiscounted bankers' acceptances, which are common forms of shadow banking activity, fell sharply to 28.9 billion yuan ($4.23 billion) in May from 177 billion yuan in April, according to Reuters calculations based on central bank data.
Still, banks reported a higher-than-expected 1.11 trillion yuan in new loans in May, as they shifted more credit back onto their books amid the shadow financing clampdown.
And the yuan has strengthened over the past month due to tighter curbs on outflows, market intervention and a weakening in the dollar, reducing the need to push rates higher, analysts said.
If the yuan were to come under renewed and sustained pressure, that could lead to a reassessment.
Policymakers could get worried if borrowing costs rise further and credit becomes even harder to access, especially for small- and medium-sized firms that account for 80 percent of employment, because although containing financial risks is important, it cannot be at too great a cost to growth.
"Stable economic growth is hard-won and we must safeguard this," said a policy adviser.
Reporting by Kevin Yao; Editing by John Mair and Sonya Hepinstall