* Cash rate falls to lowest since before squeeze
* Stocks rise 1.85 pct, led by property and financial shares
* Fears of crisis subside, but conditions to stay tight
* Concerns about shadow banking, economic slowdown remain
By Lu Jianxin and Kazunori Takada
SHANGHAI, June 28 (Reuters) - China's stock markets scored their biggest gains in two months on Friday in a sign of growing confidence that credit conditions were improving as cash rates extended their fall from peaks reached during last week's credit crunch.
The central bank, which had let short-term borrowing costs spike to record highs to drive home a message to banks that they could no longer count on cheap cash to fund riskier operations, said it would ensure policy supported a slowing economy.
"China's current economic and financial operations and consumer prices are generally stable, all of which show prudent monetary policy is appropriate and producing good results," Zhou Xiaochuan, the central bank governor, said in his first public remarks since the cash crunch last week.
Without making direct references to the turmoil, when short-term rates spiked as high as 28 percent, Zhou said that policy settings were appropriate and the PBOC would balance the need to reform China's economy with the need to keep growth on an even keel. He was speaking at a financial forum in Shanghai.
Weighing in, the nation's securities regulator said that financial markets were stabilising and the effects of recent shocks fading.
Commercial bankers have also described as exaggerated fears that they would turn off the taps on new lending after the cash crunch scare and reduce the flow of funds to the already slowing economy.
They say the crackdown on the practice of funding riskier activities in the so-called shadow banking system with short-term cash would have little bearing on regular lending, which is determined by the amount of deposits banks attract.
Zhao Huan, a vice president at China Construction Bank, said the market volatility had "exerted a positive impact on market players".
"The liquidity squeeze gave them a good lesson without triggering a real crisis," the vice president said.
Earlier this week, the central bank moved to allay fears that the crunch could escalate into a financial crisis, with assurances that it would ensure adequate funds, bringing some calm to markets after days of turbulence.
As the PBOC reiterated that message on Friday, one of the nation's three policy lenders, the Agricultural Development Bank of China, issued a statement saying that since late May it had supplied $100 billion in money market transactions to other lenders to help them cope with fund shortages.
Friday's bounce showed some investors had shrugged off their pessimism and were increasingly seeing their glass as half full, at least for now.
The index of the largest Shanghai and Shenzhen stocks closed up 1.85 percent, their biggest daily rise since April 24, buoyed by a 4 percent jump in property stocks and rebounds in smaller banks, which were hardest hit by the recent sharp sell-off.
Still, the index fell 5 percent over the week and lost 15.6 percent in June. Analysts say overall sentiment remains fragile given concerns about funding conditions ahead and China's longer-term economic outlook.
"The problems, such as excessive credit growth, shadow banking activities and local debt remain and will not go away overnight," said Ben Kwong, KSI Asia Ltd's chief operating officer in Hong Kong.
Alex Wong, director of asset management at Ample Finance in Hong Kong, said the central bank's actions and words convinced investors that Beijing even appeared ready to risk missing its 7.5 percent growth target -- a two-decade low -- to curb worrisome expansion of unregulated credit.
"The authorities sent a message to the market, and people will probably be very cautious in lending and even borrowing."
China Vice President Li Yuanchao seemed to underline the message that the government is willing to tolerate a lower growth rate, saying on Friday that China could maintain growth of 7 percent in the future.
Money traders also said the market was not quite out of the woods yet, even as fears of a prolonged crunch faded.
The weighted average for the benchmark seven-day repo rate was down around 60 points to 6.16 percent -- almost half of last Thursday's record 11.62 percent, but still well above its usual range of 3-4 percent.
The overnight rate fell about half a percentage point to 4.96 percent.
"There will still be lots of cash demand in the first half of July, including the need to set aside reserves based on end-June deposits and to pay cash dividends to stock investors," said a dealer at a Chinese commercial bank in Shanghai. "Overall market sentiment remains very cautious."