SHANGHAI, June 21 (Reuters) - The Chinese central bank's determination to rein in rapid credit growth has sent interbank interest rates to record highs, creating panic and rumours of possible default as some banks scramble to secure short-term funds. China's overnight repo rate - the interest rate for interbank lending that keeps markets liquid - climbed to levels reminiscent of the global credit market freeze that preceded the collapse of Lehman Brothers in September 2008. There has been panic in some parts of the money markets in Chinain particular among some small financial institutions that were highly indebted, traders said. But the People's Bank of China (PBOC) has been standing firm, refusing to bow to pressure to flood the interbank market with more cash. "The Chinese banking system's current liquidity scramble is a regulatory/policy choice. A squeeze by fiat," Australian bank Westpac said in a note. The PBOC told the market it would not conduct repo business in its regular open market operations on Thursday, frustrating widespread expectations it would use reverse repos to inject cash to ease an acute market squeeze. Traders said the central bank appeared determined to force banks and other financial institutions to reduce their own debt burdens. In particular, the government wants to clamp down on non-essential businesses by financial institutions, such as the widespread use of wealth management products. Banks create these products by packaging together assets such as money market deposits, corporate bonds and informally securitised bank loans. They market the products to customers as higher-yielding alternatives to traditional deposits. In addition, China has tens of thousands of non-bank lenders that are providing increasing amounts of credit to businesses and government outside the mainstream, regulated banking sector, a situation that is stoking systemic risk, credit rating agency Fitch said this month. Japanese bank Nomura said it believed China's new leaders, who took office in March following a generational leadership change, were fully aware of the financial risks in the economy. "As their tenure will last for 10 years, they are willing to tolerate some short-term pain in order to achieve long-term policy objectives - preventing financial crisis and delivering sustainable growth," Nomura said in a note. Some defaults would likely occur in the manufacturing industry and in non-bank financial institutions in the coming months, Nomura added. SQUEEZE BEGAN EARLY IN JUNE The money market squeeze that began early this month has worsened this week, forcing banks and other financial institutions to trim non-essential businesses, traders said. The market has recently been hit by heavy demand for funds, including from the approach of the quarter-end, when banks need more cash to meet regulatory checks and to boost reported deposit totals in their quarterly reports to shareholders. If money market rates remained high, it could translate into higher financing costs for businesses, economists said. A full-blown crisis is unlikely as liquidity is expected to improve significantly from mid-July, after the seasonal effects of the quarter-end fade and a large volume of maturing PBOC bills and government bonds injects cash into the market, traders said. On Thursday, the benchmark weighted-average seven-day bond repurchase rate jumped a whopping 380 basis points to a record high of 12.06 percent, while the overnight repo rate surged 598 bps to 13.85 percent. Strong credit expansion has failed to trickle down to the real economy, partly due to excessive factory capacity. Indeed, a preliminary survey showed on Thursday that China's factory activity weakened to a nine-month low in June as demand faltered, heightening the risk of a sharper second quarter slowdown. China's economy grew at its slowest pace for 13 years in 2012 and so far this year data has been weaker than expected, bringing warnings the country could miss its growth target of 7.5 percent for this year, though possibly not by much.