By Gabriel Wildau SHANGHAI, June 25 (Reuters) - Chinese stocks plunged to their lowest since the global financial crisis on Tuesday after the central bank turned off the taps for cheap cash, but markets rallied late in the day on hopes authorities would step in to prevent a crisis. The immediate fears of a cash crunch that saw banks scramble for funds as interest rates spiked last week have moderated, but the expectation conditions will remain tight has raised doubts about banks' earnings and the outlook for the whole economy. The sudden squeeze, and the People's Bank of China's (PBOC) tough message that there was enough cash and it was up to banks to manage it and control lending better, hit particularly hard the smaller banks that rely on central bank funding. "In the long term... this represents a new policy decision by Premier Li Keqiang, so the market will no longer be as loose as before," said Cao Xuefeng, head of research at Huaxi Securities in Chengdu. In a panicky stock market, sentiment swung wildly. At one point on Tuesday, the CSI300 of the leading Shanghai and Shenzhen listings was down as much as 6 percent at its lowest since January 2009, before ending down just 0.3 percent. The market had fallen 6.3 percent on Monday. Reports of outages at cash machines of some banks added to the nervousness, with the index of financial stocks on the Shanghai exchange falling 7 percent at one point before recovering to close down a mere 0.1 percent. "There is a problem with cash flow and confidence right now," said Zhou Lin, analyst at Huatai Securities. "From the perspective of investors, the danger is that the value of shares will continue to fall. If the economic situation continues to worsen, then banks' profits are likely to fall." In the money market, short-term rates continued a broad moderation, after they had shot up last week when the central bank refrained from helping banks tide over a tighter spell in a seemingly deliberate move to curb credit flowing to China's vast "shadow banking" system. Overnight and 7-day rates eased again on Tuesday after the central bank did not drain funds, but weighted-average rates of over 5.8 percent and 7.4 percent respectively were still well above long-run levels. Underscoring the tight conditions, there were spikes to 15 percent and higher for some deals during the day. RISK WORTH TAKING In addition to worries about banks as credit tightens, investors are also concerned that funding for many companies may dry up, forcing the world's second-largest economy to slow more than expected, sending ripples through other markets in the region. Several economists, however, praised the authorities and said it was a risk worth taking in order to steer the world's second-largest economy away from debt-fueled investment in infrastructure and property to a more sustainable path. "The liquidity squeeze is the first real economic test for China's new leaders, to prove their willingness to overcome tough economic issues not with words, but by their actions," Zhiwei Zhang, a China economist for Nomura in Hong Kong, said in a research note. "If the new leaders maintain their current approach, we believe it will add downside risk to growth in 2013, but in our opinion this would help reduce systemic financial risks, supporting long-term sustainable growth." For decades China's rapid economic ascendancy has been powered by heavy investment fuelled by cheap, readily available credit made possible by vast savings trapped in the banking system at artificially low rates. Most recently, a massive debt-fuelled spending spree in the aftermath of the Lehman Brothers collapse in 2008 and the global financial crisis helped China bounce back quickly and was credited for helping the global economy avoid a severe depression. But with most analysts estimating China's total non-financial debt at around 200 percent of economic output and increasing amounts of it being funneled through the shadow system of wealth management products and trust funds, the new leadership of President Xi Jinping has been trying to cool lending down. Market turbulence of the past week and violent and nervous investor reaction, however, highlighted the risks of Beijing's new approach to its debt headache. "We believe the biggest risk comes from the PBOC potentially mishandling the situation," Bank of America Merrill Lynch analysts said in a note. "In our view, dealing with banks in breach of regulations should be done by improving prudential regulations rather than engineering an interbank credit crunch which could potentially backfire should banks lose mutual trust."