By the usual measures, the world's second largest economy is doing just fine: China's growth this year looks likely to slow only slightly. Prices appear to be moderating and shops are packed as families stock up on food and clothes for Lunar New Year festivities.
But despite the upbeat holiday mood, China is struggling to clamp down on excess lending by its state-run banks, which are pumping huge sums of money into the economy, hindering moves to bring politically risky inflation under control.
"Clearly the risk is on the upside for overall credit growth and inflation in 2011," says UBS economist Wang Tao in a report estimating 2010 total bank lending, including trusts and other forms, at 10.9 trillion yuan ($1.65 trillion) — way above the 7.5 trillion yuan government-set quota for the year.
Given the massive liquidity sloshing through the economy, raising interest rates is imperative, she says.
From India and Vietnam to South Korea and Australia, countries across Asia are moving to rein in inflation as the global recovery spurs demand for oil and other commodities, accentuating pressures from rising food prices.
But China's challenge is on a scale all its own.
Figures due for release Thursday are expected to show China's economy grew just over 10 percent last year, slowing from a post-crisis high of nearly 12 percent in the first quarter of 2011. State media reports put inflation in December at about 4.5 percent, down from a 28-month high of 5.1 percent in November.
By that measure, Beijing's campaign to douse sizzling prices seems to be making progress. But the figure is distorted by a relatively high base effect in December 2009.
"There's a sense this might be temporary. It might well go above 5 percent again, and that is cause for concern," said David Cohen, an economist with Action Economics in Singapore.
While Shanghai's markets are jammed with shoppers gearing up for what is China's biggest holiday, the Feb. 3 Lunar New Year, surging prices are putting a damper on some celebrations and prompting many Chinese to cut back on spending.
"I used to spend 10 yuan ($1.52) on lunch, but recently the price of some lunch boxes has risen almost 30 percent, so I'm buying cheaper ones," said Ye Jiansheng, a 31-year-old swimming coach. "My swim training business has been seriously affected. Many people don't have spare money for swimming classes now," he said.
For pensioners and others living on low incomes, the price increases — mainly attributed to higher costs for food but also due to rising housing, utility and other bills — are a real hardship.
Acutely aware of the turmoil spun from past bouts of inflation, China's communist leaders have made curbing inflation a top priority. They have hiked interest rates twice in the past four months and repeatedly tightened investment curbs to keep inflation from spreading throughout the economy.
Following news earlier this week that the country's biggest state-run commercial banks splashed out nearly 240 billion yuan ($36.4 billion) in new loans in the first 10 days of the new year, the banking regulator again ordered banks to tighten risk controls.
Premier Wen Jiabao told the State Council, or Cabinet, on Tuesday that the government will focus on controlling food and housing costs, the official Xinhua News Agency reported. Authorities are also considering ways to penalize banks for flouting orders to cut back.
Borrowing for real estate development and other projects is the lifeblood for the sales by local governments of land use rights that provide a huge share of their revenues. Such sales rose 70 percent in 2010, helping push property prices 6.4 percent higher compared with a year earlier, further inflating what many view as a massive bubble.
A huge pool of non-bank financing nearly doubled the amount of money available for investment last year, Wang of UBS estimates. Many loans are "off balance sheet," meaning the total amount is unknown.
"Because of the property bubble, risk exists almost everywhere in China's fragile financial system," says Yi Xianrong, an economist at the Chinese Academy of Social Sciences' Finance Research Center.
While most analysts agree that public demand for better housing will support China's broader residential property market in the long run, the banks are gambling on a construction frenzy for shopping malls, luxury housing and various other projects unlikely to ever be paid back.
"The government must do more to squeeze the bubble out of the property sector to curb the obvious huge risk to the economy," says Yi. "Just think of it: every regional government is deep in property investment, involving huge amounts of loans. Once the property market collapses, it will surely be an economic disaster."
The asset price bubble has so far bypassed China's stock market, where investors remain wary of interest rate hikes and other moves to curb credit. Insulated from global speculative flows by regulations limiting investments by foreigners, it has languished more than halfway below the peak it hit in 2007.
Not all concur with Yi's bleak assessment. Ultimately, the banks will do what the government orders them to do, says CLSA analyst Andy Rothman. Given the Chinese government's dominant role, he views interest rate hikes and increases in reserve requirements as mainly symbolic tools.
Chinese economists appear divided over strategy, with some calling for further rate hikes while others argue the government needs to pull back further on its own spending to cool demand for construction materials and other commodities.
"Tight policies won't solve these problems," Li Yining, an economist at Beijing's prestigious Peking University, told the Communist Party newspaper People's Daily.
China's leaders will likely continue to move cautiously to cool overheated property investments, wary of overshooting targets and putting a damper on growth. Politically, all the choices are difficult, since from villages to the highest levels of government, powerful interests are vested in keeping the property boom on track.
"China seems inclined toward gradualism, as long as inflation is not out of hand," said Cohen.
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