The Chinese central bank, the People’s Bank of China, responded to the rapid slow-down of economic growth in the second half of 2008, by reducing the loan rate from 7.41 per cent in August to 5.29 per cent in January 2009 and the deposit rate from 4.41 per cent in September 2008 to 2.25 per cent in February 2009. Thanks to strong economic fundamentals and a decisive stimulus policy package implemented by the Chinese government, China’s economy experienced a V-shaped recovery from 2009 to the present.

Crucial economic indicators, including steel output, electricity generation, industrial output, car sales and housing, began to recover from the end of 2008 to 2009. GDP growth touched bottom at 6.1 per cent in the first quarter of 2009, recovering to reach increases of 11.9 per cent in the first quarter of this year. This rate of growth is widely recognised as being the potential growth rate of supply capacity in China.

The strong recovery has, in part, been facilitated by excessive expansion of both credit and money supply which both grew at 30 per cent in 2009. That was the second highest growth rate for bank loans, and the third highest growth rate of money supply, in the post reform period (since the late 1970’s). It is not surprising that the abnormal surge credit and money supply eventually introduced inflationary pressures into the Chinese economy.

The Chinese stock market was the first affected by this expansion. The A-share price index on the Shanghai stock exchange increased from the region of 1800 in late 2008 to reach 3123 in June, 2009. This surge in stock market prices was brought under control when the government securities regulatory body (China Securities Regulation Commission) resumed approval of IPOs on the stock market. This speeded up the application and approval process for major corporate IPO’s.

The inflationary pressure then revealed itself in the more troublesome housing market. Albeit with housing price data, it is generally believed Chinese average house prices increased between 10 and 20 per cent in the second half of 2009, and in the big cities such as Beijing, Shanghai, Shenzhen this rate was even higher. Furthermore, housing prices grew even more strongly in the first four months of this year at an annualized rate of 12.8 per cent.

Over the last six months the Chinese government has implemented a variety of measures with the aim of ‘managing the inflation expectations’. A range of methods have been used to combat surging housing market prices. Over the four months from mid-December 2009 to mid-April 2010, the state council of the Chinese government issued three official documents pertaining to housing price problems. In line with the spirit of these recent State Council documents, Beijing introduced a regulation temporarily prohibiting the purchase and/or the provision of housing mortgage loans to non-residents of the city. All these policy movements are without precedent.

The crucial driving force behind the high growth in the housing market is the rapid monetary expansion that occurred in 2009 and continues today. On top of the unusually high growth of 30 per cent, both bank credit and broad money supply again increased more than 20 per cent during the first four months of this year. Although the Chinese government’s efforts to control inflation are impressive, the prospects for fighting this inflation without effectively addressing the problems of loose money are not very encouraging.

Inflation is in essence a monetary phenomenon: this latest episode in Chinese macro-economic policy reminds us of the wisdom of this famous saying. In order to effectively control inflationary pressures, China needs to use the policy instrument of interest rates as a matter of urgency. That the People’s Bank of China may not be yet ready to raise interest rates quickly, is a topic requiring further, detailed examination. Stay tuned for more analysis of that!

Feng Lu is a professor of economics at Peking University.