— "The Financial World According to Inya" Column by Inya Ivkovic, MA

The first few weeks into the New Year, China's lending has spiked. Immediately, everyone else started worrying about the hottest economy in the world rushing head-on towards its own credit bubble. China's policymakers must have labored under the same fear, for those have resulted in attempts to withdraw excess cash out of the country's financial system. Among other things, China increased its banks' minimum reserves and placed harsher penalties for non-complying banks. Alas, as it turned out, the rest of the world didn't like that much either, fearing that tightening the reins over the world's third-largest economy could seriously impede global recovery and growth elsewhere.

I wrote in one of my previous articles that China has landed itself between the proverbial rock and a hard place. So, what steps might China take next and what might be their likely consequences?

Judging the current mood, China is very likely to continue with gradual fiscal and monetary policy tightening. Many analysts watching this market and economy have forecasted that the People's Bank of China (PBOC) is very likely keep on increasing money market rates, with the ultimate goal being the gradual siphoning out of excess cash of the financial system through open-market operations. Additionally, as a byproduct, banks would also get the message to curb their enthusiasm on lending, or at least to pace it better.

Aside from trying to prevent the formation of another credit bubble, the PBOC is also likely to work on deflating any bubbles in the making in the housing market. First, in terms of lending, the PBOC could start selling its three-year Treasuries again in an effort to lock- up money for a longer period. Second, China's central bank is also very likely to start raising benchmark interest rates, perhaps as soon as the second quarter, as it attempts to cool off the demand in the real estate market.

There is another risk factor with China — it is a highly unpredictable market. In the context of this article, the unpredictability factor could come in the form of China implementing surprise, sooner and more radical measures of fiscal and monetary tightening. If indeed such tightening commences in the late first quarter, the global commodity and equity markets could suffer quite an unpleasant blow. One trigger in that direction could be China's inflation rate, which currently sits at 1.9%, but which, if it exceeds the 2.25% rate, could be a reason for raising interest rates in the near term.

Finally, what has many economists up at night is that the PBOC's cautious steps, at least for the time being, just might be too little, too late. Although a number of steps have already been taken to curb lending, in January, new lending still registered 1.6 trillion yuan, which is one of the highest lending amounts on record. And, as for all of 2009, lending in China was up 33%. Obviously, this is not the time to be gentle in keeping the banks on a leash when it comes to keeping their balance sheets in order.

On the other hand, what is China to do after the Great Recession and depressed global demand have left the country with inventories bursting at their seams? With burgeoning capacities, China was able to battle down price pressures. However, if recovery in that part of the world is better than expected, knowing China is a well-oiled export machine, the likelihood of China's economy overheating is considerable.

China is walking a very fine line, where each wrong move, however minor, could set its economy on fire and launch it into the stratosphere. The combination of over-capacity inventories and aggressive export growth is a dangerous one indeed, potentially leading to inflation or hyperinflation and the creation of more asset bubbles that only painful draconian measures would be able to fix in the longer run.