China could raise its renminbi interest rate, if money supply continues to surge and inflationary pressure increases, experts said.

"Money supply is growing a little bit faster," said Wang Zhao, a researcher with the State Council's Development Research Centre. "There are also some early inflationary signs."

M2 money supply, including cash in circulation, deposits and personal savings, was up 20.8 per cent at the end of June from a year ago, the fastest annual growth rate in more than five years.

The consumer price index, Chinese policy-makers' key inflation gauge, rose a year-on-year 0.6 per cent during the first half of this year.

Wang said the government had tried to avoid a possible overheating economy and inflation by withdrawing money from circulation from the second half of last year.

"If the government's recent efforts to restrict loans in the real estate sector do not help reduce money supply and the consumer price index rises for more than 10 months, the government is likely to raise the renminbi interest rate," he said.

Fan Gang, director of the National Economic Research Institute, said the government should watch out for an overheating economy and possible inflation.

China's gross domestic product grew a year-on-year 9.9 per cent in the first quarter of this year and grew only 6.7 per cent in the second quarter due to the outbreak of SARS (severe acute respiratory syndrome).

"If there had been no SARS outbreak, the country's economy would have grown by more than 10 per cent this year," Fan said. "If the economy grows by more than 10 per cent, it will overheat and inflation would loom."

The faster economic growth is driven mainly by a surge in fixed asset investment and exports, Fan said.

Fixed asset investment grew a year-on-year 31.1 per cent during the first half of this year, the fastest rate since 1994.

Investment in industries such as real estate, steel and cars has become overheated.

The weakening of the US dollar on the international market is beneficial for China's exports. As a result, the country's exports grew a year-on-year 34 per cent during the first quarter of this year.

On the other hand, the government will spend a large amount of domestic currency absorbing inflows from foreign investment that has flooded China in anticipation of a rise in the yuan.

"This will increase inflationary pressure," Fan said.

Fan said the government could reduce expenditure or curb its expansionary monetary policy to prevent the economy from growing too fast.

The central bank has indicated its concerns about inflation since the second half of last year.

After boosting money supply to keep the economy growing and to fight the deflation which emerged during the Asian financial crisis of 1997-98, the central bank began tightening credit from the second half of last year through the open market.

The People's Bank of China soaked up 246.75 billion yuan (US$29.7 billion) in the second half of 2002, after injecting 260 billion yuan (US$31.3 billion) over 1998 and 1999.

Since late April, the central bank has issued 215 billion yuan (US$25.9 billion) in short-term commercial bills to domestic banks in open market operations to soak up excess cash.

To further control money supply, the central bank issued a much-anticipated rule last month, tightening controls on loans to the fast-growing real estate industry.

Under the new rule, the central bank requires commercial banks to limit loans to the category of "real estate development credit," ending the practice among some banks of giving credit to other unauthorized projects in pursuit of bigger market share.

The central bank also requires construction companies to buy only construction equipment with their working capital bank loans.

Previously, developers commonly tapped into these loans, increasing the financial burden on construction companies.

Commercial banks are also allowed to ask home buyers for bigger downpayments on their second homes, luxury housing and town houses.

But so far, the rule has not been applied because the commercial banks argue it lacks sufficient detail and are concerned it may impact on their profits, Wang Zhao said.

Zhou Xiaochuan, governor of the central bank, said at the bank's half-yearly conference last week that a priority for the second half of the year is to analyze the reasons for the rapid growth in loans and the associated risks.

By the end of June, China's outstanding loans soared a year-on-year 22.9 per cent to 15.9 trillion yuan (US$1.9 trillion).

The loans helped push the M2 supply to 20.5 trillion yuan (US$2.5 trillion) at the end of June, Zhou said.

He said money supply is growing quickly, highlighting loan risks and inflation.

Niu Li, a senior economist with the State Information Centre, said: "It's understandable that the central bank governor is worried about credit risks, overheating in the economy and inflationary pressures."

"But we are worried about the possibility of an abrupt halt in money supply," he said.

The money supply currently available is needed to maintain economic development, although there is too much investment in some sectors such as cars and steel, he said.

Yuan Gangming, a senior economist with the Chinese Academy of Social Sciences, said the 20 per cent growth in money supply is nothing to worry about.

In Japan, where money supply growth outpaced the economy and consumer price index by a far broader margin, the government last year loosened money supply and apparently eased deflation, getting the economy growing again, he said.

Wang Zhao said the central bank should focus on structural adjustments in its monetary policy.

The government could not merely rely on increasing money supply to drive economic development.

Instead, monetary policy should support the development of small- and medium-sized companies.

Small- and medium-sized companies receive insufficient support from the State in obtaining loans, due to the lack of a social credit system and an underdeveloped legal system.

The State-owned commercial banks, which worry about loan risks, are also reluctant to give credit to these companies.

And China does not have enough small- and medium-sized banks willing to offer loans to these companies, Wang said.

The government could break up one or two State-owned banks for listing on the stock exchanges to improve these banks' corporate governance and to create more smaller banks.

It could also encourage private and foreign investors to participate in small- and medium-sized banks.

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