Theoretically, rapid increases in money supply will lead to higher prices and subsequently prompt inflation. That is the true reason why the central bank has repeatedly stressed a contracting of the money supply to prevent potential inflation.

But an in-depth analysis of the demand structure tells us that, in the medium term in China, the deflationary pressure outweighs the inflationary risk.

First, the rebound in prices in the first half of this year was primarily driven by price hikes for food and some services -- such as vegetables, water, electricity and medical services -- while the prices for most industrial products continued to slide.

As a recent report by the International Monetary Fund pointed out, when the growth of the consumer price index drops below 1 percent, real prices may be falling already due to statistical discrepancies. Although China's consumer price index was on an upward trend for six consecutive months, starting in January, the pace remained below 1 percent.

Moreover, the prices of capital goods have started to fall sharply, which heralds sluggish growth in consumer prices for the months ahead.

Second, a changing market environment has caused changes compared with our historic experience. Unlike the 1980s and 1990s, when "shortage'' was the keyword in the economy, the aggregate supply now outstrips demand.

Furthermore, the economy now has a heavy foreign reliance, and prices for the vast majority of commodities involved in foreign trade are, to some extent, subject to the international market. Against the background of a decelerating world economy and an overall drop in the prices of goods traded, the likelihood of a surge in the prices of China's traded goods is dim. The stability in the prices of tradable goods, which account for more than 60 percent of gross domestic product, puts a constraint on the upward trend of overall prices.

Currently, the conditions for inflation are not yet in place in China. On the contrary, the deflationary risk has not been defused. If monetary policy is mishandled, the possibility of a resurgence of deflation in the remainder of this year cannot be ruled out.

Loan growth on fast side

Since the beginning of this year, the central bank has not changed its prudent target for monetary policy, but money supply and loans have been soaring. In the first half of the year, the growth of money supply was 2 percentage points higher than the 18 percent target set at the beginning of the year, while new loans hit 1.78 trillion yuan (US$214 billion), close to the 1.85 trillion yuan (US$222 billion) in loans that were rolled out in the whole of 2002.

Why was credit growth so rapid? In addition to demand from a rapidly growing economy, the investment momentum seen in different parts of the country has strongly stimulated demand for loans.

Among the funding sources for fixed-asset investments, which are growing at persistently high levels, the share of bank loans continued to expand, with the share dropping in all other sources. That is also true in the heated real estate sector, where domestic bank loans and self-raised funds are the major drivers of growth.

New tendencies in commercial banks' lending activities also propelled the loan rises. First, banks speeded up lending as a way to reduce their non-performing loan ratios.

Second, as the commercial paper market develops, the risks in lending to small and medium-sized enterprises and small projects are buffered by smaller banks, alleviating risk concerns at the four largest banks. Consequently, loans through commercial paper discounting rose heftily.

Third, the corporate bond market kept shrinking, forcing businesses to rely more on bank loans.

Fourth, many bank branches played tricks with their books -- for example, by issuing new loans to help borrowers repay old loans -- and therefore transformed non-performing loans into new loans.

Caution with reserve ratio

Facing these problems in the financial sector, we should not opt to merely put the brakes on the aggregate volume (of money supply) but should try to improve the lending structure on the basis of enhanced risk management.

At the same time, we need to closely monitor the growth in money supply and be cautious with the deposit reserve ratio policy in order to avoid abrupt fluctuations in money supply and loans.

According to the money-multiplier theory, money supply is the product of base money multiplied using the money multiplier, while the mandatory reserve ratio (the amount of deposits a commercial bank is required to deposit at the central bank) is an important determinant in the money multiplier.

At present, the total deposits at financial institutions are 18.89 trillion yuan (US$2.27 trillion). A 2 percent rise in the mandatory reserve ratio will add 380 billion yuan (US$45.8 billion) in money supply. Considering the money multiplier, it can cause a massive negative impact on money supply and is likely to result in a reversal in the deflationary situation, which is already improving.

An important reason behind the rapid rise in lending is the imbalance between direct and indirect financing. Businesses have limited financing channels and have to rely on bank loans.

New policies should be formulated to support the development of the capital market and therefore broaden channels for direct financing for businesses.