You know that something extremely fishy is happening when top Chinese banking authorities start downplaying the risk of inflation.

But that’s what happened last week when China’s top bank regulator, Liu Mingkang, dismissed concerns that China was facing mounting inflationary pressures. He argued that China did not need to worry about rising prices because the country had a great deal of over-capacity in its industrial sector, which will put a brake on rising prices.

“There is overcapacity for most industrial goods in the Chinese market and it’s impossible for upstream inflation to be transmitted downstream,” he said.

Separately, the head of China’s central bank, Zhou Xiaochuan, conceded that more steps had to be taken to combat liquidity-driven inflation. But, he warned, the precarious global financial situation meant that China had to be very cautious about raising interest rates.

Now, these comments from these two top officials are extremely interesting because they demonstrate that Beijing is extremely reluctant to raise interest rates, even though China’s consumer price index rose by 5.1% last month, the biggest jump in 28 months.

What’s more, it’s clear that inflationary expectations are becoming more entrenched. Because the interest rate paid on one-year deposits is only 2.5%, or less than half the rate of inflation, Chinese households have little incentive to put their money into bank deposits. Instead, they prefer to buy up physical assets, with the rich pouring their money into property, while less affluent households buy food products, such as baskets of garlic and ginger.

Beijing’s obvious reluctance to raise interest rates is fuelling speculation that China faces an even greater problem than rising prices — and that’s the level of bad debts in its banking system.

They argue that many Chinese businesses are already operating with extremely fine profit margins. An increase in interest rates would push up their borrowing costs, wiping out any profits, and instead leaving these companies with operating losses.

The big question is whether the Chinese banking system could cope with a further rise in problem loans. Chinese banks already have huge numbers of non-performing loans on their balance sheets as a result of their huge lending spree in 2008-09. As the global financial crisis struck, Chinese exports shrivelled. Beijing ordered Chinese banks to step up their lending in order to boost Chinese economic activity, and the banks duly complied with more than $US1 trillion in fresh lending.

But a lot of these loans went to local investment companies (LICs), which used the money to finance infrastructure and property projects, including building new roads, railroads and power plants, as well as hotels and office buildings. Unfortunately, many of these projects were non-economic, and already a lot of these loans are now non-performing.

Six months ago Liu Mingkang issued a stern warning about the level of problem loans held by Chinese banks. “The soundness of the banking sector is being tested,” he said, adding that one of the big risks for banks were their loans to the LICs.

Currently, Beijing is caught in a dilemma. If it raises interest rates to quell inflation, there is a risk of inducing another wave of business collapse, which will further swell the number of problem loans that Chinese banks are carrying on their balance sheets. But if it leaves interest rates at current levels, inflationary pressures will continue to build.

At least for now, Beijing appears to have taken the view that the risk of exacerbating the problems in the banking sector outweighs the risk of heightened social tensions caused by rising food prices.

This story first appeared on Business Spectator.