China’s success in achieving its 8 percent GDP growth target in 2009 has inevitably changed the economic challenges facing the country. A year ago, under the impact of the financial crisis, China faced falling prices. Today China faces capacity shortages and inflation is a major challenge.

Important information for assessing how successful China will be in meeting this challenge is contained in new details of China's 2009 growth released by the National Bureau of Statistics. These indicate that, provided sound economic policies are pursued, China is well placed to deal with the risk of inflation.

In dealing with it, however, it is crucial to diagnose the real economic situation correctly. The European Chamber of Commerce in China last year produced a report concentrating on "overcapacity" in China – at the exact moment when the problem was becoming one of capacity constraints. This ill-timed report was inspired by the ideas of commentators such as Michael Pettis of Beijing University and Stephen Roach of Morgan Stanley, who mistakenly believed China was suffering from a major overcapacity problem when, in fact, the reverse situation was developing.

To identify the real challenge in 2010, it is therefore worth looking at China's capacity constraints from two angles – the micro-economic – that is the situation in particularly industries, and from the overall macro-economic point of view.

There is only a limited amount that can be done to deal with some short term capacity constraints that have appeared in China. Severe winter weather helped increase vegetable prices by 16 percent in the single month of December. Within the 1.9 percent increase in the consumer price index in the year to December, the highest rate of increase – 5.3 percent – was for food.

But other inflationary pressures are due to capacity constraints in sectors in which additional investment can potentially tackle the problem in the medium term. As Geoff Dyer noted in the Financial Times: "According to Yu Song and Helen Qiao at Goldman Sachs, the most extreme example is in the auto sector, where extra shifts mean factories are running at above capacity. They also see emerging bottlenecks in electricity, coal and even in aluminium and steel which only a few months back seemed to be suffering from chronic overcapacity. "The capacity overhang has been quickly whittled down in major industrial sectors," they wrote in a recent report.

However, simply looking at the situation in particular industries cannot settle the issue of how serious the inflationary capacity constraints in China's economy are. Statistically there will always necessarily be examples of "overcapacity" and "undercapacity" in an economy, even when overall macro supply and demand are in balance, as it is in practice impossible to exactly match supply and demand in all sectors.

Therefore pointing to individual cases of either overcapacity or undercapacity, whether statistically or relying on anecdotes, solves nothing, as it will always be possible to find such cases. Only an overall consideration of the balance between demand and supply can determine whether (deflationary) overcapacity or (inflationary) lack of capacity is dominant.