The market is debating if China will raise rates or not, but they are already going up on the ground. The government has been limiting money growth through guidance on bank lending. The money supply has cooled from the rampant growth last year. M2 in July rose 17.6 percent from last year, 11.5 percentage points lower than the year before. The administrative measures have clearly caused a tightening in the lending market. Businesses complain of difficulties in getting loans.

To some extent, through industrial lending policies, rates are kept low for preferred industries. Large state owned enterprises, for example, can still borrow at prime rates. But the borrowing rates for others have gone up significantly, if loans are available at all. For property developers the loans are often not available at all. They have resorted to issuing high yield bonds offshore.

17.6 percent M2 growth rate would be considered high even for a fast growing economy like China's. So what explains the tightness in the credit market? The cause is the huge number of projects created by last year's loose lending. They must keep borrowing to keep going. Rapid money growth in China creates more borrowers. Even faster money growth is needed to keep lending conditions neutral. When the growth in the money supply slows, it feels like a tightening. If the slowdown is sustained, many will default, as they did following the tightening in 1994.

Rate increases do not fully reflect the tightening deposit and lending balance. Clearly, borrower discrimination is an important factor in containing money growth or preventing rates from rising much more. Hence credit demand isn't likely to drive up rates, especially deposit rates, to where they should be. But inflation expectations and their impact on deposits could do so.

The household contribution to deposit growth is diminishing. The difference between household deposits and debts was 18.9 trillion yuan in July this year, up marginally from 18.3 trillion yuan the year before, and sharply down from the 3.9 trillion yuan increase seen between July 2008 and 2009. The data suggest that household willingness to keep deposits is declining. Monetary expansion is increasingly dependent on the inflow of hot money. It makes the situation vulnerable to a reversal in exchange rate expectations.

Despite the low inflation statistics, household behavior clearly indicates that inflation perceptions and expectations are much higher. The prices for numerous food items are rising at double digit rates. Rents are rising at double digit rates. These two sectors should account for half of the household expenses. Even though most households own their properties and don't suffer a cash impact from rent increases, the imputed rental cost still matters. Property prices are not included in the CPI. The imputed rental cost should be. Otherwise, this sector, which accounts for a huge share of household lifetime expenditure, will never be reflected in the CPI. The government controls the prices of utilities and transportation. Even if it keeps these prices down through subsidies, the inflation rate is still reflected in market-driven items. That is why more and more households are saving less.

Despite the tightness of household deposits, interest rates have not increased that much. The reason is strong corporate deposits, reflecting the trade surplus, and capital inflows attracted by expectations of RMB appreciation. Both are consequences of the prevailing loose monetary conditions in the global economy, especially in the U.S. The implication is that China's monetary condition is vulnerable to a sudden reversal in expectations about the RMB and/or any tightening of monetary conditions the developed economies take to combat inflation.

China's interest rates will continue to rise in the coming months. The pace may quicken substantially in the first half of 2011. Nevertheless, the levels of interest rates will still not be sufficient to ensure price stability. Inflationary pressure reflects the money supply, not marginal changes. Monthly economic data have an insignificant impact on inflation. Indeed, inflation is inevitable. To stop inflation from getting out of control, interest rates must rise above inflation, i.e., we must maintain positive real interest rates. This is the only way to maintain stability in the years ahead. Otherwise, China could suffer a hard landing when external monetary conditions change.

It is dangerous to leave China's macro stability dependent on external developments.

Andy Xie is an independent economist based in Shanghai and former chief Asia-Pacific economist for Morgan Stanley.

(This article was translated by Lin Liyao.)