As Chinese leaders prepare to celebrate the Chinese Communist Party’s 90th birthday this Friday, they are deeply aware that they now confront a difficult balancing act. How do they respond to rising inflation and the growing mountain of problem loans in the banking system, without denting the country’s impressive economic growth?

After all, the existing system has delivered extraordinary results. China has now overtaken Germany and Japan as an economic power, and appears set to eclipse the United States as the world’s largest economy by 2020. At a time when the economies of most of the developed economies are mired in slow growth, the Chinese economy recorded growth of 9.7% in the first three months of the year, compared with a year earlier.

But critics argue that the country now faces major challenges. Rising inflation — the result of the country’s massive credit boom and widespread wage hikes of 20%-30% — is fuelling social tensions. The country is also dealing with a massive build up in indebtedness, particularly at the local government level, which is expected to show up in an increasing number of problem loans.

Chinese Premier Wen Jiabao, who is currently on a tour of European capitals, has acknowledged that the country will not meet its previous target of keeping inflation below 4% for the year. The aim now is to keep it below 5%.

“I believe it will be difficult to keep (inflation) at around 4% this year,” he reportedly told a group in London. But, he added, “with hard work, I believe it’s possible to keep the level under 5%.”

China’s inflation rate has averaged more than 5% this year, and some economists are predicting that it could climb as high as 6% next month. But Wen’s comments in London highlight the Chinese government’s concern that rising inflation is feeding social tensions. “Taken together, inflation and corruption can impact a nation’s political stability,” he said. As a result, “we must put stabilising prices at the forefront.”

At the same time, a report released by Beijing yesterday highlighted the dangerous increase in the indebtedness of local governments, again raising concerns about problems loans in the Chinese banking system.

According to the National Audit Office report, local governments have amassed debts of 10.7 trillion yuan ($US1.65 trillion), which is equivalent to 27% of China’s GDP in 2010. Much of this debt was built up during the massive two-year lending spree that took place following the 2008 financial crisis as Beijing ordered state-backed banks to boost their lending for infrastructure projects. There are now serious doubts about the viability of many of these projects, and the ability of local governments — which are now suffering from revenue shortfalls due to cooling property sales — to meet the interest payments on many of their debts.

What’s more, many believe that the debt figures compiled by the National Audit Office understate the full level of local government debts, because the figures only include debts that were explicitly guaranteed by local governments. But many local governments used land as collateral for their borrowings. Professor Victor Shih of Northwestern University estimates that local government debt was close to $2.6 trillion, or 42% of GDP at the end of last year.

There are increasing concerns about the quality of these loans. Some analysts estimate that as many as 20%-30% of loans made to local government vehicles are at high risk of souring. Concerns about Chinese banks’ exposures to local government debts are weighing on their share prices.

There are also fears that China’s central government will ultimately have to foot the bill for the bad debts incurred by local governments, either by taking over the debts, or by recapitalising banks that suffer heavy losses from bad debts.

This heavy build up in local government debt is causing a major headache for policy makers in Beijing. If interest rates rise, local governments face increasing financial stresses, and the losses in the banking system mount. But, at the same time, Beijing’s leaders — now preparing to commemorate the 90th anniversary of the Chinese Communist Party — are aware that interest rates must be raised if China is to have any chance of reaching its latest inflation target.

*This first appeared on Business Spectator.