Trends in China’s Consumer Price Index (CPI) have raised investors’ concerns about inflation and its implications for the Chinese economy’s prospects in 2010. In the event of substantially higher inflation, Chinese authorities would be forced to act more aggressively to curb economic expansion–a move that would quickly raise the cost of capital.

Such a development likely would increase the incidence of nonperforming loans, as Chinese banks have expanded lending dramatically for the past year and a half.

The result will be a violent correction in the Chinese market–potentially to the tune of 30 to 40 percent–as all the extra money that has been floating around globally has found its way to some kind of an asset–mainly stocks, real estate, and commodities. In particular, emerging markets have benefited from investors’ improving risk tolerance.

For these reasons, the Chinese would prefer that the global economy recover gradually; in that event, demand would remain subdued, keeping prices for food and input materials relatively low.

Food remains the highest component of China’s CPI and was at the forefront of the last inflationary scare in 2008. Food prices were also mainly responsible for the latest uptick in Chinese inflation, representing 178 percent of the overall CPI increase last month. But I continue to expect solid growth in the global economy in 2010, so food prices shouldn’t be anywhere near the elevated levels we saw two years ago.   

I expect that inflation in China will remain comfortably below 3 percent next year. The reason being that the Chinese government also controls the main levers of the Chinese economy, especially bank lending. At the same time the country’s capital account (a nation’s outflow and inflow of financial securities) remains tightly controlled.

It comes as no surprise that the Chinese government has taken the necessary measures to slow the economy and avoid a double-digit expansion in its gross domestic product (GDP) next year.

The most recent State Council meeting called for measures to control the rapid rise in property prices, especially in the hottest markets. On the other hand, the government’s policy of supporting the average person’s housing market will remain in place, and the government will continue to facilitate the building of affordable housing.

That being said, real estate prices in China rose between 2 to 10 percent per month over the past year–a potential cause for concern given what transpired in the US. At the same time, housing starts have increased strongly, as demand remains high and inventory levels relatively low; when supply eventually catches up with demand, prices will head lower.

The main economic parameter that China does not control is the price of oil. And this is the indicator on which investors worried about inflation should concentrate. It’s generally accepted that oil prices above USD100 per barrel for a prolonged period contribute negatively to China’s inflation, as they affect all aspects of economic life, from food to industry.

Although our in-house energy expert Elliott Gue expects the price of oil to spike above USD100 next year, as of today his assessment is that the average price for oil will be between USD85 to USD95 per barrel for 2010.

Elliott has generally been correct throughout the years when forecasting oil prices and the inclination here is to go with his assessment. If his forecast materializes, the Chinese economy will be able to grow strongly while avoiding runaway inflation and a stock market crash.