What is happening in the Chinese equity market? After the Shanghai Composite Index reached a high of 6005 on 1 November, the market has fallen sharply and it’s currently trading at around 5,300, which is more than a 10% fall.

The reason: Inflation is at a 11-year high of 6.5% in China and the government finally seems to be serious about doing something about it. That’s why they recently raised the amount of cash that banks have to deposit with the apex bank to 13.5% of the deposit base and the markets fear that an interest rate hike is also round the corner.

But in any case, almost everybody says that Chinese stocks are in bubble territory, so perhaps lower stock prices are actually a good thing. The concern, however, lies elsewhere, in the rising prices of Chinese exports.

One reason for the global bull run in equities in the last four years has been the ability of central banks to keep their interest rates low, without fuelling inflation. The main reason for that was because globalization had shifted to low-cost countries such as China and India, with the result that the prices of goods and services had come down.

As far as China is concerned, that benign state of affairs seems to be changing. The US government publishes an import price index every month, which tracks the increase in prices of imports from some of the most important locations. Since May, the price index of Chinese imports has been increasing every month, the most recent being a 0.3% monthly rise in October, over September prices.

Clearly, inflation in China is leading to a rise in the prices of Chinese exports. Also, it has recently raised its domestic fuel prices and that will also exert an upward pressure on inflation.

A few years back, the concern was that China was exporting deflation to the rest of the world. The wheel has now come full circle and observers now worry whether it has started exporting inflation instead. Also, now that the dollar is falling like a stone, imports are in any case becoming more expensive. Taken together with the high price of oil, that might tie the US Fed’s hand when it comes to lowering interest rates further. And that would not be good news for equity markets.

However, some economists pooh-pooh the worry about inflation. Their argument is that the price rise in China is almost wholly the result of rising food prices, in particular rising pork prices caused by a disease that affects pigs. It’s therefore the temporary result of inadequate supply and should correct soon.

According to this logic, inflation in China is not the result of an overheated economy.

They also point to the very plausible argument that, given the almost endless supply of labour available in China’s interior provinces, it’ll be a long while before wages are bid up and consequently China’s labour-intensive manufacturing exports will continue to be very cheap for the foreseeable future.

But this rosy view is increasingly being contradicted. For example, Morgan Stanley economist Qing Wang believes that inflation in China is mainly the result of demand-side pressures. He also points out that money supply growth has shot up to 18.5% in the last couple of months, the fastest growth since May last year.

Although Wang believes that the authorities are likely to succeed in their effort to rein inflation, he also writes that there are big risks if inflation is not controlled quickly. “By the end of 1H08 and with the new government settling in, the authorities may be ready and may have to take much more aggressive tightening measures to control inflation, which may cause a hard landing of the economy in 2H08 or early 2009," writes Wang.

Andy Xie, an independent economist formerly with Morgan Stanley, has, in an article in the Chinese magazine Caijing, pointed out that what is happening in China now resembles closely what happened to South-East Asia in the early 1990s.

Xie says that at that time the US Fed was trying to cope with the aftermath of the collapse of a housing bubble, also known as the savings and loans (or S&L) crisis. At that time, South-East Asia had an inflation problem, fixed exchange rates and a minor property bubble.

The Fed rate cuts, says Xie, led to a flood of money out of the US to the high-growth economies of South-East Asia, boosting their markets, especially their property market, which assumed bubble proportions. Everyone knows what happened to that particular bubble, when the Asian crisis erupted 10 years ago.

But China is also in many ways very different from the emerging economies of South-East Asia. There are two things the Chinese government is likely to do. One is to allow the yuan to appreciate more rapidly. That will help slow exports. The second strategy would be to allow more capital outflows, draining out the excess liquidity through programmes such as the qualified domestic institutional investors (QDII) scheme.

Whether these measures will succeed is anybody’s guess. China’s export of liquidity may even be good for other capital markets.

How China manages a soft landing for its economy will, however, be critical for markets around the world.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at capitalaccount@livemint.com.