CHINA'S growth was a global star performer in 2009, edging closer to overtaking Japan as the world's second-largest economy, but policy makers and analysts alike remain wary about pitfalls on the road to recovery.

They see four danger zones: credit risks, rising trade protectionism, inflationary pressure and factory overcapacity.

The central government has said it expects the economy grew 8 percent in 2009 and will expand by a similar percentage this year. It also revised up its figures for 2008, putting the gross domestic product in that year at 31.4 trillion yuan (US$4.6 trillion). By contrast, Japan's economy, which stood at US$4.9 trillion in 2008, shrank last year.

Many institutions and analysts are predicting China's economy will exceed government forecasts, but that outcome may depend on how deftly the government manages potential pitfalls for growth.

Rising trade protectionism

Trade tensions will be the biggest challenge for China this year, according to Wu Jiahuang, vice chairman of China's World Trade Organization Research Institute.

"Developed countries should behave like brothers and implement WTO rules fairly for latecomers like China," Wu told a forum in Shanghai last month.

But instead of extending a helping hand, some countries have targeted China in a series of trade disputes.

In the first 11 months of last year, 19 nations launched 103 probes against Chinese products. The number of cases and the value of goods both hit a record high.

Chinese exporters of tires, steel, shoes, aluminum products, toys and paper were battered by punitive duties imposed upon them, and foreign countries were also clamoring for China to lift its controls on raw material exports and remove barriers on the entry into China of foreign publications, films and audio-video products.

Zhou Xiaoyan, director of the Bureau of Fair Trade for Imports and Exports under the Ministry of Commerce, said China's foreign trade is braced for more complications and protectionism arising out of the global slowdown and resulting competition.

She predicted more foreign countries and more Chinese industries will be sucked into the vortex of trade disputes this year.

Zhou said the ministry will step up its efforts in negotiations, and will enhance business collaboration and political intervention to roll back rising trade tensions.

Inflationary pressure

Memories in China are still fresh of the 5.9 percent surge in inflation in 2008. That threat to the economy cooled with the collapse of global financial markets in November that year. But analysts say inflationary pressure still lurks.

China's CPI in November rose for the first time in nine months, fueled by ample liquidity in the markets under China's relatively loose policies.

Wang Qing, a Morgan Stanley economist, said he expects consumer prices to rise more than 4 percent this year, powered by steep rises in commodity prices, which are usually denominated in US dollars, a currency that has depreciated.

"China's industrial production and global commodity prices could both surprise to the upside, likely resulting in higher GDP growth and stronger inflationary pressures," Wang said in a preview of the year.

"Alternatively, the prices of international commodities may grow rapidly, even without material improvement in the underlying fundamentals in the global economy, due to risk-seeking speculative demand fueled by abundant liquidity and the weak US dollar."

Inflation, which causes a loss of purchasing power for consumers and a reduction in value for a country's currency, is a big headache for China as the government tries to implement a proactive fiscal policy and moderately loose monetary policy to stimulate recovery.

To control inflationary pressure without increasing interest rates or raising banks' reserve requirements, Wang said, China needs to tighten its administrative controls over the domestic prices of key commodities and prevent any speculation.

Overcapacity

Overproduction stood out as a big problem for China last year in industries such as steel, cement, aluminum, flat glass, polysilicon and wind-power equipment.

In September, the State Council, China's Cabinet, announced it would restrain investment in those industries to avoid a glut of goods and resulting cut-throat competition.

Last Wednesday, China rang alarm bells in two more sectors: the coal chemical industry and vitamin C production, warning both would face curbs if they continued their "blind" expansion.

"Overcapacity is worrisome," said Li Ningning, deputy director of the industrial department under the China National Development and Reform Commission. "It does not create value but leads to price wars."

Vitamins are just the latest example of supply overtaking demand. China produced 126,000 tons of vitamin C in 2008, accounting for 90 percent of the world's market. But last year China reported another 75,000 tons of capacity either under construction or on the drawing board. If that trend continues, China will be producing more vitamin C than the world needs by 2012.

Joerg Wuttke, president of the European Union Chamber of Commerce in China, said overcapacity can also become a source of trade disputes because excess production eventually finds its way into the global market.

China is taking a tougher stance on the problem, he said, but rules are not enough. The key is to make sure regulations are effectively implemented at the local level, where government officials are often blinded by the desire to attract more investment into their territory, according to Wuttke.

Credit risks

Although the volume of bad loans in China was on the wane last year, record new lending in yuan is leading concern about a credit bubble, analysts said.

China's outstanding non-performing loans fell to 520.8 billion yuan at the end of last June, down 42.7 billion yuan from six months earlier, according to the latest data posted on the Website of China Banking Regulatory Commission.

"However, the risk of a credit bubble is growing," said Yu Yongding, an analyst at the Chinese Academy of Social Sciences.

Banks in China issued 9.21 trillion yuan (US$1.34 trillion) of local-currency loans in the first 11 months of last year, up 5.06 trillion yuan from a year earlier. That far exceeded the 5 trillion yuan government target for 2009.

"The problem is not confined to the large amount of lending but its quality as well," Yu said.

Many banks have chosen to play it safe by giving loan preferences to larger state-owned enterprises or to infrastructure construction projects sanctioned by the government.

Many state-owned enterprises haven't bothered to develop sound and efficient ways of spending all the money being thrown at them.

By contrast, many smart but smaller companies are cash-strapped, begging banks for loans but ending up empty handed. Small businesses, which form the backbone of employment, don't have capital for expansion or development of new ideas.

The risks are obvious to analysts and investors alike. If a state-owned enterprise fails, banks will be saddled with rising bad debts.

At the same time, as infrastructure projects are completed and interest from those loans dries up, the banks may find themselves lacking adequate cash flows.

Analysts predict the volume of new yuan loans will slow to 8 trillion yuan this year from an estimated 9.5 trillion yuan in 2009, a rate widely deemed unsustainable.

They are warning that banks need to diversify their lending and better structure their balance sheets, and that regulators need to step up banking supervision.