It's not a surprise that China is worried about a potential housing bubble, the dangers of which are so vividly presented in satellite images of its so-called "ghost towns". House prices rose by 7.7% in November, marking 18 months of gains. This is despite the government prohibiting mortgages for third homes and announcing plans to introduce a property tax. In fact, sales volume jumped 14.5% from a year earlier. Housing ownership is traditionally favoured by the Chinese, but even more so at the moment since it was only a decade ago that housing was privatised. The housing market has certainly taken off since then.

The housing boom is due to a potent combination of negative real interest rates and a currency pegged to the US dollar, while America is trending towards deflation. The rapid increase in house prices has led to warnings that China could be in for a sizeable bust.

Even though China's central bank raised interest rates in October for the first time in three years to stem the flow of credit, the problem is that savers still face negative real interest rates (inflation is 5.1% while the deposit rate is 2.5%). Savers would rather buy assets since they are losing money by depositing their cash in banks. And, as China has capital controls that limit overseas investment and an underdeveloped financial sector, the assets of choice are the stock markets and real estate.

This is worsened by the managed exchange rate. The RMB has appreciated by only around 3% against the US dollar this year. This is a particular problem because strong growth in China generates inflation as compared with the slowly recovering US. The disparity in inflation rates between China, where price rises have accelerated from 1.5% to 5.1%, and the US, where CPI has come down from 2.6% to 1.1% in November, is widening.

This inflation in China is not distributed evenly. Prices in the tradable sector have appreciated minimally since the prices of traded goods are fixed by the exchange rate. This means significant price pressures in the non-traded sector, particularly real estate. The growing inflation disparity between the US and China adds more pressure to a bubbly domestic economy and housing market.

Aside from China, low interest rates often contribute to asset bubbles, as seen in the US sub-prime mortgage crisis where a housing bubble developed after the Fed kept rates low for several years after the 2000-1 recession. The consequences of a housing bust are all too well known. But, it may not be that dire for China. It has more of a "plain vanilla" housing boom and not one driven by complex debt instruments. The consequences, though, for China would be worrisome in any case as the loss in wealth for the middle class could lead to social instability as well as raise concerns about the amount of bad loans in the banking sector.

What's tougher for China, though, is that the fixed exchange rate increases liquidity pressures in the economy. Interest rates in China are higher than the 0-0.25% interest rate in the US. By raising rates to address inflation, it would further widen that differential. For investors keen to gain higher returns, China becomes even more of a magnet, particularly because the fixed exchange rate means that the central bank will act to restore the currency peg, keeping investments in China attractively priced. This is a problem not only for China but other emerging economies as they experience the "search for yields" of investors borrowing cheaply in the west and seeking returns elsewhere.

It poses a difficult mix of policies for China. If China raises interest rates, then external capital inflows could erode the impact of the tightening measures. But, if China were to make the RMB more flexible and then raise interest rates, it may well be more effective. China could also offer savers options for investment other than the housing and domestic stock markets, such as allowing more overseas investments to reduce the demand for internal assets. That is beginning to happen. But, whether it happens quickly enough to avert a bubble (and it bursting) in Chinese real estate is less than apparent.

For those counting on the might of the Chinese economy as an engine of global growth, it's worth a reminder of the challenges that it still faces. Indeed, though differences abound, there are some who point to Japan as an example of a fast-growing economy which had a cheap currency, low interest rates and a real estate bubble that burst to result in a "lost decade." The Chinese, at least, are aware of that lesson.