Short-term export prospects appear good but the prospects for later in 2010 are not clear. Given the impressive sequential recovery in exports in 2009 and early 2010, export volumes seem on course for rapid growth for 2010 as a whole even if export volumes remain flat for the rest of the year, sequentially. However, the subdued forecasts for world trade for 2010 as a whole call for caution. Based on the Bank's world trade projections, our export forecast for 2010 as a whole of almost 15 percent implies a substantially larger increase in China's global market share than in 2008 and 2009, although in 2002-07 the market share gains were even higher. We expect import growth to be somewhat faster than export growth. However, because the level of exports is much higher than that of imports, we project a mildly positive contribution of net external trade to growth this year, after the strongly negative contribution last year (Figure 14).

We expect the external surplus to remain broadly unchanged this year and next. With international raw material prices expected to recover more than prices of manufactured goods, we expect China's terms of trade to decline in 2010. As a result, in our scenario, the trade surplus edges down in U.S. dollar terms in spite of the positive contribution of real net trade to growth. We project the current account surplus to increase somewhat in U.S. dollar terms, though, mainly due to higher income on China's foreign reserves. As a ratio of GDP, we expect the current account surplus to edge down further in 2010.

Inflation is on course to be significant in 2010, after being negative in 2009, but it is unlikely to be very high. People's inflation expectations have increased after the massive monetary expansion. Meanwhile, due to rising food prices and imputed rent recently and some further pressure in the pipeline ahead from the recent increases in raw commodity prices, inflation is likely to increase and reach 3.5-4 percent on average in 2010. However, prices are unlikely to continue to increase sequentially as rapidly as they did at the end of 2009. Unlike in 2007, as noted above, international inflation prospects for this year and next are subdued. The China-specific factors behind food price increases are also not likely to persist. With regard to core inflation, unit labor costs in industry have actually decelerated and high core inflation remains unlikely in China. The net supply of labor on the urban labor market is likely to come down in the coming years. However, given China's pattern of growth, increases in the supply of goods and services tend to be rapid and large, compared to increases in demand. Indeed, overcapacity in certain sectors is likely to remain a concern. However, depending on the policy stance, property prices may well continue to rise significantly this year, particularly in the first half, before policy tightening begins to have a stronger impact and substantial new supply is expected to be finalized.

Key macroeconomic risks include higher asset prices and strained local government finances. Risks to growth are two way. Export prospects are rather uncertain and, domestically, the dynamics between economic developments and macroeconomic policy responses imply large risks and uncertainties this year. There is also some uncertainty about investment developments. But, growth prospects are much less uncertain than a year ago. There are risks with regard to prices, but these are also relatively modest. Probably the largest macroeconomic risks—and thus challenges for policymakers—are implications from the massive monetary stimulus: large asset price increases, a potential housing bubble, and local government finances.

Economic policies

The macroeconomic policy stance needs to be tighter than in 2009 to contain the emerging risks. The world economy is still subdued, with output far below potential in many parts. However, China's growth has been strong and, based on traditional yardsticks, China's actual output is actually close to potential (Figure 15). Thus, China needs a substantially different macro stance than most other economies. We think that inflation risks remain modest, in large part because of the global context. Nonetheless, the macro stance needs to be noticeably tighter than in 2009 to manage inflation expectations and contain the risk of a property bubble. Financial stability also requires policy attention to keeping local government debts manageable.

- The budget presented to the NPC rightly implies a broadly neutral fiscal stance. The 2010 budget presented to the NPC foresees a broadly unchanged budget deficit, compared to 2009.[9] As emphasized by the government, it is important to have flexibility in implementation. We think that means contingency plans and, importantly, letting automatic stabilizers work.

- The monetary policy stance needs to be tighter than last year and the case for exchange rate flexibility and more monetary independence from the United States is strengthening. It would also be helpful to increase the tolerance for modest inflation, to ensure room for desirable relative price changes. Strengthening the exchange rate can help reduce inflationary pressures and rebalance the economy. Over time, more exchange rate flexibility can enable China to have a monetary policy independent from U.S. cyclical conditions, which is increasingly necessary.

- Ensuring financial stability includes mitigating the risk of a property price bubble and ensuring the sustainability of local government finances. This calls for both macroeconomic and other measures.

Sustained, sustainable growth requires structural reforms. In the presentations to the NPC, the government emphasized the need to adjust the structure of the economy. With growth prospects good and China preparing for the 12th Five-Year Plan, this is a good time to both look at the whole structural reform agenda and to select those that can be advanced in the short term.

Fiscal policy

The increase in the 2009 budget deficit was remarkably small (Figure 16). Government revenues were down sharply in early 2009 on the back of economic weakness. Revenues from corporate income taxes and value-added tax (VAT) slowed significantly, reflecting low profit growth and the VAT reform. However, revenues picked up as the economy recovered and on intensified collection efforts. Reflecting those efforts, revenues from the windfall tax on oil companies soared in 2009. Consumption-type tax revenues were boosted by strong car sales and higher tobacco taxes. In all, budgetary revenue grew by 11.7 percent, and tax revenue 9.7 percent—much faster than nominal GDP growth of 6.8 percent despite the VAT reform. Budgetary expenditures grew 21.2 percent in 2009. In addition to large increases in infrastructure spending, budgetary spending on health, education and social security rose substantially (by 42, 15, and 11 percent, respectively). The budget deficit was 2.8 percent of GDP in 2009, on a commitment basis, up from 0.4 percent of GDP in 2008.[10] With revenues and expenditures of social security funds up respectively 17 and 25 percent, they ran a surplus of 1.1 percent of GDP, about the same as in 2008.[11]

However, fiscal policy was much more expansionary than the on-budget fiscal activity suggests. As discussed above, almost two-thirds of the stimulus from government-led spending was financed in ways other than via the government budget—largely by bank financing.

The fiscal plans for 2010 rightly imply a broadly neutral fiscal stance. The robust growth projected for 2010 calls for a neutral fiscal stance in 2010, with a broadly unchanged fiscal deficit compared to 2009 and much less off-budget stimulus. The budget presented to the NPC showed a deficit of 2.8 percent of GDP on "commitment" basis, the same as in 2009. With 0.7 percent of GDP in local government spending carried over into 2010, the "cash" deficit in the Ministry of Finance's budget rises in 2010. However, revenue growth in the budget is estimated conservatively.[12] Based on mainstream projections for nominal GDP growth and assumptions on revenue buoyancy the cash budget would be broadly neutral. The conservatism gives the government some useful leeway. If growth turns out weaker than expected, the targeted budget deficit may still be in reach without taking revenue measures.

Given the remaining uncertainty with respect to global growth, additional fiscal flexibility in implementation would be good. This calls for a contingency plan and, importantly, for allowing the automatic stabilizers to work. That is, to accept deviations in tax revenues and the budget balance if economic conditions are different than expected at the time of the budget.

The 2010 budget foresees little change in the composition of spending. The government intends to increase total budgetary spending by 10 percent in 2010. Public investment financed by the budget is set to increase by a modest 7.5 percent (in nominal terms). With respect to the "livelihood" areas that the government has emphasized recently, budgetary spending on subsidized housing is set to increase by 6.7 percent, on social security spending 10 percent, on health 14 percent, and on education 14 percent. The policy schemes to subsidize rural consumption will continue, with some adjustments.

Monetary policy

The key task for monetary policy in 2010 is to help mitigate the major macro and financial risks: high inflation expectations, unwarranted property price increases, and strained local government finances.