The authorities have outlined a less expansionary monetary policy stance and taken some steps. Overall credit growth this year is targeted at about 18 percent, compared to 30 percent in 2009. Monthly credit quota are employed to keep lending growth in check. The authorities have also taken some administrative measures and adjusted prudential regulation to mitigate risks in the property sector and with respect to local government finance (see below). The reserve requirement ratio has been raised twice by 50 basis points to withdraw liquidity.[13] However, overall liquidity remains abundant, as evidenced by still low interbank interest rates (Figure 17).

Inflation expectations and pressure can be contained by tightening the monetary stance and allowing the exchange rate to strengthen. To help anchor inflation expectations, it is important to ensure that the target of 7.5 trillion yuan in new lending in 2010 is met. Higher interest rates would make the tightening more convincing. A stronger exchange rate helps reducing inflation pressures by lowering the price of imports and toning down demand. It also helps rebalancing China's pattern of growth towards more services and consumption and less industry and investment.

Further on inflation, it would be useful to increase the tolerance for modest inflation to allow useful relative price adjustment. High inflation is distortive and not helpful. However, in rapidly growing countries like China, relative prices need to change as the economy is reformed and develops. In many emerging markets moderate inflation—of 4-5 percent—is not seen as a major problem. Constraining inflation to be very low may hinder the needed relative price changes. For instance, China needs to increase administrative prices for resources and utilities that are necessary to adjust the structure of the economy. And, higher prices for agricultural products and higher migrant wages can help boost rural incomes and reduce urban-rural inequality, thus helping to improve the primary income distribution. It would be unfortunate if such desirable developments were suppressed because of concerns about moderate inflation.

In addition to containing inflation expectations, monetary policy has a key role to play in containing risks of asset price bubbles. The recent global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policy making. While inflation may be contained by large output gaps globally, China's monetary policy needs to pay attention to its own output gap and liquidity-driven asset price inflation.

The case for a larger role of interest rates in monetary policy is strong.

l With interest rates substantially lower than expected rates of return on physical investment, property, land, and equity, relatively low interest rates contribute to the overinvestment and speculation that the government is trying to limit.

l The role of interest-sensitive capital inflows in fueling liquidity is small, compared to domestic liquidity creation. The $73 billion net financial capital inflows in 2009 were equivalent to 5 percent of new bank lending. This is in part because capital controls, though not perfect, are effective in containing capital flows. Moreover, financial capital flows into China are not likely to be very interest sensitive, since much of it is attracted by the equity and, especially, the property market.

l Quantitative and administrative measures such as credit quotas are effective in containing credit, but tend to create volatility and uncertainty on financial markets—as was underlined in early 2010. Such instruments are also distortive and sit oddly with efforts to make banks more commercially oriented.

If policymakers remain concerned about interest rate sensitive capital flows, more exchange rate flexibility would help. The perceived constraint on raising interest rates is particularly problematic when cyclical conditions in China differ from those in the United States. U.S. monetary conditions (the interest rate) are then not appropriate for China. This has been the case recently and may happen more often in the future than in the past. More exchange rate flexibility would make monetary policy more independent. By introducing useful two-way risk on the foreign exchange market, such flexibility gives monetary policy more room to be in line with domestic needs and to raise interest rates even though interest rates in high income countries remain low.

Ensuring financial stability

Ensuring financial stability calls for mitigating the risk of a property bubble and avoiding strains on local government finances. In addition to monetary tightening and other measures, several structural reforms would help.

The property market—defining the role of the government in a market economy

Policymakers are right to closely monitor the property market (Figure 18). This is so even though it is not clear to what extent nationwide property prices are systemically overvalued and how likely a negative price correction on the property market is. The impact of such a correction on households would be relatively limited as their leverage is still relatively low. However, property makes up a sizeable share of the portfolio of many firms and banks. Moreover, local governments' finances would be affected strongly, as these rely significantly on land sale revenues which, in turn, are affected by housing prices. Also, a housing sector slowdown would affect the overall economy in a major way.

The authorities have taken several measures recently to contain risks of a price bubble. In 2009, the China Banking Regulatory Commission (CBRC) urged banks to ensure that loans for "real" investment are not diverted to the property or stock market. The "Recent Economic Developments" section above discusses recent measures to increase supply and curb speculation on the property market. Looking ahead, more adjustment of prudential regulation and other administrative measures can be implemented, including more increases in loan-loss and minimum down payment ratios and higher reserve requirements. Overall monetary tightening is another important instrument.

In addition, several types of structural reforms can help mitigate risks with respect to asset prices. The supply of financial instruments can be increased, by financial sector deepening, including in the bond and equity market. Where interest rates on bank deposits are still capped, easing the caps and stimulating the development of more long-term saving instruments would help absorb financial surpluses. Introducing a capital gains tax on real estate would reduce pressures as well.

With regard to property market prices, concerns about market bubbles need to be separated from concerns about the affordability of housing ownership for low- and middle-income people. When prices on China's real estate market are rising rapidly, as now, concerns about possible overheating of the market and bubbles are combined with concerns that lower- and middle-income people cannot afford to buy an apartment in or close to the center of large cities. As a result, the government sometimes takes measures to influence the general market price. Actually these two types of concerns require very different policy responses.

In addition to an appropriate macroeconomic stance, ensuring financial and macroeconomic stability calls for improving the functioning of markets and reducing distortions. First, the functioning of the housing market can be improved, including by improving the quality and consistency of data on prices and vacancies. As a result of poor data on the real estate sector, there is a lack of clarity about affordability—the ratio between housing prices and household income—the often-used indicator of the potential for negative price corrections.[14] The real estate market would benefit from more representative data on property prices and how they compare to incomes of different groups. Second, the land transfer and sale process can be improved. A key objective should be to reduce the incentives of local governments for high prices of real estate and land, including by reducing their reliance on land sales for their revenue, by introducing a stable form of local revenue such as a property tax or adjusting the tax sharing arrangements between the central and local governments. Third, it is important to monitor and regulate the financial market aspect of housing finance—including the development of instruments such as mortgage-backed loans and the refinancing market.

On the other hand, concerns about the affordability of houses for lower- and middle-income people should be dealt with by a predictable, rule-based government support framework. In a market economy, objectives such as improving the access of people to housing or making housing more affordable are a responsibility of the government and need to be furthered through specific government support, not via measures or intervention with respect to the overall market. The government support could be based on subsidies or public housing, but should be in the form of a long-term framework. It would need to be led and probably also backed by the Central Government.[15]

(To be continued)