The background paper also explores various ways to compare China's living standards and the size of the economy with that of other countries in the future, focusing on the key role of real exchange rate appreciation in catch up.

Economic Policies

China's baseline macro prospects warrant a normalization of the overall macroeconomic stance. So far, the property-related measures notwithstanding, China's overall macro stance has remained quite expansionary, the monetary stance in particular (Figure 11). Looking ahead, despite some renewed uncertainty globally and the measures towards the property market, overall growth prospects for this year and next remain good in the central scenario—broadly as fast as potential growth—while the economy is now operating close to full capacity (Figure 12). Against the backdrop of the large monetary expansion since late 2008, the key macroeconomic risks relate to asset price movements, local government finances, and NPLs. This outlook calls for normalization of the overall macro stance, notably the monetary stance. A less accommodative overall monetary stance would also reduce the need for tough property-related measures, particularly if higher interest rates would be allowed to reduce the fundamental drivers of rapid housing price increases.

Heightened uncertainty calls for policy flexibility rather than continued stimulus by default. Preparing for the uncertainties and risks around these favorable baseline projections by ensuring flexibility in the design and implementation of policymaking is preferable to deciding now to provide added stimulus to be sure growth will exceed a certain rate. This is all the more so since the risks to growth are two-way.

Policymaking needs to take into account several features from the medium- and long-term outlook.

l In setting growth targets for the coming years, the likely slowdown in potential growth needs to be incorporated. To avoid macroeconomic stress, growth targets should be set in line with potential GDP growth that is projected in a plausible and sustainable scenario. In principle, downward pressure on potential growth from demographics and TFP growth could be mitigated by boosting investment and thus capital accumulation. However, boosting the already very high investment to GDP ratio would contradict the government's aim to rebalance the pattern of growth towards one that is less dependent on investment. Moreover, a delay of rebalancing may diminish the associated efficiency gains.

l Given the downward pressure on potential growth, there is a premium on policies that can increase TFP growth, including via more reallocation of labor, enhanced human capital, and innovation.

Fiscal policy

The headline budget deficit rightly implies broadly neutral fiscal policy, although the broader fiscal stance is not clear. The 2010 budget foresees a broadly unchanged budget deficit, compared to 2009. With robust economic growth and surging imports boosting revenues from VAT and import taxes, budget revenue grew 40 percent (yoy) in the first five months of 2010, from a low base. Meanwhile, budget expenditure growth declined to about 10 percent in that period (yoy), from 20 percent in late 2009. As a result, the 12 month rolling budget deficit shrunk to about 1 percent of GDP in May. However, the broader fiscal stance is hard to know. Taking into account off-budget government-led spending, notably that by local government investment platforms (LGIPs), the stance may still be expansionary. The monetary data suggest that in the first quarter of 2010 a large share of lending still went to LGIPs (Figure 13).

The central authorities are rightly aiming to control lending by LGIPs. Since long a core feature of China's development strategy, lending to such platforms has soared since end 2008 (see our March 2010 Quarterly Update for more discussion and details). The China Banking Regulatory Commission (CBRC) estimates that total local government debt was 8 trillion yuan at end 2009, of which LGIP debt constituted 7.4 trillion yuan. This lending may in various localities cause problems for the local governments and lead to NPLs. Given China's solid macroeconomic and fiscal position, the local finance problems are unlikely to cause systemic stress. Nonetheless, the flow of new lending to the platforms needs to be contained. It is not clear to what extent the central authorities are able to do this amidst still large overall credit creation.[13]

In current circumstances, it is important to have flexibility in fiscal policy implementation. 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 low fiscal deficit currently provides room for fiscal expansion if circumstances require that. This is so even though fiscal policy continues to be more expansionary than the on-budget fiscal activity suggests.

Fiscal policy and public finance reforms are key in keeping growth sustainable and rebalancing the economy. Reforms in the following areas are particularly opportune. In several areas, reforms are already discussed or underway.

- Continue to increase government spending on social protection, healthcare, and education, both for the direct benefits of such spending and to increase household disposable income and consumption.

- Further policy priorities in social security include putting the pension system on a financially sustainable footing; reducing segmentation, increasing pooling and portability; and responding to the implications of demographic changes. Box 2 discusses social protection and labor market policy achievements and challenges.

- Use the public finances to increase household disposable incomes, for instance by lowering social security contributions in a financially sustainable way.

- Expand the dividend policy for SOEs in coverage and level and improve corporate governance to remove the over-investment bias, especially in large, industrial SOEs. Further reforms in this area are pending.

- Remove the under pricing of industrial inputs—land, energy, water, natural resources, and the environment—through price increases and tax measures, to reflect the full cost of supply, including environmental and depletion costs. Recent adjustments in domestic fuel and water prices, the pilot with an ad valorem resource tax on oil and gas in Xinjiang, and plans to gradually end subsidized electricity prices for energy-intensive industries, are steps in the right direction.

- Remove remaining distortions in the tax system that stimulate manufacturing. Expanding the VAT system to the service sector and levying VAT at the location of consumption instead of production would help reduce current distortions.

- Consider a capital gains tax on equity to reduce distortions and make the tax system more equal.

Many of the government's objectives are not possible without reform of the system of fiscal relations. The key challenges are aligning incentives of local governments with the central government's policy objectives, improving the consistency of revenue assignments and expenditure responsibilities of local governments and reducing the inequality in public spending.

- The incentives of local governments to be "on board" with the rebalancing agenda need to be strengthened. In addition to reforming the performance evaluation system for local officials, local taxes would reduce the dependence of local governments on land revenues and allow local governments to benefit from those economic activities that the central government wants to promote, including consumption, service sector activity, and full migration (of whole families). In this connection, property tax proposals are being discussed and likely to be piloted.

- The problems with local governments' budgets—with normal budgets heavily constrained and supplementary off budget spending, notably on infrastructure—underscore the need for reform of the intergovernmental fiscal system, making urban development and infrastructure spending more transparent and better integrated in the overall public finances.

- Another aim of intergovernmental system reform should be to improve the fiscal capacity of poor regions so that they can fund a minimum level of public services determined by the central government. In the absence of significant net transfers from rich to poor regions or other revenue sources, large disparities in spending per person on public services will unavoidably persist. Transfers have increased. However, it is key to make transfers rules-based, so that local governments can base their future plans and policies on them.

- In addition, building on the pilot reform in resources tax in Xinjiang, China could consider additional revenue sources that benefit poor regions. This would make them less dependent on fiscal transfers.

Monetary policy

The authorities have outlined a less expansionary overall monetary policy stance and taken some steps towards achieving that. New credit expansion is targeted at 7.5 trillion yuan this year, which would mean 18 percent yoy growth in end December. While substantially less than the 30 percent in 2009, this is still rather accommodative, pushing up the credit to GDP ratio to unprecedented levels.To help anchor price expectations and ensure financial stability, it is important to ensure that the credit target is met. Monthly credit quotas are employed to keep lending growth in check and credit through May was broadly consistent with the target. The reserve requirement ratio has been raised three times to withdraw liquidity. Although technically a substitute for open market operations, it seems to be a useful signaling device. As discussed, 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. However, interest rates have remained low. This is true for the benchmark lending and deposit rates as well as for the interbank rates (Figure 14).

The gains from letting interest rates play a larger role in monetary policy are likely higher than the costs. Interest rates are substantially lower than expected rates of return on property and physical investment. This gap is a fundamental driver of overinvestment and real estate speculation, which are very difficult to contain without higher interest rates. The fear that high interest rates will attract massive capital inflows that could dominate liquidity developments seems overdone. So far, the role of interest-sensitive capital inflows in fueling liquidity has been fairly small, compared to domestic liquidity creation. This is because China's capital controls are relatively effective in containing financial capital inflows. Furthermore, such flows into China are not likely to be very interest sensitive, since they appear to be largely attracted by the equity and, especially, the property market. A recent State Administration of Foreign Exchange (SAFE) investigation concluded that there have so far not been large-scale "hot money" inflows into China. The alternative to interest rate adjustments, quantitative and administrative measures such as credit quotas, tend to create volatility and uncertainty on financial markets, are distortive and sit oddly with efforts to make banks more commercially oriented.

If policymakers remain concerned about capital flows, macro prudential regulation and more exchange rate flexibility would help. SAFE recently tightened regulations on overseas lending and borrowing via domestic banks and both SAFE and the People's Bank of China announced they would more strictly monitor capital flows. 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 when interest rates in high-income countries remain low. This feature of exchange rate flexibility will become increasingly important if China's cyclical conditions will diverge more often from those in the U.S., since then U.S. monetary conditions (the interest rate) are not appropriate for China. With regard to the level of the exchange rate, a stronger currency helps reduce inflation pressures by lowering the price of imports and toning down demand. It also helps rebalance China's pattern of growth towards more services and consumption and less industry and investment.

[1] The "economic climate leading index" and the (seasonally adjusted) PMI have eased since early 2010.

[2] While there is currently no recent data on migrant income available in the regular household surveys, per capita rural wage income growth, which includes the impact of both wage and employment developments, recovered since mid 2009 and was 16.4 percent (yoy) in the first quarter of 2010.

[3] China's exports are very sensitive to changes in the global trade cycle because of the role of processing trade. Thus, some—although not all—of the steep recovery in 2009 was following a very sharp drop earlier on.

[4] China's "normal" import volumes were unusually weak in end-2008 and early 2009, compared to real estimated domestic demand, presumably because of destocking (Figure 6).

[5] Food accounts for about one third of the CPI basket and "residence" for 10 percent.

[6] The minimum down payment rates were raised from 20 to 30 percent for first-time buyers for homes larger than 90 m2 and from 40 to 50 percent for second homes. The mortgage interest rate was increased from discounts before to premiums over the benchmark interest rate.

[7] According to the World Bank, energy and metal prices are likely to be contained in the coming years by the large inventory overhang and agricultural markets should continue to be "well supplied" (Global Commodity Markets, companion to the January 2010 Global Economic Prospects).

[8] New housing starts were up 87 percent on a year ago in March-May 2010.

[9] The share of housing sales value financed by mortgages rose from 40 percent in 2006-08 to 60 percent in early 2010.

[10] The share of "economic housing" in total market housing has declined over time to 6 percent (in terms of floor space) in 2008. In 2009, about 2 million units of public housing were provided, about two-thirds of the target and about 8 percent of total sales.

[11] If raw material prices would be 10 percent higher in the remaining 7 months of 2010, with manufactured goods prices and all else unchanged, the current account surplus would be 0.5 % of GDP lower.

[12] http://siteresources.worldbank.org/CHINAEXTN/Resources/318949-1268688634523/medium_term_scenario.pdf

[13] Aiming to control fiscal and financial risks, in directives issued end May and mid June the State Council called on local governments to strengthen the regulation and management of LGIPs and their activities, demanding a halt to lending to financing vehicles that mainly rely on fiscal revenues for debt servicing. It called on banks to also tighten their management of loans to LGIPs and called on local governments to stick to the rules prohibiting them from providing guarantees. This follows earlier moves by the CBRC to strengthen the regulation and monitoring of the LGIP loans.

[14] At present, there are wide variations in benefit levels and coverage rates in several SP programs, with the classic situation of decentralized systems that areas with the greatest needs are often those with the least fiscal capacity.

[15] While even higher level pooling is a clear goal of policy, urban systems remain a considerable way from achieving even harmonized provincial level pooling at this point.

Box 1. The Role of SOEs in the Economy

Developments since the onset of the global crisis have triggered questions about the role of state-owned enterprises (SOEs) in the economy. There are concerns that "the state advances, and the private sector retreats," that is, that SOEs have benefited disproportionally from the policy stimulus and are crowding out private enterprises.

The weight of SOEs has increased recently, especially in investment (Box Figure 1). With its emphasis on construction and infrastructure, the stimulus has directly benefited SOEs more than non-SOEs. This is in part because of how state ownership is distributed over the economy. Most large construction companies and steel and cement companies supplying them are SOEs. And, having close relationships with the government and the banks, SOEs seem to have benefited strongly from the monetary stimulus. Moreover, the local government platforms carrying out the infrastructure construction that boosted investment in 2009 are classified as SOEs. Easy credit also led some SOEs to spend heavily on land amidst the property boom.

SOEs' weight in production has not risen recently and the long-term trend is for it to decline. Private enterprises were substantially outgrowing SOEs before the crisis. Industrial production growth fell sharply across the board since end-2008 and then showed a V-shaped recovery in 2009. The SOE sector and private enterprises now grow at broadly similar rates (yoy). Taking a longer-term perspective, the weight of SOEs has declined steadily in terms of both production and assets (Box Figure 2). The data used here cover large industrial companies. Other statistics suggest that these downward trends also hold for the overall economy. However, the decline has bottomed out in recent years.

The economic role of SOEs remains large, partly because of policies. In addition to favorable access to credit, SOEs pay very little dividend to the state. In some sectors, SOEs are granted monopolies or oligopolies, with private sector participation prevented by policy. And it is explicit policy to maintain a key role for SOEs in many sectors deemed to be "strategic" or "basic or pillar."

The government is rightly revisiting the policy stance towards the private sector. China could derive a lot of productivity gains by opening up various sectors further to private participation, particularly in the service sector. The government has listed developing the private economy and removing entry barriers to private investment among the key reform tasks for this year. It makes sense to reconsider the composition of the list of "strategic" and "basic or pillar" industries where state ownership is meant to play a key role. The current list includes the machinery, auto, IT, construction, steel, base metals, and chemicals industries. It is not obvious why state ownership is essential in these industries. Second, a lot of progress can still be made by reducing barriers to competition. The government could also usefully clarify the role it envisages SOEs to play in China's economy.

Box 2. Reform of Social Protection and

Labor Market Policies

Social protection and labor market policies and programs have taken on sharply increased importance in China in recent years. During the 11th Five Year Plan (5YP) period, the scope and pace of social protection (SP) reform has in many areas exceeded the Government's already ambitious targets. This has included development of framework laws on social insurance and social assistance; a major rural pension reform initiative; ongoing efforts to reform the urban pension system; and introduction and rapid expansion of nationwide coverage of rural social assistance. SP measures also featured in the country's response to the global financial crisis. In parallel, China has reformed labor laws and regulations to protect labor rights and improve labor market flexibility. SP and labor market (LM) reforms are linked to pilot reforms of the household registration (hukou) system and are part of policies to promote rural-urban integration.