There are still various distortions in China's policy setting that need to be addressed, including the prices of capital, labor and resources, as well as access to markets and finance. Removing the distortions is a key part of the required policy adjustment. Thus, in our view rebalancing to more domestic demand-led, service sector-oriented growth is unlikely without significant policy adjustment and it is appropriate to keep it as a major objective for the government.
Fiscal and monetary policy
China's headline fiscal position remains sound, which helps to provide policy space. Despite the massive fiscal expansion, the headline fiscal deficit reached only 2.8 percent of GDP in 2009, as much of the expansion was financed by bank lending. In the first three quarters of this year, headline expenditure rose 20.6 percent, with fairly even growth of spending across different categories. Revenues increased 22.4 percent in this period, with indirect taxes rising faster than direct taxes. These trends suggest a further reduction in the headline fiscal deficit, although such trends may not necessarily be a good predictor of the whole year balance. China's official government debt was a modest 17.5 percent of GDP at the end of 2009.
Quasi-fiscal spending is being contained, after the surge that reduced the overall macro policy space. A significant share of the surge in lending to local government investment platforms since the end of 2008 may go bad. After an investigation, the China Banking Regulatory Commission estimated in July that of the 7.7 trillion yuan ($1.15 trillion) in lending to local government investment platforms, about 20 percent faces default risk. Given China's solid macroeconomic and fiscal position, and the reported capital cushion of most banks, the local finance problems are unlikely to cause systemic stress fiscally or for the banking sector. Nonetheless, the flow of new lending to the platforms during the stimulus was unsustainable and, overall, China now has less macro policy space than in 2008.
The overall monetary stance needs to be normalized to contain the associated risks. In addition to strained local finances, the most important macroeconomic risks are non-performing loans and the prices of housing, equity and other assets. Moreover, while the inflation outlook does not seem worrisome, the risks to inflation call for vigilance, managing inflation expectations, and monetary policy leeway. With the economy operating close to full capacity overall and the growth outlook robust, further consolidation of the monetary stance is needed.
The authorities are broadly on track to meet the 2010 monetary targets and have started to normalize interest rates. Mainstream credit growth decelerated from 33.8 percent at the end of 2009 to 18.5 percent in September, year on year, and the 2010 target for new lending of 7.5 trillion yuan ($1.13 trillion) is broadly in reach. Meeting that target should help manage inflation expectations.
However, the case for relying more on interest rates in conducting monetary policy is strong. In October, the central bank raised benchmark one-year lending and deposit rates by 25 basis points. Further normalization of interest rates is needed, as lending and deposit rates are still low relative to historic levels and the buoyancy of the economy.
Measures can be taken to protect against unwanted capital flows. Currently, it makes sense to continue to effectively apply the controls on financial capital flows and also to consider tightening regulation. Earlier this year, the State Administration of Foreign Exchange (SAFE) tightened regulations on overseas lending and borrowing via domestic banks, and both the SAFE and the People's Bank of China announced they would more strictly monitor capital flows. There would likely be more room for further tightening of micro and macro prudential regulation. In addition, more exchange rate flexibility may help in deterring capital inflows, although the recent experience in other large emerging markets shows that flexible exchange rates by themselves may not deter such inflows sufficiently.
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 toward more services and consumption and less toward industry and investment.