Domestic risks add to the global ones. Downside risks to growth stem from possibly weaker corporate sector investment or household consumption. However, both also carry upward risks. Higher raw commodity prices will challenge the inflation outlook.

The property market is a particular source of concern. With tension between the underlying upward housing price pressure and the policy objective to contain price rises, interaction between the market and policy measures could lead to a more abrupt than planned downturn in the real estate market. In the medium term, the widespread use of property as an investment vehicle and the role of local governments add to the risks. Property construction is an important part of the economy, directly and in terms of impact on large sectors such as steel and cement. Thus, shocks to the property sector that would slow down construction significantly could have a large impact on the economy and on bank balance sheets, taking into account bank exposure to construction and other sectors dependent on the real estate market. Moreover, a property downturn could affect the finances of local governments, which do a lot of the infrastructure investment and are important clients of the banking system.

Policy changes

Monetary conditions have tightened recently as monetary policy moved towards normalization. Since October 2010 the government has raised benchmark interest rates four times and reserve requirement ratios seven times. Most importantly, quantitative guidance on bank credit, traditionally the backbone of monetary policy tightening, began to be reinforced, especially in early 2011. As a result, M2 (broad money supply) growth came down from 19.7 percent in the fourth quarter to 16.6 percent on average in the first quarter, close to the target for the end of 2011, with a similar slowdown in bank lending. In recent years, total bank credit extension has been significantly larger than headline data suggests as banks expanded the use of credit instruments such as designated loans, trust loans and corporate paper, financed in part by trust and wealth management products that are not counted as deposits and are not part of M2, in order to evade lending quotas, capital requirements and reserve requirement ratios. This remained the case in the first quarter. Nonetheless, and regardless of the coverage, banking credit extension was tightened in the first quarter of this year.

Recent changes in the operation of monetary policy and a new concept do not imply a change in approach. In early 2011, the People's Bank of China, the central bank, introduced differentiated reserve requirement ratios; so far they are largely differentiated between large and small banks. There is no official overall lending target anymore. However, the central bank still has an implicit target and this change does not imply a major shift in approach. The central bank also introduced the concept of Total Social Financing to map the different sources of financing of investment (and to show that containing bank lending does not necessarily imply investment weakness). In addition to headline bank lending it includes the other types of credit mentioned above as well as direct financing through equity and bond issuance. It should be interpreted with care, though. Items such as equity and bond issuance are not new liquidity creation. Also, Total Social Financing would not lend itself well to quantitative targeting.

Over time, a larger role for interest rates could make the conduct of monetary policy more effective and less distortive. As underscored by the proliferation of non mainstream credit extension, it is increasingly difficult to effectively lower credit growth using quantitative guidance in the increasingly sophisticated and complex financial system.

Rebalancing and upgrading

The 12th Five-Year Plan (2011-15) was launched earlier this year. In terms of strategic direction and reforms, two areas of emphasis stand out—rebalancing and industrial upgrading and moving up the value chain in manufacturing.

Concerning rebalancing, the government wants to transform the pattern of growth toward greater more emphasis on consumption and services to address imbalances with regard to the income distribution, the consumption share, the environment, energy consumption and external balance. It also focuses on livelihood issues and regional rebalancing, with more emphasis on urbanization in inland regions and smaller cities. Such rebalancing obviously requires strong policy effort.

Concerning industrial upgrading and moving up the value chain in manufacturing, the emphasis is on technological upgrading, investment in new strategic industries and innovation. The plan discusses the role of the government in leading the industrial upgrading and promoting the development of new industries.

It is important to find the right balance between these two areas of emphasis. By itself, industrial upgrading would boost investment and industry. If government policy emphasizes industrial upgrading rather than rebalancing, there might be little change in the pattern of growth, keeping it investment and industry driven, with limited progress toward a higher household income share, a larger role of consumption and a lower external surplus.

With regard to the 12th Five-Year Plan's growth targets, the challenge is to make them binding and consistent nationwide. The target of 7-percent average growth during the 12th Five-Year Plan period seems appropriate, allowing for relatively rapid growth while creating space for meaningful progress on restructuring. However, under past five-year plans GDP growth far exceeded the targets while no obvious attempts were made to meet them. Also, nearly all provincial governments have set much higher growth targets for their own 12th Five-Year Plan. The challenge now is to make the announced growth rates the true targets behind future policies, and to achieve greater consistency between the policy stances at central and local levels.

The targeted 4 percentage points of GDP increase in the share of services is ambitious but supported by policy proposals. Welcome proposals include establishing fair, regulated and transparent market access rules; breaking up sector segmentation, regional blocks and industrial monopolies; opening more service sectors to private and foreign investors; and establishing an integrated, open, competitive and orderly services market.

The targeting of wage growth at or above GDP growth is new. Its motivation is welcome: to halt the decline in the shares of labor compensation in primary income and household disposable income in GDP. It is not obvious whether and how the government should directly influence wages in a market economy. Pursuing more labor-intensive growth and more permanent urbanization would boost these shares in an economically sustainable way.