The slowdown has had a major impact on the labor market, but the worst may be over. Many jobs have been shed in export-oriented manufacturing sectors, and official industrial employment declined on a year ago (Figure 8). At the same time, new jobs have been created, largely in services, construction, and the public sector, and overall conditions on the labor market are not as bad as feared earlier this year, although significant numbers of people have had to accept lower wage jobs in the process. Nationwide, employment and wage growth slowed substantially in the first half of 2009, but remained positive (according to the official labor market data and information on migrant wage income from the household survey). The labor market impact varies across regions. In export-oriented Guangdong, even total official employment was lower than a year ago in the first half of the year. These employment trends have put downward pressure on wage growth, particularly in the more flexible segments of the labor market. Migrant wage income growth slowed to 7.6 percent "per capita" in the first half of 2009, from rates more than twice as high in 2008 (see footnote 4). However, the trough may have been past. Both official wage growth and rural "per-capita" wage income growth picked up again somewhat in the third quarter (Figure 8). Survey data on the balance between demand and supply on the labor market also suggest that the labor market has tightened again in the third quarter.

Underlying inflationary pressures remain largely absent. Consumer prices were down 0.8 percent on a year ago in September, and producer prices (factory gate) 7 percent. Prices of food items including pork and grain have risen recently. However, given the subdued economic conditions globally and in China, with spare capacity in many manufacturing sectors, such developments are unlikely to cause sustained general inflation.

The renminbi has been kept virtually pegged to the U.S. dollar since mid 2008. Due to the depreciation of the U.S. dollar, China's nominal effective exchange rate (NEER) has depreciated 7.6 percent since its peak early this year. This has reversed more than one-third of the appreciation since mid 2005 and the NEER is now back at the 2002 level (Figure 9).

The current account surplus has declined materially, but reserve accumulation has continued. The trade surplus has fallen because of the trade volume developments discussed above. However, large improvement in terms of trade due to the sharp fall in raw commodity prices limited the decline to $45 billion in the first nine months (and only $14 billion in the first half) on a year ago. The current account surplus, however, fell by $60 billion (yoy) in the first half to 6.4 percent of GDP. Additional factors behind this decline were (i) a lower services balance, as services exports fell alongside goods exports while the U.S. dollar value of services imports lagged that of goods imports because prices of services imports did not fall nearly as much as those of goods imports; (ii) a strongly lower income balance; and (iii) lower net transfers. On the capital and financial account, after falling in the first seven months (yoy), Foreign Direct Investment (FDI) showed positive yoy growth in August and September as financial conditions eased globally and China's economic prospects remained relatively favorable. On our estimates, other capital flows (after adjustment for valuation effects) turned from a large net outflow in the second half of 2008 to a small ($23 billion) net inflow in the first half of 2009. Foreign reserves accumulation speeded up in the third quarter, with the total reaching $2.3 trillion in end-September, although a substantial part of that rise is due to valuation gains because of the depreciation of the U.S. dollar against other major currencies.

The stock market has declined since July, after having risen sharply earlier in 2009. A strong rebound in the stock market since late 2008 led the authorities in June to lift a ban on initial public share offerings imposed in October 2008. Since July, the market has declined again (Figure 10). There has been a lot of discussion and concern about large portions of the new bank lending flowing to the stock and housing markets instead of the real economy. Undoubtedly this has happened to some extent. However, it is not likely that a large share of the lending has flowed to these markets. With regard to the stock market, industry estimates are that net new inflows to the A share market in the first half of 2009 were around 450 billion yuan. This is equivalent to 6 percent of new lending in that period. However, four to fifth of these inflows came from individual investors and much of it is likely to have come out of existing deposits rather than from new lending.

Economic Prospects

Short-term global prospects have improved. But the global recovery is likely to be slow and subject to risk. China itself is on course to meet its growth target in 2009. In 2010, the composition of growth is likely to change, after the remarkable developments in 2009. Exports will probably stop being a drag on growth from end-2009 onwards and real estate investment looks set to be stronger. However, the government stimulus to growth is set to decline sharply next year, and market based investment and consumption may continue to feel pressure. In all, we expect GDP growth to rise somewhat in 2010, with risks evenly balanced.

Global economic activity seems to be recovering. After the steepest decline in seven decades, global financial and economic developments have largely been positive recently. Government intervention across the world has led to large improvements in financial market conditions and stabilization in the real economy. Global activity is expanding again, buoyed by restocking, government stimulus and strong growth in Asian economies.

However, there are several challenges to overcome, and the global recovery is likely to be slow and subject to risks. Banks, households and businesses in several high income countries still have a long way to go to repair their balance sheets and that will contain demand. The policy stimulus that is currently driving the recovery in high income countries will have to be reversed at some point, and restocking is also a temporary boost. Thus, in the coming quarters, the strength and pace of recovery in high income countries remains a major risk, although risks are not only on the downside. In 2010, the sustainability of the global recovery depends on several factors which all imply risks: the return of bank credit and further normalization of financial markets; effectively communicated and appropriately phased withdrawal of fiscal and monetary stimulus; and overcoming the negative impact from sustained low capacity utilization and high unemployment. Moreover, for the global recovery to be sustainable, the global imbalances will have to be reduced. This means that surplus countries such as China will have to reduce structurally their current account surplus by having domestic demand grow faster than production capacity, while deficit countries such as the United States will have to reduce their current account deficit. The latest Consensus Forecast sees the world excluding China growing 2.3 percent next year, after a decline of 2.8 percent this year—with growth holding up somewhat better if weighted by China's export composition (Table 1).

Against this light, global price pressures are expected to remain modest next year. After the recent commodity price increases, the international financial institutions expect the oil price to rise somewhat more, implying significant (yoy) increases. Non-oil commodity prices are expected to be somewhat higher next year. Prices of manufactured goods are expected to rise by 3 percent, after falling 9 percent this year (in U.S. dollar terms). With world growth now squarely led by emerging markets such as China, where growth tends to be more intensive in raw commodities than in high income countries, over time raw material prices are likely to outpace those of manufacturing products, resuming a trend decline in China's terms of trade that was temporarily reversed in 2009.

In this setting, China's exports should resume growth in 2010, but global demand is likely to remain subdued. Based on IMF WEO projections, but adjusted for China's own imports, imports of the world excluding China are expected to increase 2 percent, after falling 12.8 percent in 2009, in constant prices. Compared to the expected rebound in GDP next year, much less of this year's decline in imports is projected to be recouped. This is presumably because of relatively weak investment in machinery and equipment globally (which is import-intensive) and relatively strong investment in infrastructure (which is not import-intensive). China's exports benefit from the strong and increasing fundamental competitiveness of its manufacturing industry. In fact, while most of the current investment boom—focused on infrastructure—does not directly benefit manufacturing, it does strengthen its broader setting. The recent depreciation of the (nominal effective) exchange rate provides further support. China is likely to continue increasing global market share in 2010 and beyond, but in a more difficult global environment than before and the medium term outlook for global demand and exports is subdued compared to the recent decade (see Box 1 in our June 2009 China Quarterly Update).

China is on track to meet the government's target of 8 percent GDP growth this year (Table 2). This is led by a projected contribution of domestic demand of almost 12 percentage points and despite an expected drag on growth from net trade of 3.4 percentage points. Growth is higher than expected earlier because of larger-than-expected macroeconomic stimulus. Our forecast of 8.4 percent GDP growth for 2009 assumes an increase of 6.8 percent in the fourth quarter (SAAR), which is within reach given current trends.

We project growth to increase somewhat in 2010, with a marked shift in the (expenditure) composition. The expected turn-around in exports allows for a halt of the negative contribution of net trade (Figure 11, Table 2). In addition, with housing starts rebounding swiftly, real estate investment is set to add significantly more to growth than in 2009. However, government-influenced investment, the key driver of growth this year, is bound to decelerate. Spending under the stimulus package may rise somewhat in 2010. However, this implies a large deceleration after the spectacular growth this year. Moreover, market based investment is likely to continue to feel negative pressure from spare capacity in several manufacturing sectors.5 In all, we project overall investment growth in 2010 to be around half of the projected rate for this year, in real terms (and on national accounts definition) (Figure 12).

Consumption may feel some headwind. In China, consumption growth is closely correlated to income growth. Continued significant increases in government transfers are likely to support income growth somewhat in 2010, including the 10-percent rise in pensions already committed to. However, the more subdued labor market may continue to put pressure on nominal income and consumption growth, even though migrant wage income growth appears to have troughed already. Moreover, in much of 2009, households benefited from negative inflation, which boosted their purchasing power. This will change next year as inflation is likely to turn positive again. In all, key domestic risks in the short term—both downward and upward—are market based investment and the pace of income and thus consumption growth.

Inflation is likely to remain subdued. If the government allows the oil product pricing mechanism to function, as the recent adjustments suggest, (yoy) oil product price increases will be significant in end 2009. However, these pressures are likely to moderate in 2010. Moreover, we think underlying inflation pressures will remain low because of the large spare capacity in China and other countries.

China's external surplus is set to shrink sharply this year, and only rise somewhat in 2010. We expect import volumes to continue outpacing exports by a large margin in the rest of 2009. Moreover, the terms of trade gain—from import prices falling much more than export prices (yoy—is expected to come down, compared to the first half of the year. As a result, we expect the decline in the trade surplus to accelerate in the second half of 2009 and it could fall from 8.3 percent of GDP in 2008 to less than 5 percent of GDP in 2009 as a whole. The decline in the trade surplus is compounded by changes in other current account flows (see above). We expect that, as in the first half, in 2009 as a whole the current account surplus will fall more than the trade surplus. In 2010, with domestic demand expected to remain robust and processing trade recovering, overall imports should grow solidly. In our scenario exports and imports will broadly grow at the same rate in 2010. However, the expected deterioration in the terms of trade would lead to some further decline in the external surplus. Over the medium term, with the gap between domestic growth in China and the rest of the world expected to diminish, we expect the external surplus to rise again, even with moderately successful rebalancing in China.