Medium-term growth prospects are less favorable than recent experience, but rebalancing could buoy sustained growth. China's medium-term prospects continue to be supported by pro-growth economic policies and institutions. However, insufficient progress in rebalancing the pattern of growth and getting more growth out of the domestic economy would contain growth. Our medium-term projections suggest "potential" or "trend" GDP growth of about 8 percent in the coming five years on current trends and policies, some 2 percentage points lower than in the previous five years due to the weaker export prospects (see Box 1 of our June 2009 Quarterly Update). Conversely, more progress with rebalancing would help raise potential GDP growth through more reallocation of labor, more human capital accumulation, and more service sector growth. However, this would only happen with bolder structural reform, including in difficult areas such as opening up several service sectors to private sector participation and reforming the intergovernmental fiscal system to make more permanent migration possible.

Economic Policies

The government has expressed its intentions to keep the overall macroeconomic policy stance broadly unchanged for now. Senior leaders have acknowledged the "consolidation" of China's recovery and the need to "balance the relationship between boosting growth, rebalancing the economy and managing inflation expectations. "However, emphasizing that downside risks to growth remain and that inflation is not yet a major source of concern, the government has for now decided to keep fiscal policy "proactive" and monetary policy "moderately loose," relying largely on administrative measures to contain the risks of asset price increases and worsening asset quality.6

In our view, macroeconomic conditions in the real economy do not yet call for a major overall tightening. Even though short-term prospects for China appear relatively favorable, risks and uncertainties in the world economy are indeed high. Moreover, our projections do not see growth significantly exceeding potential growth in 2010 and it will take time to undo the spare capacity in several key manufacturing sectors. Thus, underlying inflation is not a concern for now. A somewhat supportive policy stance is appropriate, and it is particularly important to have flexibility to add or subtract support if needed.

However, the costs and risks of sustaining the current expansionary policy stance increase over time. With our projections indicating continued respectable growth in 2010 even without significant fiscal stimulus (large further increases in the fiscal deficit), we think the focus is best placed on measures with lasting effect on rebalancing and getting more growth out of the domestic economy.

l In the monetary sphere, risks of asset price bubbles and misallocation of resources amidst abundant liquidity need to be addressed. Thus, one of the key policy challenges is how best to do this when inflation is not yet much of a concern. With risks largely financial instead of inflation-related, monetary policy tightening is more obvious than fiscal tightening. While administrative measures can help mitigate pressures, in the end, general monetary tightening will be the most effective and least distortive approach.

l Significant additional fiscal stimulus does not seem warranted, although flexibility is. While China's government debt is still modest compared to many other countries, it is higher, and increasing more rapidly, than the headline official numbers suggest. Given our economic projections, a neutral or mildly supportive fiscal stance in 2010—meaning a constant or only slightly higher deficit—would fit best. The need for flexibility calls for contingency plans and letting automatic stabilizers work, this year and next.

l In the medium term, the recovery can only be sustained by successful rebalancing of the economy. Rebalancing and getting more growth out of the domestic economy call for more emphasis on consumption and services and less on investment and industry. While the government-led investment boom is not necessarily directly adding heavily to manufacturing capacity, the reliance on infrastructure investment is not sustainable and its contribution to rebalancing is limited.

Monetary and Exchange Rate Policy

Serious asset price bubbles are unlikely to be imminent. In the housing market, some cities have seen major price increases in recent months and years. However, nation-wide, price rises have not exceeded income growth significantly (Figure 13). Affordability is now also supported by lower interest rates. However, there is a lack of clarity about affordability. The real estate market and policymaking towards it would benefit strongly from better (more representative) data on property prices and how they compare to incomes. Stock markets are up significantly this year, but this is after a sharp fall earlier on and share prices are still down strongly from their peak in 2007 (Figure 10).

However, risks of misallocation of credit and bad loans are real and it pays to be proactive. These risks may be rising now because of the sheer overall volume of new lending—projected to be a massive 30 percent of GDP this year—and the particularly rapid growth of lending by smaller banks (city banks and rural credit cooperatives), with possibly weaker risk management systems (Figure 14). The recent global financial crisis has shown the dangers of neglecting asset price increase and misallocation of credit in monetary and financial policy making. With monetary policy in key high-income countries traditionally geared only towards inflation, monetary policy remained loose for too long, even as asset prices rose to levels deemed worrisome by many.

China's exposure to asset price risks differs from that of most other countries. The impact of sharp negative corrections in asset prices on households would be relatively limited as their exposure to the stock market and leverage is still relatively low. However, many firms and banks are exposed considerably to asset prices because of the large share of property in their portfolio. Moreover, local governments would be affected strongly, as land transactions are a key source of their revenues and these would be impacted significantly. Also, given the property sector's importance for the economy, a housing sector slowdown would affect the overall economy.

The authorities have taken several steps recently in an effort to mitigate these risks. Monetary conditions have tightened somewhat since July (Figure 15). In addition, the loan-loss coverage ratio was increased; banks with particularly large loan expansions have had to buy low yielding central bank bills; China Banking Regulatory Commission (CBRC) has urged banks to ensure that loans for "real" investment are not diverted to the property or stock market; and the minimum down payment for a second house was raised to 40 percent. On the supply side, on the equity market, IPOs are allowed again, after having been frozen for a year.

Eventually, general monetary tightening will be required to dampen these risks. Under China's current (not-flexible) exchange rate regime, policymakers consider their ability to increase interest rates to be constrained by their fear of capital inflows. Thus, monetary tightening has tended to rely on administrative measures, including credit quotas. These have in the past been effective in affecting the overall volume of credit. However, such instruments are distortive and sit oddly with efforts to make banks more commercially oriented. Over time, more exchange rate flexibility would make monetary policy more independent, giving it the leeway to raise interest when warranted domestically even though interest rates in high-income countries remain low.

Several types of financial market policies could enhance financial stability and reduce risks on asset prices and quality. First, increasing the availability of financial titles would allow diversification of investors' portfolios, and could reduce stock market volatility. Building on the re-introduction of IPOs, further financial sector deepening would be useful, including in the bond market. Second, easing the interest ceiling on bank deposits, encouraging financial institutions to develop more long-term contractual savings instruments, and increasing interest rates on longer term deposits could tie up more liquidity in the banking system, and prevent it from flowing to the stock and property markets. A credible regulatory and supervisory regime needs to be set up for those instruments so that the public has the confidence to invest in them. Third, the introduction of a capital gains tax on equity could be considered.7 Finally, further opening up the capital account in a controlled fashion could help increase capital outflows.

The government has continued with steps to increase the role of the renminbi in international finance and trade (see our June Quarterly Update for earlier steps). A pilot scheme will let "qualified" Chinese companies in selected Chinese cities settle cross-border trades in renminbi with counterparts in Hong Kong, Macao, and the 10 ASEAN (Association of Southeast Asian Nation) countries. The scheme allows lenders in these economies to buy or borrow in renminbi from mainland lenders to settle trades and mainland lenders to provide trade finance to overseas firms. To support the development of the renminbi-denominated financial and bond markets in Hong Kong, China's Ministry of Finance (MOF) and the China Development Bank have issued renminbi-denominated bonds in Hong Kong.

Fiscal Policy

Remarkably strong revenues in the third quarter limit the increase in the deficit. After steep (yoy) declines in the first four months of 2009, government revenues rose 26 percent in the third quarter and 5.3 percent in the first three quarters (yoy). Fiscal expenditure rose 24 percent in the first three quarters. Since the summer, revenues have grown much faster than the underlying tax base, apparently in part because of strong efforts to meet the 8-percent fiscal revenue growth target. It is appropriate to strengthen tax collection. However, an all-out effort to meet a revenue target that was set with a significantly higher projection for nominal GDP growth in mind may not be consistent with a pro-active fiscal stance.8 A pro-active fiscal policy should probably imply letting the automatic stabilizers work.

In 2010, continued large fiscal stimulus does not seem warranted, although being able to flexibly respond to further shocks is important. It would be good to retain room for fiscal policy stimulus in later years, given the global uncertainty. China's government debt is still low compared to many other countries. But it is higher, and rising more rapidly, than the headline official numbers suggest, in particular if debts accumulated by state-owned enterprise (SOE) type entities under the local governments that develop infrastructure are included. These local debts are estimated to be sizeable already.9 The current large-scale new lending is adding to them. While some of the stimulus spending will show up immediately on the government's balance sheet, some is likely to show up later, such as in the case of government commitments to co-finance the repayment of bank lending or subsidies to cover operating costs of projects that are otherwise not financially sustainable. Moreover, as the stimulus continues, it becomes more difficult to indentify infrastructure projects with high social returns. There is still significant room for further measures to stimulate consumption. However, with growth expected to be respectable, structural measures with permanent effect are much preferable to measures without lasting effect. Overall, our economic projections call for a neutral or only mildly supportive fiscal stance in 2010 (with unchanged or slightly higher deficit, compared to 2009). The ability to flexibly respond to changing economic prospects calls for a contingency plan and for allowing the automatic stabilizers to work, that is to accept deviations in tax revenues and the budget balance from those budgeted if economic conditions are different than expected at the time of the budget.