Faced with a severe economic downturn at the end of last year and the beginning of this year, people are debating intensely the prospects of the Chinese economy. However, there is increasing evidence to indicate that the ongoing recovery is likely to be V-shaped.

Factual evidence of a strong rebound can be found in China's steel output, electricity production, industrial value added, foreign trade as well as the Shanghai Exchange's A share index which has jumped by 65 percent so far this year. China's surprising pent-up automobile sales amid the global recession shows that no matter how radical a prediction about the Chinese economy is, it still risks being too conservative. The country is now set to break the mark of selling 10 million new cars in a year. Yet not so long ago it was still deemed too optimistic to expect that the country's car sales can reach that figure by 2015.

What explains China's rapid recovery?

One is the country's policy mix of demand stimulus, wherein the overall demand stimulus policy is effectively supported by pro-active fiscal and monetary polices. Second, strong fundamental factors like China's development stage advantage and sound balance sheets and financial strength have also hastened the recovery.

In July 2008, the Chinese government had already shifted its policy focus from preventing economic overheating and inflation to maintaining stable growth and control price growth. Then, 10 stimulus measures were announced in November 5, 2008.

The policies for resolving can be divided into three major categories.

In the first category fall the pro-active fiscal policies with sweeping tax cuts and massive investment. On the one hand, China has reduced tax on housing transaction and purchase of car; introduced tax reform to allow rebates on VAT for investment goods; and, increased the ratio of tax rebates for various exports. On the other hand, the country has kick-started a "4-trillion-yuan (US$585 billion) investment plan".

Second, pro-active monetary policies have been adopted to bring down interest rates from 7.2 percent to 5.31 percent for 1-year loans, and from 3.87 percent to 2.25 percent for 1-year deposits. Required reserve rate was cut down from 17.5 percent to 14.5 percent while quantitative control on credit was abolished.

Third, the State Council announced industrial promoting plans for 10 targeted sectors including steel, automobile, textile, equipments, ship-building, electronics and IT, light industries, oil and chemicals, non-ferrous metals, and logistics and distribution.

Extra-investments from "the 4-trillion-yuan plan" and huge credit expansion have definitely played a crucial role in boosting the country's aggregate demand. It was estimated that the plan would contribute one percentage point of GDP growth during the period.

Why are the stimulus policies so effective?

The underlying reason is that China is still at the development stage of rapid urbanization and industrialization. China has a ready demand for infrastructural construction to support its ongoing urbanization and industrialization. The sound domestic financial situation also helps a lot.

In short, the Chinese V-shaped recovery is the result of strong government policies of massive investment and credit expansion. It is supported by uniquely favorable fundamental factors in terms of developmental stage combined with the financial soundness of the basic sectors of the economy.

The case has several implications for Chinese policymakers.

First, the expected strong recovery is likely to confirm that China does not have to excessively rely on external demand. A growing trade surplus is not a necessary condition for generating sufficient demand to match the growth of potential supply. Second, on managing demand, policymakers should realize that insufficient aggregate demand might cause a lot of problems, especially if it is the consequence of a balance sheet crisis. But, the government commands effective policy instruments to boost demand.

Finally, it is the importance of further reform. Deepening reform and structural change is the long-term priority for achieving China's sustainable growth. The country needs to press ahead with market-oriented reform in land system, resource price, and market access for non-SOEs. It should also establish a holistic management regime consistent with the open macro-economy through reform of interest rate and exchange rate system. And, social reform and structural adjustment in areas of social security, health systems, and environmental protection cannot be delayed any longer.

Excerpts from a speech delivered at the 11th NBER-CCER conference. The author is a professor with China Center for Economic Research of Peking University.

(China Daily July 6, 2009)