The continuous heating of the economy has aroused significant unease in the government and among economists. The government is tightening economic policies to steer the economy towards a "soft landing."

The government's concern is two-fold. First, growth will accelerate further and eventually inflation will spin out of control. Second, in an environment of investment fever, structural imbalance mainly in the form of the presence of "bottleneck industries" such as electricity and important raw materials will worsen and a long-term growth prospects will be compromised.

Last year the most important feature of the Chinese economy was the abnormally high growth rate of fixed assets investment. Total investment in 2003 increased by 26.7 percent over the previous year, whereas growth of investment in different industries in 2003 was highly uneven.

The highest growth came from six industries: cement, steel, aluminum, automobiles, textiles and coal.

Investment in real estate development, local-government-led infrastructure, industries producing high-end consumer durables (cars especially), and export industries (textiles, for example) was the driving force that led to high growth of investment in 2003.

Among these industries, the real estate industry was the single most important contributor to the abnormally high growth rate of investment.

The real estate industry has shown strong growth momentum since the late 1990s. Considering the urbanization drive nationwide, the strong demand for new houses, office space and related urban infrastructure development probably will continue through this year and beyond.

However, the rapid growth of real estate investment is also related to speculation, unequal distribution of income, and the wealth gap between rural and suburban areas. For the sake of financial stability, social justice, environmental protection and sustainable development, the government should keep a close eye on real estate development and make corrections when necessary.

The nature of the current high growth of investment in many industries ,to a certain extent, is a "kickback" growth, due to the low growth in the past, and is likely to slow down in the near future even without government intervention. The increase in investment in response to the dramatic rise in prices is a welcome sign of the growing role of the market. A direct and drastic clamp down on these industries is not advisable.

Because the driving force for high growth in 2003 was investment, the growth rate of aggregate supply will increase in the near future. As a result, strong growth in aggregate demand in 2003 will not necessarily lead to high inflation in the future. In the short term, price stability, deflation and inflation are all possible.

In fact, according to a recent survey published by the National Bureau of Statistics, more than 70 percent of products are either in excess supply or in balance. While prices of materials, energy, and some semi-finished goods have increased significantly, prices of many products are falling.

It can be expected that after the strong growth of gross domestic product (GDP) in 2003, the inflation rate will rise correspondingly this year.

Efforts to lower inflation rates are likely to cause GDP growth to slow down. However, no effort should be spared to avoid a significant slowdown of GDP growth. While fighting inflation, the tough situation of unemployment should not be neglected.

In 2003, with a 9.1 percent GDP growth, 8 million jobs were created. The objective set by the government for this year is to create 9 million jobs. It is difficult to imagine how 9 million jobs can be created with a GDP growth rate substantially below 9 percent. It seems reasonable to argue that as long as China's inflation has not surpassed the threshold of 5 percent, macroeconomic policies should not be further tightened in any significant way.

In late 2003, the People's Bank of China (PBOC) raised reserve requirements from 6 percent to 7 percent and recently the rate was further raised to 7.5 percent. This way, a large quantity of liquidity is frozen. However, liquidity seems not to be an issue for the big four commercial banks. The growth rate of the monetary base is still high, as is the excess reserve ratio. This means that credit may expand rapidly again in the future, when commercial banks decide to do so. Intervention by local governments will make it difficult for commercial banks to exercise restraint in lending, even if they want to.

To implement monetary tightening, an obvious option is to raise interest rates. However, the central bank is also constrained from doing so. A rise in interest rates will cause more capital inflows aimed at interest rate arbitrage. The increase in foreign exchange reserves will lead to an increase in the monetary base and hence nullify the monetary tightening.

Due to the fact that commercial banks hold huge amounts of government bonds, an increase in interest rates will lead to a fall in the price of government bonds. As a result, the value of commercial banks' assets will drop significantly.

The potential impact of higher interest rates on China's fiscal sustainability also calls for caution, because of the consequent rapid increase in interest payments by the government.

However, despite all the possible negative effects, the PBOC should not hesitate to raise interest rates, when necessary. Prudence does not mean indecisiveness.

Last year the central government continued its proactive fiscal policy. However, efforts were made to shift the fiscal policy toward a more neutral position. In 2003, the government set six priorities aimed at re-orientating fiscal policy towards alleviating social tensions. While the reorientation is fully justified, the role of government budget as a macroeconomic instrument should not be downplayed.

The reappearance of bottleneck industries, especially the severe shortage of electricity supply shows that during the period of deflation, the Chinese government was too cautious about its fiscal position and hence failed to fully utilize the opportunity to carry out more public work aimed at improving the nation's infrastructures.

Despite the existence of inflationary pressure, the government may have to continue to use proactive fiscal policies in 2005 and beyond. China's fiscal position may worsen somewhat in 2005. However, this is a cost we must pay for the maintenance of social and economic stability.

Regarding revenues, one of the most obvious tasks is to further reform the taxation system to take away the incentives for reckless investment from local governments. Local governments have their own utility functions that are not entirely consistent with those of the nation as a whole.

Changes in taxes may lead to changes in budget constraints and hence improve local governments' behavior. The tax system should also serve as a built-in stabilizer for the economy. In this regard, there are also many things that need to be done.

(China Daily July 7, 2004)