China's economic growth last year was impressive and healthy despite overheating in some sectors. But what needs further improvement is the method of macroeconomic regulation.

GDP growth was 9.5 percent last year and the consumer price index was kept under control despite the initial runaway growth. To cool overheating caused by excessive investment in some sectors, such as cement and aluminium, the central authorities resorted to stricter control of land, loans and construction projects.

But this administrative interference has brewed its own problems, even though it served as a quick fix for the overheating.

To improve macroeconomic regulation, it is necessary to first ferret out the real reason for the overheating.

In the first place, it is the non-marketized price of production factors that has caused the economy to overheat.

In terms of the relationship between consumption and investment, China's rising consumer price index is not the result of prosperous consumer demand. Apart from rising prices of agricultural products and oil, soaring prices of investment-orientated products are the main culprit. They pushed up the price of housing, urban construction, equipment and fertilizers, while on the other hand led to strong demand for land, capital and low-priced labour.

If the production factor market functions well, the rising price of land, capital and labour would dampen investor demand and automatically cool investment. However, China's production factor market is largely non-market-orientated and under the control of the government, which decides the price of land and capital.

The price of the former does not reflect its scarcity, and some agricultural land has been requisitioned at a price lower than the set market level. As a result, some farmers and township enterprises purchase such land to launch real estate projects. Moreover, the government tends to make use of low-priced land to lower the cost of urban construction and attract foreign investors.

Worse, some local governments sell such cheap land at a much higher price to real estate dealers so that they can pocket excessive revenues.

All this has contributed to overheating of the economy.

Cheap labour in the market, as a result of oversupply, is also a factor behind excessive investment in some sectors. Investors do not pay much attention to labour costs when it comes to making investment decisions.

The third reason for excessive investment is the regulated capital price. The interest rate does not fluctuate in accordance with market conditions. Last year, the real interest rate on deposits was below zero due to rising consumer prices.

Some systematic defects are the root causes of these problems.

Even if regulators raise the interest rate to real market levels, it remains doubtful whether such a rise will substantially rein in the investment fervour of State-owned enterprises (SOEs), which are yet to become real market entities. Although many SOEs have conducted corporate governance reform and even become shareholding companies, many of their managers do not care much about the cost of financing.

To develop urban construction, some local governments form their own companies, or ask local SOEs to guarantee bank loans. Those governments pay little regard to interest rates, because it is their successors, not them, who will be picking up the loan repayment tab.

Regarding land transfers, the State can requisition farmers land if it is used for the "public interest." Some local governments have then gone on to sell requisitioned land at a much higher price to real estate companies for commercial development. Farmers have no say in the land deals between them.

Central government has adopted administrative methods to hold back excessive economic growth and the rising price of production materials. Such a move will bring the relationship between central and local government closer.

In China, most tax revenues come from the production-orientated value-added tax of enterprises. It means the more projects there are, the more tax revenue local government gets from them. And under China's existing taxation system, most tax revenues from land belong to local coffers.

As a result, local government is driven to sell more land and start more construction projects to gain the tax benefit.

Central government-orientated regulation flies in the face of market rules.

Such a regulation strengthens administrative control of the economy room but undermines efficient investment decision-making.

To rein in runaway economic overheating, central government now requires investors to undergo more approval procedures. To this end it has to employ more administrative resources, which means increased costs to government.

A better method would be to bring out the role of the market in allocating resources and clarify the property rights of production factors.

Formation of a sound market-based pricing regime is vital for solving the problem of economic overheating. Such a regime will ensure the price of production factors and will dampen market demand and cool the economy.

The central bank should gradually let commercial banks and credit co-operatives have more say in setting interest rates.

According to law, farmland is collectively owned by the farmers and they each have individual land use rights. But the property rights of land need to be better protected to prevent government from requisitioning farm land at will for commercial use.

Corporate governance reform of SOEs and banks must be accelerated to make decision-makers truly accountable for their investment decisions.

The government can also play a role.

It should better protect the interests of farmers-turned-workers. Effective measures must be taken to prevent defaults of payments to them and a minimum wage system should be introduced to protect the interests of farmers.

Combining market and administrative forces would help stabilize the market and economic overheating would be effectively controlled.

(China Daily February 19, 2005)