China's key economic challenge is to rebalance the economy, said the World Bank in its latest China Quarterly Update released in Beijing today. "The concerns about high investment growth and the pattern of growth have to be addressed by structural reforms," says Louis Kuijs, senior economist on China and main author of the Quarterly.

With supply growing broadly in line with demand the main short-term macro imbalance is an external one, notes the Quarterly Update. Policymakers remain understandably concerned about the over-investment that triggered the mid-year tightening measures. "The lower investment growth that the authorities aim for, which is desirable for efficiency reasons, could aggravate the external imbalance if achieved without more consumption growth," says Bert Hofman, lead economist for China. "These considerations put a premium on measures to boost consumption alongside those already taken to reduce investment growth."

By "consumption" Hofman refers mainly to public spending coming from the government in such fields as education, Medicare and social security. Such spending would in turn lead to increased consumption from people. "If individuals think the government is taking care of them they'll spend more," Hofman said. He added that increased expenditure on education nationwide currently in place was a very good policy.

China's GDP growth slowed to 10.4 percent in the third quarter from 11.3 percent in the second quarter after tightening measures reduced investment growth. Exports continue to outpace imports by a large margin so slowing domestic demand was partly offset by rising contributions of trade to GDP growth while the current account surplus reached new highs.

The Quarterly Update finds that macroeconomic prospects remain favorable for growth. Prospects for a soft landing of the world economy remain good although risks remain. China is relatively well placed to deal with a mild global slowdown that would help to arrest overall activity and reduce the current account surplus.

Domestically underlying conditions remain favorable to continued rapid growth. The World Bank expects 2006 growth to be around 10.4 percent and it projects a slight easing of growth to 9.6 percent in 2007. Upside risks remain as investment growth may rebound with abundant liquidity in the banking system and higher profit growth.

Pressing problems are still in the way for China to achieve a balanced economic structure with investment growth tilting toward industry. "The underlying causes of high investment can be tackled through better pricing of energy, resources, land and environmental damage; higher interest rates; limiting retained earnings by better corporate governance and an SOE dividend policy; and moderating local government incentives to pursue growth."

Rebalancing the economy means a shift in production from industry toward services, greater reliance on domestic demand, more equally shared growth and more environmentally sustainable growth. Besides being desirable in their own right, measures that support rebalancing are also likely to address the surging trade surplus, China's main short-term macro challenge.

The Quarterly Update notes that some measures have been taken in this direction, notably the reduction in VAT refunds and introduction of export taxes on energy intensive products, but the report argues that these measures create new distortions as well as address old ones.

Although macroeconomic risks appear manageable, continuing mopping up liquidity remains necessary, the Quarterly notes, since financial risks remain and excessive credit expansion may lead to problems later. Abundant bank liquidity is at the core of rapid credit growth. The apparent receding of non-FDI inflows implies more room for monetary policy tightening although these flows cannot be counted out. In addition to the liquidity creation stemming from foreign exchange purchases, structural changes in the financial sector are boosting M2 growth and may require additional central bank efforts while in the short run liquidity will also be boosted by higher government spending in the fourth quarter.

The current policy of some exchange rate flexibility around an appreciating trend can bring about desirable expenditure switching and create a welcome two-way risk that discourages speculative capital inflows.

(China.org.cn November 14, 2006)