China economic outlook: a tighter macro stance and renewed focus on structural reform

We just released our China Quarterly Update. For us (the economics unit in the World Bank’s Beijing office), this is a good disciplinary device to go through the data, look at what has happened, think about what the economic prospects and policy implications are, look in some more detail into some issues, and write it all down.

In addition to the usual topics, this time we focused a bit on two macro risks that have caught the attention of analysts: a property bubble and strained local government finances. In this blog I summarize our current understanding of the general economic outlook and what it means for policymaking. In a separate blog post, I will soon discuss the issues on local government finances.

China’s economy has held up remarkably well during the global recession. GDP grew 8.7 percent in 2009, led by a massive investment-led stimulus that showed up partly in an increase in the official fiscal deficit and, especially, in an increase of net new bank lending of almost 30 percent of GDP in 2009. Real estate investment gained prominence more recently.

Through all this, household consumption growth has remained solid, in no small part because the labor market held up well. It is not easy to have good timely labor market indicators on China. But I like the quarterly income data from the household survey.  Per capita rural wage income growth, which includes the impact of both wage and employment developments, dropped sharply to 7-8 percent (yoy) in the last quarter of 2008 and the first quarter of 2009. But, as the economy picked up again, it recovered quickly, reaching more than 13.5 percent (yoy) in the second half of 2009. This confirms more anecdotal indications that the trough in the labor market was quite shallow and short.

Exports declined an estimated 10.6 percent in 2009 as a whole, even as China gained global market share. With imports holding up much better than exports, net external trade was a major drag on growth in 2009, subtracting 3.9 percentage point from GDP growth, and the external current account surplus declined from 9.4 percent of GDP in 2008 to 5.8 percent of GDP in 2009. The higher frequency data shows a dramatic shift, though. After falling steeply in late 2008, exports rebounded strongly through 2009 and in early 2010 they already exceeded the pre-crisis level.

The growth momentum continued in the first months of 2010, with particularly strong exports, retail sales and industrial production. Building on this, GDP growth is likely to remain strong this year. We project 9.5 percent. However, the composition of growth is set to shift markedly in 2010. 

• Exports are on course to grow robustly, as global demand recovers, even though forecasts for world trade for the year as a whole imply a slowdown later in 2010. Although imports should outpace exports somewhat, we project a mildly positive contribution of net external trade to growth this year, which is a large improvement compared to last year (Figure 1).
• However, real investment growth may be around half of the rate last year (Figure 2). In a heated housing market, real estate investment should grow strongly. But, government-led investment, the key driver of growth in 2009, is bound to decelerate heavily.
• With labor market conditions favorable, we expect consumption growth to remain robust, even though sales of consumer durables, notably cars, are likely to decelerate after the spectacular, partly policy-induced surge in 2009.

On other aspects, in our scenario the trade surplus edges down in US dollar terms  because of an expected decline in the terms of trade. The current account surplus may increase somewhat, though, in US dollar terms, though, mainly due to higher income on China’s foreign reserves.

Inflation is likely to increase. But, we think inflation will remain modest—maybe reaching 3.5-4 percent on average in 2010—because international inflation prospects are subdued; the China-specific factors behind food price increases are unlikely to persist; and China’s rapid supply response is likely to continue to contain core inflation.

However, in a heated real estate market, property prices are rising rapidly. In large cities they were on average more than 30 percent higher than a year ago in February, and further increases are in sight. This has triggered policy measures to expand supply and curb speculation, although the government is cautious in its policy response and does not want to clamp down on real estate to heavily.

The world economy is still subdued, but China’s growth has been strong. Unlike in most other countries, China’s output is close to potential (Figure 3). Thus, China needs a different macro stance than most other economies. We think that inflation risks remain modest, in large part because of the global context. But, the macro stance needs to be noticeably tighter than in 2009 to manage inflation expectations and contain the risk of a property bubble and strained local government finances.

• The budget presented to the National People’s Congress (NPC) rightly implies a broadly neutral fiscal stance. The 2010 budget presented to the NPC foresees a broadly unchanged budget deficit, compared to 2009. However, there are still uncertainties about the world economy and it is important to have flexibility in implementation. We think that means contingency plans and, importantly, letting automatic stabilizers work.
• The monetary policy stance needs to be tighter than last year and the case for exchange rate flexibility and more monetary independence from the US is strengthening. It would also be good to increase the tolerance for modest inflation, to ensure room for needed relative price changes. In our view, strengthening the exchange rate can help reduce inflationary pressures and rebalance the economy. Over time, more exchange rate flexibility can enable China to have a monetary policy independent from US cyclical conditions, with is increasingly necessary.
• Ensuring financial stability includes mitigating the risk of a property price bubble and ensuring the sustainability of local government finances. This calls for both macroeconomic and other measures. The Quarterly discusses them.
  Sustained, sustainable growth requires structural reforms. In the presentations to the NPC, the government emphasized the need to adjust the structure of the economy. With growth prospects good and China preparing for 12th Five Year Plan, this is a good time to both look at the whole structural reform agenda and to select those that can be advanced in the short term.  The Quarterly provides an overview of the key areas of reform.