China: Robust growth in sight provides room for shift in policy focus

The economic data for the third quarter of 2009, released almost two weeks ago, confirmed an impressive recovery in China’s economy, supported by very large fiscal and monetary stimulus. Real GDP growth rose to 8.9 percent year-on-year in the third quarter. This is clearly good news, for China and many other countries whose economies are benefiting at the moment from strong demand from China. As the World Bank economic team for China (which I'm part of) argues in more detail in the new China Quarterly Update, it also means that it is time to consider a less expansionary macroeconomic policy stance and focus more on the structural reforms needed to rebalance the economy and get more growth out of the domestic economy on a sustained basis.

It’s not as if China has not been hit by the global recession. China’s real economy has been hit hard. Exports fell sharply since November last year, and the contribution of net external trade to GDP growth was minus 3.6 percent points in the first three quarters of this year – with the negative contribution particularly large in the third quarter (in year-on-year terms).

But China’s government has been able to offset much of this hit by a massive stimulus effort. China started to implement a stimulus package earlier than most countries, and it has been large and effective in stimulating the economy. Most of the stimulus has shown up in infrastructure-oriented, government-led investment, much of it as part of the well know “RMB 4 trillion” (US$ 580 billion) package.

However, some of the stimulus has been consumption-oriented – via higher government transfers and pensions, lower taxes and social security contributions, and consumption subsidies. This, combined with continued solid income growth, has allowed consumption to continue to expand. Car sales, which benefited from a decline in consumption taxes for small cars, grew by one-third in the first 9 months, compared to a year ago, and China’s car market is now the world’s largest. Moreover, resurgent housing sales have started to feed through to construction activity. Thus, the domestic demand growth of around 12 percent in the first three quarters has been more broad based than just relying on infrastructure investment.

With a larger than expected impact from the stimulus, China’s GDP growth target, which seemed difficult to attain early in 2009, is now in the bag. We project 8.4 percent growth. The strong domestic demand has swelled import volumes and the closely watched current account surplus may fall from almost 10 percent of GDP last year to 5.5 percent of GDP this year, even though import prices have come down sharply.

We think the composition of growth will change quite a bit, after the exceptional developments in 2009.

• China’s export growth is likely to resume next year. The global recovery is probably slow and subject to risk. But, global demand is expected to recover in 2010, after falling sharply in 2009. Moreover, China is likely to continue to increase market share, based on increasingly strong competitiveness of its manufacturing sector. On top of that, the recent depreciation of the nominal effective exchange rate gives a boost to exports.
   
• Domestically, real estate investment is also bound to be stronger, taking into account current growth of housing sales and starts.
   
• But, the growth impact of the government stimulus is set to decline sharply next year. The amount of stimulus spending is probably going to be higher in 2010 than this year. However, what matters for growth is how quickly spending increases. Growth in government-led investment is likely to decline from around 40 percent this year to less than 10 percent next year.
   
• Moreover, investment in manufacturing is likely to remain under pressure from spare capacity in China and abroad. This spare capacity is also expected to keep inflation pressures low. Thus, overall investment growth is likely to fall substantially (Figure 1).

 

Click graph to view large.

Nonetheless, overall growth is likely to remain robust in 2010 – our scenario foresees 8.7 percent. In this scenario, exports and imports grow at broadly the same pace next year and the contribution of net external trade to growth is around zero (Figure 2). However, because the external terms of trade are likely to deteriorate, the current account surplus may edge down further.

What does this outlook mean for policy making?

In our view, macroeconomic conditions in the real economy do not yet call for a major tightening of the policy stance. However, risks of asset price bubbles and misallocation of resources in the face of high liquidity need to be mitigated. Because of the downside risks to growth, especially coming from abroad, and the absence of inflationary pressure for now, the government is reluctant to change the overall monetary stance. It has started to use administrative measures, including tighter prudential regulation. This is understandable.

However, the overall monetary stance will have to be tightened eventually, to limit the flow of new credit creation. On the fiscal side, given our economic projections, we think an unchanged or only slightly higher fiscal deficit would fit best but flexibility is important. This means having contingency plans in store. Equally important, this means allowing the automatic stabilizers to work, this year and in 2010.

Click graph to view large.

Now that the government has basically succeeded in dampening the impact of the global crisis, it is a good time to concentrate focus and effort on the structural reforms that are needed to rebalance and get more growth out of the domestic economy on a sustained basis. Achieving this calls for more emphasis on consumption and services and less on investment and industry. Following on earlier initiatives, some steps have been taken in recent months to rebalance and boost domestic demand, including increasing the presence of the government in health, education, and social safety; improving access to finance and development of small and medium enterprises (SMEs); and mitigating resource use and environmental damage. These are useful steps, but more policy measures will be needed to rebalance growth in China, given the strong underlying momentum of the traditional pattern. Structural reforms to unleash more growth and competition in the service sector and stimulate more successful, permanent migration would be particularly welcome.