Like most other economies in the world, China currently faces the extraordinary challenge of slowing growth and rising inflation. Some continuing changes, especially the slow-down of the US economy, elevated oil prices and the normalisation of domestic costs, are likely to reinforce this challenge in the coming months. The probability of stagflation, however, remains extremely remote. Real GDP growth will likely moderate slightly; however, barring major surprises, China should be able to comfortably maintain growth of about 10 per cent in the next five years. The earthquake in early May in Sichuan was a human tragedy, but its direct economic cost should be limited.
Inflation rates, however, could move up, although the food-driven CPI should moderate further in the coming months. The low-inflation phase of the past 10 years, supported by relocation of factories and labour and associated productivity gain, is probably over. The anticipated broad-based increases in costs of factors including labour, land, capital, energy and the environment imply that the economy should face inflationary pressures that are stronger than ever. More and more policymakers will also adopt the idea of the need to tolerate high inflation. Given that China is still a developing country and a transitional economy, it is reasonable to expect it to maintain 5 per cent inflation. This could open the door to major inflation problems, as the central bank is always behind the curve.
Tight monetary policy is likely to continue, as long as inflation remains a key risk. The central bank will, however, probably continue to focus on liquidity management. It stopped hiking its policy rates for fear of attracting more capital inflows. Currency appreciation will probably maintain an annual pace of 5-10 per cent in the coming year or two, despite recent dramatic fluctuations in market expectations. At the end of the day, policymakers will have to strike a balance between the need to rebalance the economy and the need for smooth structural adjustments. Job losses remain the top concern for the government. For the same reason, the probability of one-off revaluation or devaluation looks extremely low. If, however, the global financial risks recede quickly in the coming months, the reform of the exchange rate policy and liberalisation of the capital account could accelerate significantly.
Currently, the Chinese authorities employ a combination of tight monetary policy and neutral fiscal policy. While the purpose of tight monetary policy is to control inflation, the intention of neutral fiscal policy is to prevent downside risks to the economy. Fiscal policies could turn more expansionary in the second half of 2008 or in 2009. First, the government will probably need to spend at least RMB250 billion—or 1 per cent of GDP—every year in the next three years for post-earthquake reconstruction. Second, the government needs to play a more active role in facilitating structural adjustment, including helping technological upgrading and re-employment. Finally, active fiscal spending could boost domestic demand, lower the external account surplus, reduce capital inflow and ease inflationary pressure.
There is a misunderstanding among many economists and policymakers that China needs to reduce investment. One important reason for this is the risk of over capacity. While overcapacity risks existed in certain industries at certain times, there is no evidence of an economy-wide overcapacity problem. There is still huge investment potential in areas of urban development, the resources sector and environmental protection. In fact, a large current account surplus means China needs to expand its domestic demand in order to rebalance the economy. China needs less but better quality investment.
Finally, 2008 could be the first year since 2001 in which the Chinese economy sees a major downturn in growth. This could point to significant increases in financial risks. The stock index has already declined by 50 per cent from its peak in late 2007. Housing prices are also becoming less stable. The banking sector has already experienced major reform steps during the past six years, but the new institutions have not had any stress tests. A 1998 East Asian-type financial crisis is unlikely; however, any significant increases in financial risks could still lead to losses of large amounts of financial assets.
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