China’s real economy has been hit hard by the global crisis, but has been holding up. Although China’s growth is set to slow, it is still likely to outgrow most other countries.  However, the continued global crisis is bound to contain China’s growth in 2009 and 2010, especially via weaker exports and market-based investment. The World Bank projects GDP growth of 6.5 percent in 2009.  Nonetheless, China’s economic fundamentals are strong enough to allow policymakers to consider policies that will affect the economy well beyond 2009. There are useful synergies between China’s short and medium term policy objectives.  Financial sector reform will help. China’s real economy has been hit hard by the global crisis, but has been holding up. Although China’s growth is set to slow, it is still likely to outgrow most other countries.  However, the continued global crisis is bound to contain China’s growth in 2009 and 2010, especially via weaker exports and market-based investment. The World Bank projects GDP growth of 6.5 percent in 2009.  Nonetheless, China’s economic fundamentals are strong enough to allow policymakers to consider policies that will affect the economy well beyond 2009. There are useful synergies between China’s short and medium term policy objectives.  Financial sector reform will help.

RECENT ECONOMIC DEVELOPMENTS
The global financial and economic crisis intensified in the fall of 2008. The adverse impact on output and trade is very large and geographically broad-based.  Against this backdrop, China’s economy decelerated substantially. The intensification of the global crisis hit China’s exports hard.
    
Domestically, with a strong starting position providing space, stimulus policies seem to help dampen the downturn. The relaxation of monetary policy is leading to more bank lending and support for economic activity. Thus, domestic demand has held up better than foreign demand.

Government-influenced investment is coming on stream while market-based investment is decelerating. The unwinding of involuntary stock building has subtracted from activity since November, but the stocks overhang does not appear very large.  Consumption is decelerating to still robust rates. Weaker labor demand is creating labor market pressure. The slowdown is adding further downward pressure on inflation.  Profitability in the corporate sector deteriorated in the second half of 2008.

ECONOMIC PROSPECTS AND RISKS
Global financial markets are likely to remain strained during 2009. Global growth prospects are very unfavorable and uncertain.  Risks and uncertainty about the international outlook are unusually large. 
   
Domestically, on balance the outlook suggests support for activity. Spare capacity is emerging, and is starting to have several types of effects. With market based investment expected to retreat, government-influenced investment will be key. The World Bank expects private consumption growth to decelerate, but to remain significant. Rural consumption is likely to lag behind. 

In all, due to substantial policy stimulus, China’s economy should continue to grow significantly in a very challenging external environment. China’s economy is likely to receive support from the expected global pick up if and when it occurs late in 2009 or in 2010. With raw material prices low and a significant output gap building up, inflationary pressure will be very low in 2009. Price pressure resulting from the slowdown drags down profitability. In this scenario, labor market weakness is set to continue.  Domestically, there are also several risks.

ECONOMIC POLICIES
China has important short, medium, and long term challenges. With the short and medium term objectives overlapping, the medium term objectives need to shape economic policies in 2009.

Looking ahead, there may be less need for investment-oriented stimulus. Regarding possible and recommended labor market policies to alleviate the labor market consequences of the downturn, the report argues that using the social security system has advantages over several other labor market policies. Financial sector and capital market reform could help rebalance the growth pattern.

Fiscal policy
Fiscal policy in 2009 is likely to lead to a sizable but manageable increase in the government deficit. How strongly should fiscal policy respond if the growth target for 2009 is in danger, and how? The consequences of temporary economic dislocation and layoffs can also be alleviated by expanding and using the social safety net, preferably combined with training.  Spending under the 10 point stimulus plan is taking place. As part of the 10 point plan, the government has announced 10 sector specific plans.
    
Other recent fiscal policy initiatives have focused on stimulating consumption and improving people’s livelihood. First, the government recently announced the outlines of a health care reform plan. Second, steps are taken to improve the social safety net. Third, the government sees great potential to boost rural consumption and has taken initiatives to achieve this objective.

There are also several tax policy changes. Additional tax cuts are also discussed, but it is unclear whether further tax cuts would be desirable. If tax cuts are considered, several points are worth noting. Finally, to support rebalancing, some further tax increases to improve the energy efficiency and environmental friendliness of economic activity in China should be considered.  Spending of many local governments may be particularly constrained this year.

Monetary policy
With international and domestic growth prospects weaker and inflation projections revised down sharply, monetary policy was rightly loosened. Subdued inflation prospects imply space for continued expansionary monetary policy. Deflation is a risk, but in China the government has some tools to fight it.  Policymakers do not need to worry about a somewhat reduced pace of reserves accumulation. In the medium term, China’s exchange rate will continue to be supported by the large current account surplus.  Also in the medium term, reform of monetary and exchange rate policy can contribute to more equal access to credit.

 

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