China's Economic Outlook Remains Favorable

China's economic outlook remains broadly favorable with real GDP growth projected at 9.3 percent in 2011 and 8.7 percent in 2012 but risks on inflation and the property market call for full normalization of the macroeconomic stance to keep growth on track, according to the World Bank's latest China Quarterly Update released today.

"Headwind from a normalized macroeconomic stance, inflation, and somewhat slower global growth is likely to be partly offset by solid corporate investment and a still robust labor market," says Ardo Hansson, Lead Economist for China. "In all, with a broadly neutral contribution of net trade, we now project China's real GDP growth at 9.3 percent in 2011 and 8.7 percent in 2012."

The Update, a regular assessment of China's economy, finds that both fiscal and monetary policy contributed to the tightening of macroeconomic policy after the massive stimulus during the global financial crisis. Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust due to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4 percent, largely on higher food prices.

In the important housing market, an expected slowdown in mainstream housing construction should in part be offset by the government's ambitious social housing construction plans, according to the Update. On the back of the surge in raw commodity prices, the World Bank expects another decline in the current account surplus this year. However, whether the trend towards a lower external surplus and lower dependence on external trade will be sustained remains to be seen.

The Update finds that inflation should moderate eventually with food price increases slowing, core inflation still in check, and quite a bit of adjustment of the macro stance already.

"However, much of the impact of the higher oil and industrial commodity prices is still in the pipeline, inflation expectations are high and there is little spare capacity in the economy. Therefore, a full normalization of the macro policy stance is important." says Louis Kuijs, Senior Economist and main author of the Update. "Also, macro policy is better placed to address the risks on inflation and the property market than moral suasion and administrative measures. It is too early to stop the macro tightening. Two way risks are better dealt with by maintaining fiscal and monetary flexibility."

While the macro and financial risks on the property market require macroeconomic measures and reforms, social concerns require a different policy response, concludes the Update. Macro and financial policy is supposed to prevent different types of risks from building up and make the economy and the financial system robust to a possible property downturn, rather than mainly focus on containing overall housing prices. If housing prices are considered systematically too high from a market perspective, macroeconomic levers are more obvious than administrative measures, especially locally administered ones.

On the other hand, making housing more affordable for targeted groups requires sustainable rules-based arrangements, almost unavoidably explicitly subsidized by the government. The scaling up of social housing is in the right direction. However, finding a transparent, rules based financing model is key.

The Update notes that the 12th Five-year Plan (5YP) can provide direction for reform. Its two key overall objectives are rebalancing and industrial upgrading and moving up the value chain in manufacturing. Policy-wise, it is important to find the right balance between these two.

With regard to the 5YP's growth targets, the challenge is to make them binding and consistent nationwide. The targeted four percentage points of GDP increase in the share of services is ambitious but supported by fruitful policy proposals. The targeting of wage growth at or above GDP growth is new. Reforms of inter-governmental fiscal relations will be crucial for achieving meaningful progress on a range of other policy priorities. Barriers to labor mobility may require more attention.