Large fiscal and monetary stimulus has supported a recovery in China's economy, according to the World Bank's latest China Quarterly Update released Wednesday.

The Update, a regular assessment of the Chinese economy, finds that falling exports amidst the global recession have been a major drag on growth. Nonetheless, real GDP growth rose to 8.9 percent year-on-year in the third quarter on the back of the stimulus.

Most of the stimulus has shown up in infrastructure-oriented government-led investment. But some has been consumption-oriented and domestic demand growth has been broad based. Resurgent housing sales have started to feed through to construction activity. Investment in manufacturing is affected by spare capacity, but consumption has held up well.

The strong domestic demand has buoyed import volumes and the current account surplus may fall to 5.5 percent of GDP this year even with import prices down sharply. The downturn has clearly affected the labor market, but the impact has been smaller than expected and the trough may have been past.

"On the back of a larger than expected monetary stimulus, China is on track to meet the target of 8 percent GDP growth this year," said Ardo Hansson, lead economist for China. "We project GDP growth of 8.4 percent. Growth is likely to remain robust in 2010, but the composition will change."

The global recovery is likely to be slow and subject to risk. Nonetheless, China's export growth is likely to resume, helped by strong fundamental competitiveness and the recent depreciation of the nominal effective exchange rate, and net exports are likely to stop being a drag on growth. Real estate investment is also bound to be stronger. However, the growth impact of the government stimulus is set to decline sharply next year and investment in parts of 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. With exports and imports projected to grow at broadly the same pace next year and the terms of trade likely to deteriorate, the current account surplus may edge down further.

Turning to economic policies, "the costs and risks of sustaining the current expansionary policy stance will increase over time," said Louis Kuijs, senior economist and main author of the Update. "In our view, macroeconomic conditions in the real economy do not yet call for a major tightening. However, risks of asset price bubbles and misallocation of resources in the face of abundant liquidity are real and the overall monetary stance will have to be tightened eventually."

On the fiscal stance, the World Bank thinks that, given its economic projections, in 2010 an unchanged or only slightly higher fiscal deficit, compared to 2009, would fit best but flexibility is important and this includes allowing the automatic stabilizers to work, this year and in 2010.

The Update concludes that, in the medium term, China's recovery can only be sustained by successful rebalancing of the economy. Rebalancing and getting more growth out of the domestic economy call for more emphasis on consumption and services and less on investment and industry. Following on earlier initiatives, some further 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 SME development; 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.

(China Development Gateway November 4, 2009)