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China's economic growth has moderated to a more sustainable pace.
Headline inflation is receding even as non-food price pressures emerge.
Amidst weaker and uncertain global prospects, China's growth will be supported by strong international competitiveness and a robust domestic economy.
On current growth forecasts, there is no need to ease the overall macroeconomic stance, although global uncertainty calls for vigilance and flexibility.
Reducing China's very large external surpluses remains a key policy challenge.
In line with slower growth elsewhere, China's GDP growth moderated so far in 2008.
The moderation of growth in 2008 in part reflects less buoyant investment.
External trade volumes have decelerated, but sharp increases in import prices are inflating import values.
The large decline in the terms of trade reduced China's trade surplus from a year ago in the first five months.
More detailed external trade data seems consistent with a slowing global economy and a still robust domestic economy.
High food price increases pushed up overall consumer inflation, but the worst of the food price hikes may be over.
Surges in other commodity prices had until recently had less impact on China's consumer prices.
Higher prices of food, oil, and industrial raw commodities have started to spill over into some other prices, although spill-over to core consumer prices has remained limited.
Foreign reserves accumulation breaks new records.
The balance of payment surpluses complicate monetary policy, but money growth remains under control.
Motivated by the need to rebalance the economy and to dampen price pressures, China's RMB has continued its gradual exchange rate appreciation.
China's three main macroeconomic policy challenges are:
How, if at all, to respond to the prospective slowdown? So far, China's economy seems on track to slow down in 2008 to a pace just below potential output growth, after two years of above-potential growth. Given that growth in 2008 is on course to exceed the official target of 8 percent and the need to contain inflationary expectations, there is no case for easing the overall macroeconomic stance. However, uncertainty about the global outlook is currently larger than usual and future developments may call for a reassessment of the policy implications. Thus, vigilance and flexibility are key. In the case of a more serious slowdown than currently envisaged, China's strong fundamentals and fiscal position allow for an easing of policy. A fiscal easing would be better suited than a monetary loosening, given the need to contain inflationary expectations, rebalance the growth pattern, and lower the current account surplus. By the same token, a weaker exchange rate, or slowing down of the pace of appreciation against the dollar, would not be obvious.
How to contain spill over and inflation expectations? Inflation in China has so far been driven by surging food and other raw commodity prices instead of excessively loose monetary policy. Nonetheless, containing spill over and inflation expectations requires relatively tight monetary policy and effective communication. Meanwhile, a stronger exchange rate helps dampening inflation pressures. Coordination of fiscal and monetary policy is important. Thus, other things equal, looser fiscal policy would imply a need for tighter monetary policy.
How to reduce and deal with continued large balance of payment surpluses, including speculative inflows? The current account surplus remains responsible for the majority of the external surplus, while speculative inflows appear to have increased recently. Reducing the current account surplus calls for a set of structural policies to rebalance the pattern of growth towards more services and consumption and less industry and investment. This set of policies includes a stronger exchange rate; a shift in government spending towards health, education and social security; more financial reform; dividend payments for SOEs and stronger corporate governance; better pricing of resources, energy, and land; loosening remaining restrictions on the mobility of labor and capital; and stronger incentives for local governments to rebalance growth. Speculative inflows could be discouraged by tightening controls on capital inflows and policies that effectively change exchange rate expectations.
Monetary and exchange rate policy:
A relatively tight monetary policy stance is needed to contain spill over of price pressures and inflationary expectations.
China's current macroeconomic situation calls for continuation with strengthening the exchange rate.
Discussions take place on whether speculative inflows are a large problem and what the implications are for exchange rate policy.
One school of thought considers speculative inflows a potentially large problem and calls for a change in exchange rate policy to affect exchange rate expectations.
A second school of thought also considers speculative inflows a large problem but draws a very difficult policy implication.
A third school of thought thinks speculative inflows are currently not a large problem and that there is no need for significant adjustment of exchange rate policy.
It is important to clarify the size of speculative inflows and whether a change in the exchange rate regime could help address them.
In 2007, fiscal policy was appropriately prudent. The consolidated government balance for the central and local governments moved into a surplus of 0.7 percent of GDP in 2007.
The 2008 budget conservatively foresees a small deficit. The budget reflects the increasing government attention to and spending on health, education, and social security, with total expenditures set to grow 22 percent.
Both government revenues and spending are likely to be higher than budgeted. In previous years, revenues have risen substantially faster than budgeted. We expect that to be the case this year as well.
In the current challenging environment, macroeconomic management needs good coordination between fiscal and monetary policy.
The government has recently introduced several measures to contain food prices. During 2007, the government introduced several administrative measures to contain food prices. In 2008, these were complemented by others.
The government could usefully consider shifting more to direct subsidies to consumers. That is because keeping food and other basic items affordable in the face of high food prices may be just as important or more important than keeping prices low.
Pricing:
The large increases in international prices recently put pressure on pricing policies.
The government uses a range of policies to prevent high international grain prices from affecting domestic grain prices.
The high international oil price challenges China's petroleum product pricing system.
The financial consequences of this arrangement are significant, although not as large as in some other countries.
However, even if the financial consequences of the price controls are sustainable, there are strong reasons to adjust prices.
As with food price policies, a more efficient way to protect people's purchasing power would be to let prices increase and introduce direct subsidies for consumers.
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