China’s GDP growth hardly slowed in 2005, with domestic demand firmly taking the lead over net trade in the second half. GDP growth was 9.9 percent in 2005, 0.2 percentage point lower than in 2004. Investment was supported by still-robust profit developments and a relaxed monetary policy. Consumption, although still lagging GDP growth, was supported by strong income growth, especially in urban areas. While China's trade surplus of over $100 billion for the year grabbed the headlines, the contribution of net trade to growth had already turned negative by the end of last year, and this pattern continued in the first two months of 2006. In 2005, monetary policy was strongly influenced by foreign exchange market considerations. M2 growth was buoyed by PBC purchases of foreign exchange, stemming from continued surpluses on the balance of payment—$209 billion in 2005— which were only partly sterilized. The resulting liquidity drove down inter-bank interest rates to low levels in line with the goal of discouraging non-FDI capital inflows. |
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The trend of falling inter-bank rates was in sharp contrast to international rates, notably US rates, which moved upwards for most of the year. Combined with the introduction of some flexibility in the exchange rate regime in July, when a “managed floating exchange rate regime…with reference to a basket of currencies” was introduced, this has helped deterring non FDI capital inflows, which declined in the second half of 2005. Since the July move, the exchange rate strengthened less than 1 percent against the US dollar. The overall outlook for China’s economy remains benign, although rebalancing growth will take time. In 2006, China will benefit from solid export demand, while profit and credit developments suggest that investment remains robust. Price pressures should remain limited with more moderate commodity price developments and strong increases in potential GDP. Internationally, risks include a disorderly adjustment in global imbalances and trade tensions, even though China's trade surpluses are likely to come down. The main domestic risk is that abundant liquidity will re-fuel bank credit and investment. Fixed asset investment grew 26 percent in 2005, in nominal terms, not much slower than in 2004. However, changing the composition of domestic demand, one of the government’s key economic objectives, may take time. Looking for more balanced economic growth, the government would like to rely more on domestic demand and less on exports. Within domestic demand, the government would like to boost consumption while keeping investment growth in check, in order to raise living standards and avoid problems of overinvestment and overcapacity. However, a dramatic pickup in consumption is not likely soon, despite some positive impact of past and planned tax cuts. This is largely because it is difficult to significantly boost rural income growth in China without much faster migration out of rural areas. Rebalancing the composition of demand will have to rely to a large extent on policies addressing structural issues, including public finance measures, financial sector reform, dividend policy and corporate governance, and these take time. For macroeconomic policy, the good overall outlook implies that the “prudent” stance announced last year is appropriate for this year as well. Monetary policy could in the short run focus on absorbing some of the excess liquidity to reduce the risk of excessive credit growth. This task may be complicated somewhat by active financial innovation, with hefty issuance of short term corporate notes, asset-backed securities, and financial bonds. Its impact should be closely watched and taken into account when judging monetary and financial conditions. The overall fiscal stance needs little change for now, but a shift towards social spending away from capital spending, is needed to redress China’s macroeconomic and structural imbalances. Over time, with a rebalanced economy that relies more on services and consumption, tax revenues may come under pressure. That should be countered by reforms in the tax structure and administration, and medium-term expenditure restraint. Back to top
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