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It is difficult to say at the moment how credit growth will develop. Since the re-imposition of the credit quota in late 2007, actual loan growth has been lower than loan demand as expressed by the business sector in the PBC's survey (Figure 16). While loan demand appears to have decelerated recently, the gap remains significant. In October, after the initial partial easing of the quotas but before the complete lifting, credit growth picked up. In addition, because of the way that infrastructure is financed in China, the stimulus package calls for bank lending (and/or other finance). However, private sector demand for loans is likely to soften as growth prospects weaken. Moreover, banks are likely to become more cautious in lending in such an environment.
The calls for more bank financing in specific areas, such as rural investment and to SMEs may create challenges. These calls possibly create tensions with the strive for a stronger commercial and market-based orientation of banks.
Lingering concerns about inflation among some of China's authorities strengthen the case for more exchange rate flexibility and monetary independence. Despite the prospects for very low inflation in 2009, some of China's policy makers remain concerned about inflation, including because of the impact of the liquidity injections and other measures in developed countries. This worry should probably not shape monetary and financial policy in China now. However, if policymakers are seriously worried about inflation pressures in the industrial countries, increasing the independence of monetary policy—via more exchange rate flexibility—would insulate China from inflation dangers in the large industrialized countries.
Although speculative capital inflows seem to have diminished in recent months, China's large external surpluses are unlikely to go away soon, and sterilization to contain domestic liquidity will remain needed regularly (Figure 17).
Box 3. Overview of Rebalancing Policies
First, several macroeconomic and structural measures will help to stimulate domestic consumption and stimulate the service sector:
- Increase government spending on health, education, and social security, to raise disposable incomes, especially of low income people, and reduce the reluctance to consume. Good examples in health include increasing the government contribution to the New Rural Cooperative Medical System and Medical Assistance, the basic health care system, and the community health service system. In education, funding for education in poor and rural areas can be increased.
- Strengthen further the exchange rate to shift production from tradables to non-tradables and increase exchange rate flexibility to give more independence to monetary policy.
- Further strengthen financial market opening and reform, to improve the efficiency of the allocation of capital—thus sustaining growth with less investment—and increase the role of consumption. Such reform and more efficient allocation of capital should benefit the service sector and SMEs. Higher demand deposit rates would support the role of household income in overall income.
- Expand the dividend policy for SOEs introduced in 2008 and improve corporate governance, to remove the over-investment bias, especially in large, industrial SOEs. This could possibly be combined with an overall cut in the corporate tax rate. Such a combination would improve the level playing field between SOEs and non-SOEs.
Second, fiscal and tax policy can help to adjust the structure of production:
- Eliminate the underpricing of industrial inputs—land, energy, water, utilities, natural resources, and the environment through price increases, tax measures, and/or pollution charges. Accelerated energy price reform would allow prices to reflect the full costs of supply, including environmental and depletion costs.
- Further remove distortions in the tax system that subsidize and stimulate manufacturing, including from the VAT system and remaining preferential tax treatment of FDI.
- Remove remaining restrictions on the development of the service industry, including addressing monopolies and oligopolies in several service sectors and removing other barriers. China's WTO commitments support this agenda and the government may want to consider even further liberalization of international trade and investment in service industries.
Third, further relaxing restrictions on the movement of labor and land transaction would facilitate rural-urban migration and mitigate rural poverty. Relatedly, the fiscal system could be improved to provide host cities with more incentives to deliver social services to incoming migrants.
Fourth, institutional reforms can be introduced to give local decision makers stronger incentives and better tools to pursue rebalancing. A key is to strengthen accountability, especially via the performance evaluation of local officials and enforcement of laws and regulations.
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