Spending of many local governments may be particularly constrained this year. Local governments traditionally carry much of the responsibility for spending on health, education, and social security. They are also expected to play a role in the financing of the 10-point plan package. However, many local governments do not have sufficient fiscal capacity, especially those in poorer areas. Moreover, the weakness in the real estate market has accentuated the financial problems of many local governments, because revenues from land sales are a key source of income. According to the Ministry of Land and Resources, local governments' income from land transfers fell 20 percent to 960 billion in 2008. Continued real estate market weakness is likely to contain such revenues, although the investment projects under the stimulus plan should increase land transfers. The pilot to allow some local governments to officially issue debt will help some. But it will not help the local governments with the weakest financial position, since the pilot is likely to include richer local governments with a strong capacity to repay. Pending more comprehensive reforms of intergovernmental relations, it may be necessary to increase ad hoc transfers to lower levels to fund key programs.

Monetary policy

With inflation prospects subdued, there is further scope for expansionary monetary policy. Deflation is a risk, but policymakers have some weapons to fight it. Policymakers do not need to worry about a reduced pace of reserves accumulation. In the medium term, reform of monetary and exchange rate policy and in the financial sector can contribute to more equal access to credit.

With international and domestic growth prospects weaker and inflation projections revised down sharply, monetary policy was rightly loosened. The large-scale injection of liquidity by the PBC made base money surge and is still keeping interbank and bill financing interest rates low (Figures 10 and 11). The reversal of quantitative policy, from credit controls to active encouragement, has played a particularly large role in boosting bank lending. Banks seem to have been keen to lend to the infrastructure projects under the stimulus plan. Looking forward, though, it is not clear that, once banks have finished with the pre-approved backlog projects and stimulus projects, bank lending will continue to grow rapidly. Banks' balance sheets are not highly leveraged and thus not a constraint on further lending. However, until uncertainty has been reduced and there are stronger signs of a rebound, banks may be cautious in expanding lending to the private sector. Meanwhile, enterprises and households may also be reluctant to invest and borrow.

Subdued inflation prospects imply space for continued expansionary monetary policy. With raw material prices low and significant output gaps emerging internationally as well as in China, inflation is set to be low in 2009, and inflationary pressures are unlikely any time soon. If, despite these considerations, China's policymakers remain concerned about the impact of liquidity injections and other policy measures on inflation in industrialized countries, increasing the independence of monetary policy—via more exchange rate flexibility—would insulate China from inflationary dangers in the industrialized countries.

Deflation is a risk, but in China the government has some tools to fight it. In February, consumer prices were 1.6 percent lower than a year ago, and China will continue to see consumer prices down on a year ago for a while this year. However, this does not necessarily constitute the kind of deflation that is a problematic, with core prices and wages, as well as output, declining in tandem. Nonetheless, given the global economic weakness and likely significant spare capacity in the coming years, problematic deflation is a risk. To cushion this risk, it is a good time for the government to remove remaining price controls on some industrial inputs—energy, water, utilities, natural resources, and the environment—through price increases, tax measures and/or pollution charges, and allow the prices to reflect the full costs of supply, including environmental and depletion costs. Such measures would contribute to rebalancing the pattern of growth. Initiatives such as the significant increase in public pensions announced for 2009 and 2010 also mitigate deflation pressures, and more such steps could be considered if needed.

Policymakers do not need to worry about a somewhat reduced pace of reserves accumulation. In early 2008, large apparent non-FDI inflows fueled the accumulation of foreign reserves and became a concern for policymakers. In the second part of 2008, China's accumulation of foreign reserves slowed. This was despite a renewed ballooning of the trade surplus to unprecedented levels, suggesting a reduction or even reversal of non-FDI capital flows. In the current context, some capital outflow need not be a source of concern. Unlike in many other emerging markets, the recent massive build up of foreign reserves stemmed from large current account surpluses instead of capital flows. China's current account surplus will continue to be very large in the years to come—even though from a global balance perspectives it clearly needs to come down. Even if FDI were to disappear completely, China's "basic balance" is likely to remain significantly larger than reasonable estimates of potential outflows of "hot money". Moreover, reserves are so large that, even if, as is unlikely, a few hundred billion dollars of non-FDI capital were to leave China, that would not be a major concern.

In the medium term, China's exchange rate will continue to be supported by the large current account surplus. Looking at prospective balance of payment and relative productivity trends, the is likely to strengthen in the coming decade in real effective terms. In the shorter term, the nominal exchange rate is determined by policy. While depreciation is sometimes suggested as a way to revive exports, when world demand falls away, it is unlikely that export demand can be stimulated by depreciating the currency. Depreciation would also be unhelpful for boosting consumption. Some of the confusion about exchange rate issues and policy in China is caused by an unuseful focus on the bilateral US$ exchange rate. The has stopped its gradual appreciation against the US dollar since the early fall of 2008. But it has appreciated by an impressive amount in effective terms since then.

Also in the medium term, reform of monetary and exchange rate policy can contribute to more equal access to credit. China's highly managed exchange rate regime compromises monetary independence. In the recent past, when policy was aimed at cooling the economy, concerns about the impact of interest rate increases on capital inflows led the authorities to impose credit controls instead. However, credit controls created distortions. In particular, they accentuated a bias in bank lending towards preferred, traditional customers, the large and/or state-owned companies. They have reduced access to credit by the newer and smaller enterprises which will need to play a prominent role in the future. Further reform and opening up, as well as the need to support SMEs would benefit from a larger role for the interest rate in monetary policy. This, in turn, would call for more exchange rate flexibility.

Financial sector policies

Impact of the Economic Slowdown on the Financial System.

It is important to monitor the effect of the slowdown on the banking system. As Chinese banks had little direct exposure to the toxic assets that ignited the financial crisis and China has a relatively closed capital account, the direct effect of the global financial crisis has been limited. However, the indirect impact via the real economy will be much larger. As some of the recent investment in the export and real estate sectors goes bad, there will be an inevitable rise in non-performing loans (NPLs). Some of the smaller and newer banks may be particularly vulnerable. It would be helpful to speed up the reform of the bank insolvency resolution system in anticipation of potentially rising insolvencies.

Banks should not be pressured to ramp up lending beyond prudent levels. This would risk creating new NPLs, and thus greater risks of insolvency. It would also be seen as rolling back significant recent progress in moving to more market-based allocation of credit. Fortunately, the approach of the banking regulatory authority has so far been balanced. While noting that it encouraged commercial banks to support the government's stimulus plan, it also stressed that they should perform strictly in line with the prudential requirements, such as concentration ratio, provisioning coverage ratio, and other best practices of risk management.

Financial Sector Reforms to Support Rebalancing

A well-functioning financial system can help China manage the slowdown and make the transition to a rebalanced growth model. The traditional growth model based on industry, construction, and exports was one that was well suited to a "big bank" financial system. China's growth has been relatively capital intensive, and the banks could facilitate this – lending for real estate and manufacturing while holding as collateral the buildings and machinery. China's banks have not been as effective providing finance to the smaller firms and to service industries that have fewer tangible assets. But these are exactly the firms that will play a more important role in the future and where most/many jobs will be created.

Thus, further structural reforms can increase finance for micro and small enterprises and the service and rural sectors. While micro and small firms may not have many tangible assets, successful ones often have good cash flow and receivables. Structural measures can help improve the flow of finance to such firms. Further liberalization of interest rates in rural areas and entry of institutions serving small or even micro enterprises will enhance their access to finance. Artificially low interest rates do not help micro and small firms; they simply cannot get credit. Such firms would benefit from greater access to credit, even if at higher rates than big firms pay. Scaling up the consumer credit information reporting system is also important: both for consumer lending and for lending to rural households and micro firms. Other innovations that could help smaller firms get access to credit include development of the leasing industry, micro-leasing, factoring, and reverse-factoring. Such structural reforms can also promote the formalization of "underground credit", which should reduce the cost and lengthen the maturity of loans to small private sector borrowers.

Box 2. Labor market policies to alleviate the consequences of the downturn.

As the global crisis has hit China's real economy, its impact on employment becomes an increasing source of concern. While these effects have not yet appeared in the (unrepresentative) official statistics on urban unemployment, there is much anecdotal and survey evidence of rising joblessness, particularly among migrants (see main text). The authorities have also expressed concern about the impacts on other groups, including recent college graduates and urban youth with low educational attainment.

China's central and local authorities have already responded by complementing their overall stimulus plans with more targeted initiatives. These include policies to allow certain firms to temporarily delay payment of workers' social security contributions, greater (often subsidized) vocational and technical training opportunities for laid-off workers, programs aimed at creating jobs for recent graduates, and efforts to encourage SME development. Local governments have also been allowed to use unemployment insurance funds to temporarily subsidize jobs at struggling companies.

Three features of the current crisis can guide the design of further policy responses to its labor market impact. First, while not all sectors are affected equally, the crisis is first and foremost a large and general negative shock to labor demand. Second, some of China's most affected groups are not well covered by the social safety net programs which are typically best placed to help alleviate the impact of shocks. Third, China will likely emerge from the crisis with a different economic growth model, driven by different sectors requiring different job market skills. This will place a premium on policies which facilitate rather than hamper the reallocation of labor, and which help supply citizens with the most highly demanded skills.