China's internal macro challenges remain manageable, but the external imbalance is on the rise, the World Bank said at the China Quarterly Update on Wednesday.

"Thus, policy measures that address domestic concerns could ideally also reduce the external imbalance," says Bert Hofman, Lead Economist for China.

"The government has already decided on a dividend policy for SOEs and a more rapid increase in spending on health and education, and has stepped up the pace of currency appreciation. These measures tend to reduce investment and increase consumption, and are thus steps in the right direction."

Meanwhile, containing investment growth and inefficiency on a more sustainable basis calls for structural policies that address the underlying causes of inefficiency and excess investment.

Economic growth eased slightly in the second half of 2006. Investment cooled in the second half in response to tightening measures introduced mid-2006. However, as exports continued to outpace imports by a wide margin, the impact on overall growth was largely offset and the external surplus reached new highs, while foreign reserve accumulation continued apace. Surging stock prices prompted measures to slow new funds moving into the stock market.

The Quarterly Update finds that near term prospects remain broadly favorable. Chinese exporters and manufacturers have been affected by several recent policy measures to rebalance the economy, including tax measures and appreciation, and more such measures are likely to follow. However, continued productivity growth and a resilient world economy promise only a minor export slowdown. Domestically, the fundamental drivers of investment remain, and investment is therefore unlikely to slow drastically in 2007, while boosting consumption will remain challenging, particularly in rural areas. In all, the World Bank's projection for GDP growth in 2007 remains unchanged at 9.6 percent. The external imbalance is unlikely to shrink much in the near term, and the World Bank considers a significant surge in inflation unlikely.

While growth has been impressive in recent years, in the medium term China will increasingly rely on new sources of growth. "China still has a vast potential for catching up in productivity, but China's industry, investment and export based growth has become increasingly problematic because of trade tensions and environmental and resource constraints," says Louis Kuijs, senior Economist on China and main author of the Quarterly.

"With a growth pattern that relies more on services, and more labor-intensive urban growth, more of growth could come from reallocation of labor out of agriculture." Growth along such rebalanced patterns could boost urban employment, wages and household incomes and reduce rural-urban disparities, while mitigating external imbalances.

The third national financial work conference held in January set out directions for major financial sector reform. The Quarterly Update discusses the reforms in the key areas of rural finance, foreign exchange management, and policy banks. On rural finance, it was decided to reduce the access thresholds for financial institutions to attract a more diverse set of providers and to continue the reforms of the Agricultural Bank of China. Looking ahead, the Quarterly notes that rural finance would also benefit from interest rate liberalization and further reforms in existing providers.

(China.org.cn February 14, 2007)