Stuctural reform not stimulus

Debates about the slowdown in China's economic growth, the subdued global outlook, and how the government should respond have heated up again. As in late 2008, China's economy is slowing while the global economy is suffering from turmoil in the developed world. Then the center was the US subprime market and the collapse of Lehman brothers. Now it is the eurozone and its fiscal and banking sector problems.

Harking back to the deep recession three and a half years ago and the collapse of global trade that followed, some people are urging the government to take action, possibly along the lines of the bank credit-financed stimulus package that China implemented in 2008-10. This stimulus package is rightly credited with keeping China's economy growing at a critical time, thus supporting the global economy.

However, the stimulus package also saddled China's economy with some problems that are still being processed. A bout of new bank lending in 2008-10, equivalent to 60 percent of GDP, has led to concerns about non-performing loans and unsustainable local government debt. It also raised inflation expectations and, with a lot of liquidity flowing into the housing market, fueled a housing price boom that the government is still attempting to rein in.

Until a month or so ago, the government largely resisted calls for major policy easing or outright new stimulus measures. It did so because the deceleration of growth in China's economy was gradual, with no signs of a hard landing.

However, since the release of especially weak economic activity data for April, the government seems to have started to shift course. On the monetary front, reserve requirement rates were cut, guidance on bank lending shifted to become more accommodating and in early June benchmark interest rates were cut for the first time since 2008, combined with a reform toward more leeway for banks in setting lending and deposit rates. The National Development Reform Commission has started to speed up approval of investment projects, including infrastructure and large steel plants. In the property market, access to finance for property developers improved somewhat and restrictions for first-time buyers were eased. On the fiscal front, the government has introduced subsidies to stimulate consumption of energy saving household products.

Since the government is considering further possible measures, how much policy easing is needed and what would be the most obvious types of measures?

After the April data, economists revised downwards their economic forecasts. Most now expect GDP growth of around 8 percent in 2012. This is down from growth in recent years, but a far cry from a hard landing. It is also higher than the government's own target of 7.5 percent. Admittedly, these forecasts assume some policy easing and growth may well come out somewhat lower still. Nonetheless, given the strength still visible in key parts of the economy, barring a major global crisis, China is on course to avoid a hard landing even without a major new stimulus plan. Indeed, the May activity data was somewhat better than expected, especially on exports, housing construction and car sales, while the labor market remains buoyant.

For a long time, 8 percent GDP growth was considered necessary to create enough jobs. However, with China's shifting demographics that benchmark should shift as well. China's working age population (people aged 15-64) is growing at 0.5 percent per year nowadays, or one-third of what it was 10 years ago.

The future is inherently uncertain and the outcome may well turn out weaker than these forecasts. For instance, the eurozone crisis may intensify further. But such risks call for flexibility and readiness to act when needed, rather than upfront expansionary policy.

Some sectors have been harder hit than the overall GDP growth numbers suggest. In particular, heavy industry has slowed especially strongly. However, this is part of normal economic dynamics; heavy industry tends to show more pronounced ups and downs than other parts of the economy. Given the government's strategy of rebalancing the pattern of growth, upgrading the industrial structure and containing property market excesses, it would not seem right to prop up parts of the economy that are meant to take up a more modest role in the future anyway.

If and when growth-supporting measures are deemed necessary, pure, on-budget fiscal measures are preferable to bank lending based stimulus. While banks are leveraged up and many local governments financially strained, the central government's fiscal position remains sound. In addition, credit and project based stimulus is likely to perpetuate growth along the old lines, with the emphasis on investment, especially property and first generation infrastructure and industry.

On the other hand, fiscal policy measures can be part of the effort to transform China's growth pattern toward more domestic consumption and services. Expansionary fiscal measures such as lowering social security charges paid by employees and further raising government spending on health, education, and social security could be combined with structural reforms, such as development of the services and private sectors and financial sector reform and encouraging full urbanization.

With its domestic growth engines still functioning, albeit at a lower speed, China can afford to focus mainly on the structural reform agenda rather than concentrating on a short-term stimulus based on credit and investment projects.

The author is an economist and project director at the Fung Global Institute.