HONG KONG: If the central government decides to deal with the problems of inflation and the escalating asset bubble immediately, it will necessarily hinder the momentum of rapid economic growth at this moment. However, if no appropriate action is taken, the risks of inflation and asset bubbles will intensify, making the problems even more difficult for the future.

The main driver of economic growth in 2009 was investment, spearheaded by government and State-owned enterprises. However, growth in consumer demand did not improve much and among the large-scale investments, the growth of bank credit was decisive. Nevertheless, excessive investment and credit growth are risky and unsustainable. Therefore, it is unrealistic to expect China's economic growth to depend solely upon investment this year.

Even though China's economy has not completely escaped from the threat of deflation, people are also worried about anticipated inflation, while asset bubbles are now threatening China's steady economic growth and macro-economic policy.

Although China's economy grew strongly in 2009, the economic structure has barely changed. The structural problem is an old issue within China's economy, which was not easy to tackle even when times were good, let along in the current stark economic situation.

The core issue within Chinese economic structure is the economic growth mode, namely, a mode which has been over-reliant on investment, with domestic consumption having contributed little. Other structural issues, such as overcapacity and excessive dependence on the external environment, are all related to the same core issues. Excessive investment ratios and investment growth will inevitably lead to production growth's exceeding domestic demand growth, resulting in excess capacity. This excess capacity can only resort to exports since domestic demand is not able to digest it. Thus, a strong dependence on external demand is created, representing too great a proportion of the country's economic output.

Since the global financial crisis in September, 2008, the central government has made decisive adjustments to its macro-economic policy, with "a proactive financial policy and a moderate loose monetary policy". Over the past year, the two policies successfully achieved the goal of maintaining economic growth in 2009.

However, an over-loose, rather than moderately loose monetary policy, has led to an expansion of liquidity, which has resulted in a rapid rise in asset prices, triggering concerns about inflation and asset bubbles, making people anxious about the possible tightening of monetary policy.

Under the present circumstances, monetary policy should be "moderately loose". Should interest rates stay unchanged in the short term, credit growth should be maintained. However, the credit scale should be controlled strictly. Measures should also be taken to recover the excessive liquidity gradually. Issues related to liquidity in the market, like hot money inflows, should be regulated effectively by the central bank.

In contrast to the overly loose monetary policy, fiscal policy has been not "proactive" enough. But this inadequacy could be helpful in keeping China's economy healthy in times of financial crisis, as it provides more room for fiscal policy to play a greater role in the future.

When monetary policy returns to moderately loose, the government should implement a proactive fiscal policy and make it the main vehicle, instead of monetary policy, to facilitate economic growth. Given that deficits and debt ratios should be below the alert level, the central government can further introduce some measures to reduce taxes and increase stimulate economic growth.

Implementing a proactive fiscal policy also helps with the long-term goals of transforming the economic growth mode. First of all, the investment direction should emphasize structural change and giving financial support to the advancement of industrial technology, in order to build the foundation for long-term economic growth. Secondly, the distribution of financial resources should be equally allocated to economic development and people's livelihood improvement. A greater proportion of financial funds should be applied in subsidies to enhance the people's real income and stimulate consumption.

Dr. Li Tao is the Chief Research Officer of the One Country Two Systems Research Institute. This is an edited and translated version of an article first published in the January 2010 edition of Bauhinia magazine. Translated by China Daily reporter Li Tao.

(HK Edition 01/30/2010 page2)