The massive $585 billion fixed-investment weighted stimulus plan was an expedient put in place to maintain high growth rates in order to maintain employment and social stability. It was never meant to restructure the economy.

Prior to the growth figures coming out the country's Premier Wen Jiabao told a Cabinet meeting Wednesday that policy will focus on balancing economic growth while managing inflation. The numbers show that growth is now accelerating. (Although some observers make good arguments that the figures cannot be trusted. Gordon Chang in a Forbes Op-Ed, writes, “China's economy, for all the stimulus it has received in 11 months, is underperforming.”) Regardless it is clear that continuing investment-oriented policies will only exacerbate imbalances and dislocations.

The tremendous investment program has divided critics. Some predict inflation and warn that excessive bank loans are causing sharp rises in share and property prices, while others argue that lending excesses will exacerbate over-capacity and encourage deflation.

Both are likely occurring simultaneously. Most observes, including the Wall Street Journal, who take the numbers at face value, believe that inflationary pressures pose the greatest threat. However, Gordon Chang's contrarian view that lending excesses are creating over-capacity leading to deflation agrees more with observations on the ground in China. Stock and property bubbles are surely forming, but the stimulus has only aggravated the excess production capacity caused by the drop in exports.

The National Development and Reform Commission (NDRC) warns of obvious production overcapacity in six sectors, including: steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

Neither the domestic market nor the export market has really returned, and overcapacity, if not checked, will lead to bankruptcy, unemployment and bad bank loans.

To balance growth during the recovery Beijing has indicated a willingness to take the following actions as they become prudent.

1. redress production overcapacity in six sectors.
2. taper out the stimulus package.
3. raise interest rates - tighten monetary policy.
4. increase controls on lending.
5. raise banks' reserve requirements.
6. raise the value of the yuan. (Significant appreciation requires liberalization of rural finance.)
7. broaden social security coverage.

The State Council, China’s cabinet, on Oct. 21 gave its first signal that it was considering a tighter monetary policy. It stated that the policy should focus both on managing inflationary expectations as well as securing stable growth. Geoff Dyer of the London Financial Times noted that this was the first time it has mentioned inflation since the global economic crisis hit China last year. (However, Gordon Chang argues that China is not really that fearful of inflation at this time.)

Bloomberg reports that there have been hints however that increases by the yuan against the dollar are likely to continue as early as the beginning of 2010. Since November 2008 China halted gains by the yuan against the dollar to help exporters.

Barclays Capital analysts even said on Oct. 22 that currency appreciation may play a role in policy tightening next year as the government tries to control inflation.

In a video interview Sebastien Barbe, senior economist at Calyon Corporate & Investment Bank, predicted that China will likely push rates up again next year at a pace similar to before the crisis. He expected an appreciation of 5 to 6% per year.

Zhao Jinping, a researcher with the Development Research Center of the State Council, or Cabinet, nonetheless mentioned the elephant in the room, "Weak domestic consumption is the key problem that makes the foundation for recovery fragile. Expanding domestic consumption will be the focus in restructuring the economy."

A reform package which restructures the economy must include the following.

1. reverse the one-child policy
2. liberalize the labor market
3. liberalize financial services (including rural micro-finance)
4. broaden social security coverage further
5. support small and medium sized private enterprises
6. expand domestic consumption
7. raise the value of the yuan to a reasonable level

The reform package must include the “painful” and “politically difficult” items which remain outside the bounds of the massive stimulus package.

The New York Times believes Chinese consumers have had very good reasons for restraint and neither the slowdown nor the government’s response has done much to address them. They make the all too familiar argument: individuals save at a high rate to meet the need to cover their own health care and retirement needs.

A better reason for the restraint might be that the average Chinese spends 40% of their income on food, and that 700 to 800 million residents, about 60% of the population, has not seen their income growth keep up with the nation's GDP expansion.

China could expand domestic consumption if it promoted financial liberalization particularly in the countryside through microfinance, but the political will to loosen up economic controls appears weak in Beijing.

-----------

Stay Connected to ChinaManufacturingBlog:

Follow on Twitter: @ChinaManufBlog or @DanielRFeldman NOTE: Twitter blocked in China