China's GDP growth hardly slowed in 2005, with domestic demand firmly taking the lead over net trade in the second half of the year, according to the World Bank (WB)'s China Quarterly Update released today.

The report presents an overall benign outlook for China's economy in 2006.

While China's 2005 trade surplus might have hogged the headlines, the contribution of net trade to growth had already gone into the negative by the end of the year, with solid consumption growth and strong investment growth. Export growth, meanwhile, decelerated.

Notwithstanding the large build-up of foreign reserves in 2005, lower non-FDI (foreign direct investment) capital inflows in the second half suggest that the new exchange rate regime should over time add to domestic stability.

China will benefit from solid export demand, while profit and credit developments suggest more robust investment in 2006.

Consumption might not accelerate much in 2006 because of subdued rural income prospects.

Overall, GDP growth of 9.2 percent is projected for 2006, based on the new GDP data, which is equivalent to an unchanged forecast of about 8.7 percent based on the old data.

International risks include a disorderly adjustment in global imbalances and trade tensions, even if China's trade surpluses are likely to fall.

The main domestic risk is that ample liquidity will re-fuel credit and investment.

For macroeconomic policies, this setting implies that the "prudent"stance announced last year is appropriate for this year as well.

"Monetary policy could in the short run focus on absorbing some of the excess liquidity to reduce the risk of excessive credit growth,"according to Bert Hofman, WB Lead Economist for China. "This task may be complicated somewhat by the rapid financial innovation, whose impact should be closely watched. The overall fiscal stance needs little change for now, but a shift towards social spending is needed to redress China's macroeconomic and structural imbalances."

Over time, with a rebalanced economy that relies more on services and consumption, tax revenues might come under some pressure. That would need to be countered by reform in tax structure and administration and medium-term expenditure restraint.

The report, in a special focus section, notes that the GDP revisions moderate, not substantially change, the perspective on China's main structural challenges.

"China still shows a strong reliance on industry and investment and a lower than normal share of services in GDP,"according to Louis Kuijs, WB Senior Economist on China, and main author of the report. "Interestingly, two thirds of the GDP revision came from higher price increases, which, amongst other things, implies that China's real exchange rate has appreciated 10 percent more than previously thought."

The report also discusses the Party's Proposal for the 11th Five-Year-Guidelines. The proposal signals a change to more balanced growth, with more attention focused on the environment and income distribution.

However, while local leaders' announcements fall in line with these national goals, local growth targets remain high.

To achieve these high growth rates, local spending is likely to continue to be directed at investment rather than at social services.

The targeted reduction in energy intensity of the economy by 20 percent over the next five years is very ambitious, and the announcement of an industrial rather than pricing policy to realize this target raises some concerns.

(China.org.cn February 9, 2006)