Structural reforms remain important

The global economic slowdown has created a volatile environment for policymakers, and exacerbated China's domestic challenges. The impact of the slowdown is reflected in the economic figures for the first half of 2012 that were published last week. The data confirmed lackluster trade flows, decelerating investment, and declining quarterly GDP growth.

Responding promptly to the challenges the government has taken an expansionary policy stance, and in late May it announced a set of stimulus measures combining short-term actions with longer term economic restructuring.

These measures will underpin growth in the second half of 2012. They include cuts and more flexibility in benchmark interest rates; increased public spending in education and health; targeted subsidies to boost consumption; and accelerated infrastructure investment. However, the economy remains vulnerable to sluggish growth in major world economies.

Weak external demand poses daunting challenges to economic growth. However, it also creates an opportunity for policymakers to address structural constraints, and allocate resources more efficiently for development needs. Major reforms should strengthen the domestic engines of growth and enhance the role of consumption and services, to offset the impact of the contraction in external demand.

Economic restructuring is a complex process encompassing structural adjustments to the supply and demand sides of the economy. Policy reforms must be mutually supportive and consistent. Fiscal and monetary policies both have a key role to play.

On the fiscal front, well-targeted policy actions to increase social expenditure will help to improve living standards. Social spending has increased substantially in recent years, but public expenditure on education, health and social security remains low by international standards. Shifting the composition of public spending from investment to public services will raise the disposable income of households, resulting in higher levels of consumption. This is key to transforming the growth model.

Other fiscal measures include strengthening resource transfers from central government to local governments, and increasing local governments' share of tax revenues. Currently local governments' fiscal revenues are insufficient to fund their obligations to provide social services. In addition, the central government could introduce transfer mechanisms to support poorer provinces and reduce regional disparities across the country.

Larger budget allocations are needed to provide adequate social protection in the world's most populous country. Accelerating social security reform is vital. By securing incomes and protecting workers from social risk, a comprehensive social security system reduces income inequality and fosters the role of domestic demand as a driver of growth. Given the rapidly aging population, pension reform requires urgent attention.

Tax reforms are also needed. The regressive bias of the taxation system should be reduced to promote social equity and inclusive growth. Direct taxation is more effective in adjusting income differences and introducing a progressive tax system would be a major step toward more equitable development. The current emphasis on indirect taxation is effective in raising revenue, but highly regressive. Taxing capital gains and property, and inheritance and gifts, would balance income distribution while offsetting revenue losses from the transition to more progressive taxation.

On the monetary front, prudent policy making should continue. This, in turn, requires greater financial liberalization. Monetary policy in the years ahead should focus on ensuring adequate and widely accessible financial resources and price stability. This will support economic restructuring and avoid an erosion of living standards.

Financial sector liberalization would help to increase the effectiveness of monetary policy. It is also essential for a successful transition to a services-oriented economy. Small and medium-sized enterprises are the backbone of the service sector, and they currently encounter difficulty obtaining financing. They urgently need access to bank loans. More sophisticated capital markets would widen companies' access to international and domestic capital markets and new financial options, and bolster government initiatives to technologically upgrade the industrial sector.

The counter-cyclical policies recently adopted by the government will support economic growth in the rest of 2012. China's fiscal position is strong and receding inflation gives confidence that there is scope for further monetary expansion. Together these should ensure a soft landing. However, it is essential for policymakers to move rapidly on the economic reforms set out in the 12th Five-Year Plan (2011-15). Failure to implement the reform agenda decisively could jeopardize the sustainability of growth.

Robert Wihtol is director-general of the East Asia Department of the Asian Development Bank, and Yolanda Fernandez Lommen is head of the economics unit of the ADB's office in China. The views are the authors' own.