The latest data have prompted many market economists to revise down significantly their 2009 GDP forecasts. This is probably an overreaction. First, current headline production and GDP data overstate the slowdown in underlying demand. Growth of fixed asset investment has only moderated slightly, growth of retail sales held up quite well, and trade surpluses actually surged. According to the Deputy Governor of PBOC, Yi Gang, the difference is explained by inventory adjustment. Given the collapse of commodity prices and the darkening clouds surrounding the economic outlook, companies began to slash their material inventories, leading to faster slowdown in production than in demand. Once inventory adjustment ends, probably during the first quarter of this year, according to Yi Gang’s estimation, production could rebound sharply.

More importantly, the government still has the will and capability of supporting growth at around 8 per cent. Some economists have argued recently that the Chinese government won’t be as successful as 10 years ago because now 37 per cent of the economy is directed to exports and 60 per cent of the economy is accounted for by the private sectors. It is true that the Chinese economy is a lot more market-oriented today. But that by no means implies that the state’s ability to influence economic activities has diminished significantly. The state still controls 43 per cent of fixed asset investment and 60 per cent of banking assets. Fiscal revenues as share of GDP increased from 11 per cent in 1997 to 21 per cent 2007. In early November, the State Council announced a package of RMB4 trillion to stimulate domestic demand in 2009-2010. In the following months, provincial governments proposed investment plans totaling Rmb25 trillion, which is equivalent to 100 per cent of 2007 GDP.

All recent official statements confirm that maintaining 8 per cent growth has become a political as well as economic policy priority. And we can be confident that the government can achieve this goal, at least for the next year or two.

This sounds like a very positive story. But that’s not the end of it. The government should be able to support growth, but it won’t be able to support profits or income. In fact, deflation is likely to return and haunt China again in 2009. During the past 10 years, China suffered from a deflation problem twice – first during the 1998 Asian financial crisis and second following a mild recession in the U.S. in 2001. During both episodes, deflation was directly caused by collapse of export growth and emergence of overcapacity. If the same causation still exists, then we are likely too see much more serious deflation in 2009 — not only are exports a much greater component of GDP, but the collapse of external demand will be more severe and broad-based.

Deflation can create room for more aggressive policy easing. But it’s bad for profits, investment and, therefore, employment and income. In other words, we are likely to see a soft landing in headline growth but a hard landing in corporate earnings. It will be tough for investors, who will likely need to focus on those GDP proxies (such as utilities), low-income elasticity items (such as consumer staples) and beneficiaries of stimulus packages (such as commodities).

Unfortunately, the biggest challenge will probably occur after 2010. Essentially this is because the current stimulus packages are likely to be effective in supporting growth, but are probably sub-optimal in improving growth quality. For years, the government has been trying to rebalance the growth model, reducing reliance on exports and investment. But of the RMB4 trillion announced by the State Council, at least three quarters of the package are for investment projects (RMB1,800 billion on railways, highway, airports and power grid, RMB1,000 billion for post-earthquake reconstruction Rmb280 billion for low-rental housing). The RMB25 trillion projects proposed by provincial governments are almost exclusively for investment expenditures.

The massive spending will surely ensure the government’s 8 per cent growth target will be met. But it may bring its own problems. First of all, the massive increase in investment is likely to make China’s growth model even more unbalanced. Of course China still needs more infrastructure, but imagine what happens if it invests an amount equivalent to the size of 2007 GDP within two years, not to mention the inefficiency, waste, bad planning and even corruption problems. More importantly, this kind of stimulus package is not sustainable. So the ideal scenario is that the world economy recovers before the stimulus packages end. Then the export engines can operate at full speed again. And GDP growth can return to high gear.

There is one small problem. After this crisis,  import demand from the US is likely to fall. As Citigroup forecasts, the US household saving rate is expected to rise from around 1 per cent last year to 5-6 per cent over the next two years, while the US current account deficit may fall from 4.5 per cent of GDP to around 2 per cent. This could mean that China may not be able to export as much as it used to before the crisis. And in order to maintain rapid growth, China will again be forced to turn to boosting domestic demand. China and other Asian economies were able to export their way out of recession after the 1998 Asian crisis, but they won’t be able to do the same this time around. For all these reasons, the government needs to focus more on boosting consumption than on promoting investment during the current round of stimulation.

A minimum 8 per cent growth has become the universally accepted target in China. It has almost become a religion – everybody believes it, but nobody can explain exactly why. The most authoritative answer is social stability. In order to maintain social stability, China needs to create 10 million jobs (inclusive of 8 million new labor market entrants) every year, and that translates into 8 per cent growth.

This argument has a number of problems. Firstly, the correlation between job creation and GDP growth is clearly non-linear, depending on the structure of economic growth. Building railways and highways do not really create many urban jobs, and certainly not sustainable urban jobs. And during the 1990s, new job market entrants were about 8 million a year. New entrants fell to about 5 million during the current decade and may fall into the negative during the next decade. So perhaps the growth rate necessary to sustain full employment will also fall over time?

If social stability is the primary policy objective, perhaps it would be more effective to attack the problem directly? For instance, spending most of the RMB4 trillion or even RMB25 trillion on social security, tax cuts or even giving out consumption coupons would be more effective for maintaining social stability. If low-income households receive better income support and migrant workers become entitled to unemployment benefits, then it wouldn’t be that devastating even if growth dropped below 8 per cent. In fact, because that would improve social security and income distribution, it should also boost consumption over time.

To be fair, the government has been making efforts to improve social security and income support. The RMB4 trillion package contains spending items such as rural social security and healthcare. Policymakers have also been designing new measures to improve pensions and minimum income support, to increase farmers’ income, and to improve healthcare and other social welfare systems. But the spending committed to these items looks tiny compared to investment expenditure. One reason for this bias is because the impact of infrastructure spending on growth is felt much faster. Yet it may also be related to the political system – in a democratic system politicians may be more willing to cut taxes since it helps election prospects, whilst in an authoritarian system big image projects are much more effective in facilitating promotion.

China is likely to maintain 8 per cent growth over the next year or two. But deflation is also likely to return and corporate earnings could suffer greatly. The biggest challenge will be after 2010. Even if the global economy recovers by then, China may still be forced to adjust toward domestic demand when stimulus measures run their course.

Policymakers are already aware of the structural problem. Hopefully they will make efforts to optimize sources of growth over the next two years, while lifting rates of growth, and that could make the post-2010 transition smoother. But so far this outcome remains only a hope.

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Dr Yiping Huang is Chief Economist Asia for Citigroup and Professor of Economics, Crawford School of Economics and Government at the ANU.

This is part of the special feature: Reflections on developments in Asia in 2008 and the year ahead