With much investment still needed for job creation, infrastructure development and the provision of public goods, the room for fiscal expansion in China is considerable. Fiscal measures to boost the economy are needed because abundant liquidity makes monetary policy less effective. The efficacy of implementing such large-scale fiscal expansion will depend on how it can be directed to restructuring the Chinese economy at this stage of its industrialisation.

With a growth rate of nearly 10 per cent per annum during the past thirty years, China’s economy is like a fully loaded truck travelling at a high speed on a super highway powered largely by capital investment and strong exports. Imagine how precarious it would be if the truck not only needed to decelerate quickly, because of the economic slowdown, but was also forced to make a sudden turn (shift) from being highly dependent on exports to reliance on domestic consumption. Such a shift is generally regarded as necessary in resolving the problems of global imbalance. Failure to change direction increases the risk of running the economy into ‘deflation’, increasing unemployment and causing social instability.

China’s stimulus package might boost domestic demand and accelerate growth, but it may not be able to rebalance the economy towards a new pattern of growth driven primarily by domestic consumption. At the same time, if it is not implemented well, the package could set back ongoing institutional reform aimed at reducing the direct involvement of local governments in generating growth. The package’s underlying growth target could also undermine the government’s goals of reducing the energy (as well as pollution) intensity of its industries set as part of China’s commitment to deal with energy and environmental problems.

Can China’s stimulus package work more effectively so as not only to generate more growth and more employment, but also 1) to enhance the ongoing reform, at the core of China’s success in the past, and 2) to promote industrial upgrading through technological advancement and innovation and increase domestic consumption through boosting rural development and strengthening the social security system. Both are crucially important to a more sustainable growth path in the long-term.

For the stimulus to work the government will have to impose strong disciplinary measures on different levels of government to ensure that investment accords with government planning and priorities. Investment by local governments is prone to inefficiency both because of irregularities in its use or its allocation to financially non-viable projects. Since it is effectiveness which ultimately determines the real impact of the public spending package, the importance of continuing systemic reform is paramount.

Implementation of the package has to be combined with other macroeconomic policies, including policy measures ranging from easing monetary policies to increase bank lending to reducing taxation for both enterprises and households. Direct government payments to low-income groups in both urban and rural areas must also aim to increase domestic consumption.

It is important that the huge expansion of government spending from all government sources doesn’t crowd out non-state and private investment which now accounts for more than 70 per cent of China’s total fixed asset investment. The stimulus package inevitably strengthens the role of governments which might go against the grain of market-oriented reform.

One challenge will be to frame the stimulus package so that it encourages further investment from the private sector, which has played a pivotal role in driving growth in the past and holds the key for reviving the economy. With many factories already being closed down, government support in the form of finance and credit will be essential for small and medium sized private firms which continue to rely heavily on borrowing from informal financial sources at much higher cost. One policy option is to quicken the pace of liberalising the informal financial sector and integrating it with the formal financial sector.

The stimulus package won’t work unless both China and its trading partners keep their markets open to each other. Guarding against rising protectionism will require both China and its main trading partners to make some adjustments both domestically and internationally. As one of the largest beneficiaries from open trade, China can contribute to global economic recovery by importing more goods and by liberalising trading arrangements with its trading partners.

There is no room for complacency on the viability of the commercial banks in China even though the overall ratio of their non-performing loans has been falling. This could be reversed when the economic slowdown starts impacting on firms’ ability to repay their bank loans. Commercial banks will also be lending money to fill the funding gap in the stimulus package further increasing financial risk.

China is conscious of the need for fiscal sustainability in spite of the estimated budget deficit for 2009 accounting for only 2.9 per cent of GDP (lower than the internationally recognised alert level). Fiscal expansion has, however, been accompanied by substantial reduction of taxation for both enterprises and households, weakening the government’s fiscal position in the short-term. And a large proportion of funding in the stimulus package comes from local governments many of already heavily in debt.

For China, a failure to deepen its economic, governmental and institutional reform in time of crisis would not only undermine the efficacy of implementing its stimulus package, but also pose more medium- to long-term difficulties in confronting the challenges in the post-crisis world in which China is expected to play a more important role.

The current crisis is likely to get worse before it gets better. But, the possibilities for further high growth in China have not been exhausted because the fundamentals which have driven past Chinese growth remain basically unchanged. The room for further rapid growth and industrialisation is large given China’s present level of per capita income, its continuing urbanisation, the scope for further improving productivity by deepening reform and institutional change. The preservation of an open global trading regime is important to the resumption of fast growth in China that will also benefit the rest of the world.