By Hu Shuli, editor of Caijing

(Caijing.com.cn) Various signals suggested China's economy had returned to a stable track by the end of the second quarter, giving us an opportunity to reassess macroeconomic policy.

Data released by the National Bureau of Statistics showed that China's GDP rose 7.1 percent in the first half of the year, and 7.9 percent in the second quarter alone. Apparently, China's economy has bottomed out.

Arduous efforts contributed to this upward trend. External developments have had a much more serious impact on China's economy recently than during the Asian Financial Crisis a decade ago. However, first half growth was only a bit below the level recorded in 1998. And although heavily dependant on exports, China may yet achieve its 2009 growth target of 8 percent, even while other major export countries report contractions.

These achievements could intoxicate Chinese policymakers. But we see no miracles here. In fact, economic growth recovery in China is being driven by investment. Some 6.2 percent of the country's first half GDP growth rate can be credited to investment, while consumption accounted for 3.8 percent. The net export business contributed a minus 2.9 percent to the growth rate figure.

It's long been acknowledged that China's traditional methods of achieving economic growth cannot be sustained. However, we are now racing down this traditional path of economic development.

Dramatic increases in the currency supply and lending have been backing this investment, the single most important engine of economic growth. M2 increased 28.5 percent and yuan-based lending rose 34.4 percent in the first half, setting new records for each. But nominal GDP growth was only 3.8 percent during the first six months of 2009. And these astronomical increases in currency and lending are a double-edged sword that can support GDP growth as well as endanger the economy.

Current monetary policy, in practice, has exceeded the limits of a genuine "moderately loose" framework. Now this policy, as a result of the interrelated activities of the government, commercial banks and investors, exists in name only. (See the cover story in the latest edition of Caijing, Whither China's Loose Monetary Policy?)

It's high time we re-emphasize the actual policy of moderation. A moderately loose monetary policy is necessary for an unpredictable, downward-sloping economy. However, monetary policy that's too loose will have more drawbacks than merits once an economy levels out. It's only a matter of time before loose monetary policy leads to inflation and asset bubbles.

Some argue that extremely loose monetary policy should be maintained to shore up market confidence and liquidity, since the foundation for an economic rebound is not yet solid. We strongly disagree. The root of the current crisis is plummeting demand. An era of excess demand in the United States and Europe has been swept away by the crisis and will not return in a short period. Astronomical levels of investment cannot create adequate demand. Besides, China's government investment has not attracted enough of the kind of private investment that creates jobs and encourages consumption.
　
It's fair to say that major economies rely on consumption for lasting prosperity. Investment-based economic growth is not sustainable. A constant expansion of investment may keep the economy booming temporarily, but it also may exhaust limited resources accumulated over China's 31 years of reform and opening up. A long-term, sluggish economy may follow a fleeting period of prosperity. A similarly horrible scene once haunted the former Soviet Union and Japan. Now, the United States is bracing for what could be a nightmare of its own.

With excess production capacity and weak domestic demand in China, extra liquidity will not immediately push prices higher. However, cash released through new loans, due to low domestic demand, is flowing into the stock and real estate markets instead of the real economy. This is pushing up asset prices, encouraging even more profit-hungry capital to flow into the investment market. This vicious circle will compromise the foundation for further economic growth as well as encourage speculation, which creates bubbles.

China's monetary policy should return to "moderately loose" from "extremely loose." Policymakers should be more preemptive about avoiding market fluctuations and keeping the economy stable. The ultimate goal of China's monetary policy is to keep prices stable and facilitate growth. Adjusting currency supplies and increasing loans are simply measures toward realizing that goal. Policymakers should balance economic growth and price fluctuations, and be wary of the fact that inflation may jeopardize the foundation of long-term economic development.

The central bank recently decided to issue central bank notes with a slightly higher interest rate to signal its preparations for fine-tuning monetary policy. Beyond that, policymakers should keep an eye on systemic risk in financial markets. For example, the percentage of long-term loans at some financial institutions is too high, and some local governments are interfering with bank lending operations, threatening a new round of bank liquidity crisis and a jump in non-performing loans. We may even re-stage the tragedy of the sub-prime mortgage crisis. Because the effects of monetary policy lag behind policy execution, the central bank should express its will to maintain a stable economy and healthy market through a combination of various policy tools.

In the current economic environment, the more quickly China's economy grows, the greater the effort needed to adjust future methods of economic development. Now is the right time to consider the timing of exit from stimulus. The third quarter can be a crucial juncture.

Full article in Chinese: http://magazine.caijing.com.cn/2009-07-18/110199626.html