China eyes gradual fiscal exit, no rate rise -IMF

BEIJING, July 29 (Reuters) - Subdued inflation is reducing the need for higher interest rates in China, which intends to withdraw its fiscal stimulus gradually, the International Monetary Fund said on Thursday.

Chinese policymakers, in the course of an annual policy review with the IMF, said that debt strains in Europe had increased their worries about the global economic recovery, making them more cautious about unwinding anti-crisis measures.

"Over a longer horizon, they were also concerned that the process of fiscal consolidation in Europe, Japan, and the U.S. had the potential to lower global growth with longer-lasting negative spillovers to China," the IMF said.

The comments were contained in a report drawn up by IMF staff as the basis for an evaluation by the fund's board of directors of China's policy stance.

For the most part, the report is glowing. China, it said, "is contributing greatly toward ensuring strong, sustained, and balanced global growth".

Central bank officials, responding to the IMF's call for less reliance on credit quotas, indicated they were fully committed to a greater use of indirect monetary policy instruments.

"They noted, however, that, with a benign inflation outlook, there was less need for higher nominal interest rates at this point," the report said. They were concerned that higher interest rates could risk fueling capital inflows.

On fiscal policy, officials told the fund that they had yet to decide their stance in 2011. Any eventual withdrawal of stimulus would be "measured and gradual", but over the longer term they wanted to return to a balanced budget.

CURRENCY SPAT

China has blocked publication of the staff report for the past three years because it objected to the fund's view that the yuan, also known as the renminbi, needed to be a lot stronger.

Even this year's final report omits a staff estimate, contained in a draft version, that the yuan is between 5 percent and 27 percent undervalued. [ID:nTOE66Q092]

The IMF board, in conclusions released on Wednesday, declined to endorse the staff's description of the yuan as substantially undervalued, though some directors said it was too low.

The long-running disagreement between China and the fund's economists over the exchange rate is laid bare in the report.

The Beijing authorities did not view China's rapid build-up of international reserves as "compelling" evidence of meaningful yuan undervaluation and disputed the IMF staff's view that the recent drop in China's current account surplus was temporary.

They believed the surplus would shrink further before stabilising at around 4 percent of GDP by the end of this year. That would be an appropriate level for China and would imply negligible yuan undervaluation, according to policymakers.

"They viewed the level of the renminbi right now as much closer to equilibrium than at any time before," the report said.

In the staff's eyes, however, holding the current account surplus down would be an "exceptionally complicated exercise in macroeconomic engineering".

The report took stock of several near-term risks for China:

OVERHEATING

The IMF expects inflation to begin falling in the second half of 2010 and settle around 2-3 percent over the next few years.

It said wages were rising in the 10-15 percent range, but this was no higher than in previous years and reflected productivity gains rather than tightness in the labour market.

Moreover, rising wages do not appear to pass through into higher domestic inflation. "At this point in the recovery, there is little evidence that the upswing in inflation is coming from either binding capacity constraints, rapid growth in broad monetary aggregates, or demand pressures," the report said.

PROPERTY SECTOR

A property bubble is beginning to inflate in some larger cities. The IMF's modelling suggests prices in Beijing were 20 percent above fair value at the end of March.

"Nonetheless, at a national level, it does not seem as if property prices are significantly above fundamentals," it said.

Policymakers were "acutely aware" of the risk of asset price inflation, not least due to Japan's experience in the 1980s, and indicated that research into a property tax was under way.

LOCAL GOVERNMENT FINANCES

Sparse information made it "exceedingly difficult" to assess the risks that borrowing by local government finance vehicles imply for the banking system.

"Indeed, officials indicated they were only now putting in place systems to identify and measure the level of recourse to these financing arrangements," the report said.

IMF staffers said China should think of setting up a municipal bond market to formalise local government financing, while a "meaningful" property tax would lessen local governments' reliance on land sales as a source of revenue.

BANKING SYSTEM

Last year's record credit spree will generate non-performing loans that will strain banks' balance sheets in coming years.

But profitability is solid, most banks are well capitalised and provisioning levels are being increased. "At this point, the banking system looks well-placed to withstand a significant deterioration in credit quality," the fund concluded.

In an annex on the sustainability of China's public sector debt, the Fund reckons that recognising implicit or contingent liabilities would increase the debt burden by 16.8 percent of 2010 GDP, taking it to 36.0 percent of GDP.

The estimate assumes that unfunded pension liabilities, realised losses from non-performing loans and interest on bonds issued to cover NPLs are made explicit and brought on budget.

On that basis, the IMF projects that China's total public sector debt will rise to 61.0 percent of GDP by 2015. (Reporting by Alan Wheatley; Editing by Ken Wills)