As the global economy is entering arguably another tumultuous year, spotlight is sharply on the prospects, policies and risks of China's economy, which has all but sailed past Japan's as the world's second largest after the United States.

The following is a look into Chinese economy's prospects in 2011 and the nature and gravity of the challenges it faces.

GDP GROWTH

The fast-growing Asian giant's economy grew an average 10.6 percent in the first three quarters of 2010 though signals of a moderation in the pace of growth have risen of late. A Reuters poll has shown China's growth next year will be marginally weaker. Economists surveyed for the poll said the economy will slow to 8.9 percent in 2011. However, a poll in the previous quarter had shown that growth could be 9 percent next year.

The poll showed Chinese economy will bottom out in the first quarter of 2011, at which point the year-on-year pace of expansion could hit a low of 8.2 percent.

China's slowdown is not an unanticipated development. The government has been scaling back its fiscal stimulus program as well as tightening the extra-loose monetary policy this year as fears that an overheating could lead to asset bubbles and higher inflationary pressures.

The Chinese Academy of Social Sciences (CASS) said in its annual 'Blue Book' on the economy that growth could breach the 10 percent mark in 2011. It put 2010 growth at 9.9 percent.

However, analysts have said though a slowdown in GDP growth is inevitable next year, the economic scene will be more complicated than what statistics show. The slowdown of China's economic expansion is not only associated with the growth base of last year, but it is the inevitable result of macroeconomic regulation and control initiated this year, according to said Xia Bin, director of the Financial Institute of the Development and Research Center of the State Council.

He told the People's Daily the direction of the macroeconomic regulation and control should firmly be unchanged and the transformation in the economic development mode should be further advanced.

INFLATION/REFLATION

While the global economy was largely paralyzed by the great meltdown of 2008 China managed to boom back into the mix of things by virtue of a massive 4 trillion-yuan stimulus spending and the adoption of loose monetary policies. But this led to a surge in inflation and fears of an asset bubble.

According to CASS, inflation will remain moderate next year, with the consumer price index (CPI) rising 3.3 percent. However, according to a Goldman Sachs research, inflation rate will surge to 4.3 percent next year.

The Goldman Sachs report says though it's certain that the People's Bank of China will raise interest rates there won't be steep hikes that could result in a deceleration of growth coupled with excessive exchange rate appreciation.

With official interest rates near zero in major economies and quantitative easing in various disguises continuing at least in the G3, monetary policy looks set to remain super-expansionary and will support the ongoing reflation of the global economy, in our view.

Wang, Qing, a China economist with Morgan Stanley, said year 2011 will be a year of reflation for the Chinese economy and that tackling inflation will be an overarching policy priority for the country, especially in the first half of 2011. CPI inflation is expected to rise in the first half of 2011 and peak at 5.5 percent year-on-year by mid year and then start to decelerate to the tune of 4 percent by the end of the year, he said.

Specifically, the lagged effect of massive monetary expansion in 2009-10 is expected to continue to provide strong tailwinds for inflation in the near term, while the headwinds stemming from weak external demand are letting up. Beyond the near term, China's economic rebalancing that features a shift in growth drivers from tradable to non-tradable sectors also points to a higher future secular inflation rate.

On the other hand, if policy makers are focused on fighting inflation aggressively it will result in a thaw in growth, especially in the real estate sector which has been witnessing a bull run.

TRADE FRICTIONS AND REBALANCING

China's competitors and trade counterparts argue that the Asian giant should rebalance its economy to address the global trade imbalances. Critics have pointed out that China should shift gears from being an export-dependent economy and boost its domestic demand.

The Morgan Stanley report paints hope on this front. It says Chinese consumer spending will become the biggest contributor to GDP growth in 2011, accounting for more than half of the forecasted 9 percent growth.

This ongoing process of rebalancing from export-led to domestic demand-led growth and vice versa has two important implications. First, it requires a shift of resources (capital and labour) from the external to the domestic goods-producing sectors or vice versa, which takes time and thus weighs on growth in the meantime.

A Reuters poll in October showed that China's trade surplus, a nearly constant source of friction with the United States and the European Union, could be gradually declining. According to a median forecast, the surplus could shrink to $180 billion this year and $174 billion in 2011 from $196 billion in 2009.

The surplus peaked at $295.5 billion in 2008. If the forecasts come true, Beijing will be able to point to the decline as proof that its efforts to power domestic demand and smooth out global imbalances are gaining traction, the report said.

Whether China is on the right track to achieve rebalancing will be known in the coming year. So far there are concerns on areas like wage growth. Wages have still remained too weak to propel a rise in consumer spending. Also it remains to be seen if China will let its currency appreciate significantly to give more purchasing power to the people.

RATES

As a commodity boom, possible rise in labor costs as well as a highly liquid financial system threaten to drive inflation higher next year, the focus is on China's monetary tightening policies next year.
The Chinese Communist Party's politburo announced early this month the country will shift to prudent monetary policy in 2011. It was a marked defection from the professed “moderately loose” monetary policy followed by the government since late 2008.

China had reduced interest rates considerably through a series of moves between September and December 2008 in the wake of the global financial crisis. However, the government has said it will scale back the expansionary policies that propelled the bounce back of the economy after the recession.

It raised key rates in a surprise move in October. The People's Bank of China raised its one-year yuan lending rate to 5.56 percent from 5.31 percent, the first time it has raised interest rates in three years. The central bank also said one-year yuan deposit rate would rise to 2.5 percent from 2.25 percent.

China has also repeatedly told banks to keep away larger deposits as reserves, a move that will cripple banks' capacity to lend. This measure jells with Beijing's broader objective of mopping up stimulus and tightening policy in the long term.

TACKLING OVERHEATING

China has taken several drastic measures recently to keep the commodities boom in check and keep the markets well supplied and the focus will be on how far Beijing will go to clamp down on commodities boom without gravely affecting growth. Measures adopted recently included the State Reserves Bureau selling off stocks of aluminum, zinc and lead, and the government's sell-off of edible commodities like corn, wheat, soy, rapeseed oil, sugar and rice.

China discouraged fertilizer exports by imposing punitive tax rate on exports and asked coal miners to freeze annual prices for the next year. The governments' crackdown on the power consumption of companies in fact resulted in a diesel shortage in November as firms turned to diesel generators.

However, there is also a view that Chinese economy’s commodity-intensity will lessen largely in the coming years and that the commodity boom may not last forever and the prices could likely fall. Julian Jessop, an economist at Capital Economics has said China’s commodity demand in 2025 could be half the level that a simple extrapolation of the recent trends would suggest and that the prices of industrial commodities may already have risen to unsustainable levels.

Jessop says the commodity-intensity of China’s economy is likely to fall as the economy undergoes a rebalancing in the coming years. He says China’s GDP growth could slow in the next few years to between 8 percent and 10 percent, compared to the 10 percent and 14 percent recorded from 2003 to 2007 during the last commodity boom.

CURRENCY AND LIQUIDITY

The U.S. has time and again accused China of keeping its currency under valued and of engaging in exclusionary trade policies. Though China managed to stay the course despite repeated efforts by the U.S. and the western bloc to make it appreciate the currency, there is renewed speculation over China acting on the currency front in the next year.

It is argued also that, faced with inflationary pressures, Beijing might go for yuan appreciation earlier than expected. But it still remain to be seen how big an appreciation will be effected. China will also have to deal with the excessive liquidity unleashed on the market by the government’s fiscal measures.

LABOR COSTS AND DOMESTIC DEMAND

Export-dependent China frets a runaway rise in wages. However, a depressed wages scenario, on the other hand, is dampening the domestic demand which in turn makes the rebalancing difficult. It will be a challenge for China in the next year to nicely balance this 'rebalancing act'.

The CASS report says rising labor costs could hit the rapid growth of the economy. The first challenge comes from the rapid rise of labor costs in the country, Liu Shijin, deputy director of the Development Research Center of the State Council said. The competitiveness of Chinese companies will be threatened by rising labor costs unless they find a new source of growth, such as innovation.

At the same time there are many policy makers in China who believe that an expansion in domestic demand is the key to ensure the country’s economic stability over the long term. It is critical to begin the research on long-term institutional reforms as soon as possible when implementing short-term policies, Xia Bin, director of the Financial Institute of the Development and Research Center of the State Council.