Commentary: Remedies for economic challenges

China's National Bureau of Statistics reported last week that the economy rebounded in September. While the third quarter's growth was slower (7.4 percent year-on-year) than the second quarter's 7.6 percent, growth picked up quarter-to-quarter. Data on industrial production and fixed asset investments suggested that China's economy, along with inflation and export growth, was bottoming out.

While the media and market have been pre-occupied with China's recent slowdown, it's steering China's transition away from the resource-intensive growth model that will be the challenge for the incoming leadership. Going forward, reforms - in the fiscal system, the enterprise sector, and factor markets - will have to be accelerated for effective rebalancing processes, not only from external to internal demand, but also in economic activity, from rural to urban areas.

On one hand, the transition from foreign to domestic demand has taken place: the 2008 stimulus package absorbed much of the excess savings, resulting in a sharp decline in China's trade surplus, from more than 8 percent to around 2 percent last year. The shift in economic activity from rural to urban areas is also underway: Urbanization has raised demand for services and goods from the expanding middle class; interior regions have been growing more rapidly than those along the coast, some in double digits, in recent years.

Seen another way, reforms in the fiscal system, the enterprise sector and factor markets will promote the structural shift from the investment-driven coast to consumption-driven interior. Lower wages and rents in the interior could develop a production network serving both domestic demands and even some export industries. These reforms will also facilitate the spatial transformation to ensure an optimal pace and pattern of urbanization.

So what should be changed in the fiscal system, the enterprise sector and factor markets?

The fiscal system: Public investments in basic amenities and recurrent expenditures to deliver social services will expand, and will be increasingly borne by local governments. Such increases will need to be achieved while maintaining fiscal sustainability, avoiding levels of taxation that harm growth, and strengthening fiscal institutions.

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