China's economy, projected to grow at a rapid?9.5?percent this year, remains on a strong footing, propelled by vigorous domestic and external demand, the IMF said in its latest assessment.

But China's key policy challenge now will be to accelerate the ongoing transformation of its economic model toward one that is more linked to domestic consumption and less reliant on exports and investment, the IMF said at the conclusion of its annual Article IV discussions on the economy.

"China continues to be a bright spot in global growth," said IMF Acting Managing Director John Lipsky at a Beijing press conference. "We see this continuing and, thus, maintain our growth forecast for both this year and next at around 9? percent. Inflation has clearly become a much more pressing social concern over the past year. However, we expect that many of the drivers behind inflation will soon start to dissipate and inflation should fall to around 4 percent by year-end."

Lipsky praised China's part in helping counter the global recession through extra government spending. More recently, the steps taken by the Chinese authorities to tighten monetary policy, normalize credit growth, and withdraw fiscal stimulus were fully appropriate.

"The measures that the authorities have progressively taken to slow down the rise in real estate prices are having the desired impact," he told reporters. "However, China still has a propensity for property bubbles driven by high savings, cheap financing, low carrying costs, and the lack of alternative investment instruments. Any durable solution will need to involve broader financial development, a higher cost of capital, and increased real estate taxation."

Emphasis on the financial sector

The IMF team, led by Nigel Chalk, Senior Advisor of the Asia and Pacific Department, visited Beijing, Shanghai, and Chengdu from May 23 to June 9 to conduct the annual review.

Lipsky and Anoop Singh, Director of the Asia and Pacific Department, joined the final policy discussions and met with Vice Premier Wang Qishan, People's Bank of China Governor Zhou Xiaochuan, and Finance Minister Xie Xuren.

With the financial sector growing and evolving rapidly, the team for the first time conducted a Financial Sector Assessment Program (FSAP).

Citing the FSAP analysis, Chalk said it showed that important progress has been made in moving to a more market-based financial system. Nevertheless, China still confronts the risk of a steady buildup of financial sector vulnerabilities.

"The complexity of the system is growing and there are limitations in terms of data collection, monitoring of systemic issues, and information exchange. There are also well known near-term risks arising primarily from the recent credit expansion, off-balance sheet exposures, the rapid increase in real estate prices, and potential external spillovers," he said. The FSAP findings point to the need to expand the regulatory and supervisory perimeter, improve coordination among regulatory agencies, and revamp the financial stability and crisis management framework.

Equally importantly, Chalk underlined the importance of reform and liberalization of the financial system as a means to ensure a smooth transformation in China toward a more inclusive growth model that is focused on improving people's livelihoods. According to the IMF, a roadmap for this process of financial reform should include a stronger monetary policy framework, improvements in the regulatory, supervisory, and financial stability frameworks, a deepening of financial markets, and eventually moving to an open capital account with the renminbi as a fully convertible currency. This is a huge task and financial sector development would need to be well sequenced and handled carefully. However, it offers significant payoffs in terms of China's long term economic growth and performance.

Reduced surplus

In the wake of the financial crisis, China's current account surplus has fallen significantly. Lipsky said it would be important for China to deploy a package of policies in the coming years to prevent that surplus from rebounding.

Lipsky noted that "Many of the policies that will be needed are mentioned in the government's latest Five-Year Plan. They include measures to further strengthen the social safety net, particularly pensions and healthcare; raise the cost of capital, energy, and other factors of production; and find ways to increase household income."

"A stronger renminbi will be a key ingredient of this comprehensive package of reforms and would very much be in China's interest," he added.

China—a growing impact on the world

The IMF is also undertaking spillover analysis of the world's five largest economies—Japan, China, the United States, the euro area, and the United Kingdom—as part of its annual Article IV discussions with these countries. This innovation is intended to strengthen analysis of economic and policy interactions across large countries in the wake of the global financial crisis. Lipsky was in London on June 6 for release of the U.K.'s annual health check and visited Tokyo June 7–8. The euro area and U.S. visits will follow later this month.

For China, the spillover analysis puts in a global context why transforming China's economic growth model is so important to the rest of the world. The positive outward spillovers from China will undoubtedly increase and contribute significantly toward a strong, sustained, and balanced global growth if economic transformation is managed successfully.

"However, so do the stakes for the global economy if that process proceeds too slowly or in the event that stresses from the current policy framework cause disruptions in China" Lipsky said.