Economic growth in China has remained rapid in 2005 buoyed by a strong contribution from the external sector. During the projection period, output growth may stay above 9% and seems likely to be driven by domestic demand, as fiscal and monetary policies have been eased, moving to a more neutral stance, while the effective exchange rate has appreciated slightly. Nonetheless, the current account surplus, after increasing markedly in 2005, is unlikely to fall relative to GDP and may continue to increase in nominal terms. Inflation is projected to decline to under 4%, when measured by the GDP deflator.

Increasing stress is likely to emerge in the interaction between the authorities' exchange rate and monetary policies, given the continued size of the current account surplus and capital inflows. A further appreciation of the exchange rate would help to resolve these problems and guard against resurgence in inflation. It would also help move economic policy towards the use of market instruments, reducing the need for administrative control of credit and thereby reinforcing the progress that has been made in reforming the banking sector in the past year.