The International Monetary Fund has urged China to embark on sweeping financial system reforms to shore up long-term growth, starting by freeing up its undervalued yuan.
The IMF praised market-oriented changes already underway, but said China needed to embark on a complex 'rebalancing' plan that would take the country from an export focus to a more domestic-consumption model.
That would boost household incomes, help build the country's service industries, and strengthen China's role in - and reduce its systemic threats to - the global financial system.
'China's capacity to both transmit and originate real shocks is rising, implying an important stake for the world in its stability,' the Fund said in a new report on the Chinese economy.
'Insofar as its export-oriented growth model is a source of stresses, economic rebalancing is crucial,' he added. 'A prerequisite for that financial reform will be to have a more appreciated renminbi,' IMF China mission chief Nigel Chalk said.
The IMF, as before, called the yuan, also called the renminbi, 'substantially' undervalued. It said that despite a 5.5% appreciation against the US dollar in the past year, in fact it had depreciated in both real and nominal terms against a basket of key currencies.
The IMF mapped out a sequence of 'risky' reforms necessary to adapt the country to shifts in its labor market, keep a strong hand on financial bubbles, and give the authorities better tools to manage the world's second largest economy.
It said that letting the yuan appreciate and float would open the door toward other key measures that would include developing more outlets for savings and investment; liberalised, market-based interest rates; better credit allocation; and eventually the dismantling of China's capital controls that prevent the yuan from being an internationally traded currency.
'A stronger renminbi would increase household income, boost consumption, make China's manufacturing products more affordable for the Chinese people, and help build a stronger service economy,' Chalk said.
China manufacturing at 28-month low
Manufacturing activity in China contracted for the first time in a year in July and hit a 28-month low, HSBC data showed today, the latest sign tightening measures are impacting the economy.
However, the figures also indicated that despite several interest rate hikes aimed at tempering stubbornly high inflation the cost of raw materials continued to rise.
HSBC's preliminary purchasing managers index fell to 48.9 in July from a final reading of 50.1 in June, the banking giant said. A reading above 50 indicates the sector is expanding, while a reading below 50 indicates contraction.
The July reading, which is subject to revision when the bank publishes its final figures on August 1, was the lowest since March 2009 and fell below 50 for the first time since July 2010.
The bank said that it expects Chinese industrial growth to decelerate in the coming months as tightening measures continue to filter through. The world's second-largest economy is still likely to grow nearly 9% in the rest of the year, supported by resilient consumer spending and continued massive investment in infrastructure projects, it added.
But what will likely cause a headache for policymakers is data showing the price of raw materials rose at a faster rate in July than the previous month, indicating manufacturers remain under significant inflationary pressure.
Chinese officials have been pulling on a variety of levers to prevent the economy from overheating and rein in inflation - which hit a three-year high of 6.4% in June - amid fears high prices could trigger social unrest.
In a bid to stop money flooding the system Beijing has increased the amount banks must hold in reserve several times - which cut lending 10% in the first half of 2011 - while interest rates have risen five times since October.
Economic growth slowed to 9.5% in the second quarter from 9.7% in the first three months of the year and 9.8% in the fourth quarter of 2010.
