The nature of China's economic recovery is unlikely to be defined by how much domestic banks lend or the government spends. Instead, a sustainable rebound must depend on a consumer-centric shift in the growth model that can address the long-term problem of alternative overcapacity and overheating.

Growing worries over both inflation and deflation, however, only highlighted a lack of progress on the structural changes needed to wean the Chinese economy off its dependence on export and investment for growth.

Last Wednesday, the State Council vowed to curb overcapacity in not only traditional industries like steel and cement but also the emerging sectors of wind power and polysilicon.

For those who see the glass half full, the statement is interpreted as fresh evidence of Chinese policymakers' confidence in the current economic rebound. Had they not been so sure about the growth momentum, who would risk a premature restriction on investment growth at this critical moment?

For those who insist that the glass is half empty, nevertheless, the warning justifies their concerns about the deflationary pressure that persistent overcapacity will exert on economic growth in the coming years. If redundant projects could have surfaced so quickly in such promising sectors as wind power and polysilicon, how serious will the problem of overcapacity be in traditional industries after this investment boom?

Chinese policymakers have long made use of rounds of macroeconomic control to tackle overcapacity in certain industrial sectors. This problem looks less dangerous in years of red-hot growth, but can lead to disastrous consequences by triggering a vicious deflationary circle in chilly days like what the world economy is suffering.

To make the case more complicated, the National Development and Reform Commission, the pricing authorities, last Thursday asked local authorities to tighten price monitoring and stabilize prices of important products, including food, gas and transport. Meanwhile, it assured that the country would avoid large, widespread and long-term price rise as overall supply would match demand in the foreseeable future.

Though the recent surge in credit and continuous price hikes in stock and property markets that have resulted in rising inflationary expectations across the country have little to do with the pricing authorities, climbing food prices are a real concern.

Sufficient material supply, such as ample reserves of grain and competitive pressures would help stabilize prices, the NDRC said, without providing details.

Admittedly, consecutive bumper harvests in the past five years guarantee grain supply in spite of this year's serious drought, which has left millions of people short of drinking water and has damaged crops on millions of hectares. And as headline consumer inflation remained down 1.8 percent year-on-year in July, declining for seven consecutive months, the pricing authority need not worry too much about inflation.

Yet, pork prices, a key driving force for inflation in this country, have been rising for about 10 weeks.

The hostile tone that the pricing authorities took might indicate that it is already feeling the heat of accelerating inflation. Besides, the surprising change in some local labor markets also demands attention from policymakers. It was reported that a shortfall in labor resources has recently cropped up in some coastal cities like Dongguan and Wenzhou just as overseas orders are piling up.

It is hard to imagine such a thing as labor shortage in the same year when about 20 million migrant workers were found to return home in rural areas jobless before the Spring Festival. But if that is true, labor shortage, as a phenomenon that China's demographic change predicts, will lay the ground for a wage inflation spiral as a long-term process.

Coincidentally, emerging signs of both overcapacities that invite deflation and price hikes that fuel inflation have raised a hard question on the sustainability of an investment-led stimulus package. If China's economic recovery is not to be caught between deflation and overheating, the growth engine of investment must be replaced by domestic consumption as fast and as much as possible now.

(China Daily August 31, 2009)