Massive policy stimulus should keep China growing at a respectable rate this year and next, but a robust recovery is unlikely given global weakness and soft non-government investment, the World Bank said on Thursday.

In a quarterly update, the bank raised its forecast for gross domestic product growth this year to 7.2 percent, still below Beijing's official target of 8.0 percent but up from the 6.5 percent it projected in March. Growth in 2010 was likely to be just a bit stronger, at 7.7 percent, the report said.

The bank expects China's foreign exchange reserves to grow by $218 billion this year, the smallest increase since 2005, after leaping by $419 billion in 2008 and $462 billion in 2007.

That is largely because the bank is now forecasting a whopping capital account deficit of $170 billion this year, driven by a variety of financial outflows including undisclosed transactions between the central bank and financial institutions and a growing stream of outbound foreign direct investment.

These outflows already totaled $109 billion in the first quarter, limiting the increase in FX reserves in the January-March period to just $8 billion. China's reserves were $1.95 trillion at the end of the first quarter, the world's largest stockpile.

There seems to have been an intention to let capital flow out of China in these various guises, Louis Kuijs, an economist in the World Bank's Beijing office, told a news conference.

He said such outflows would chime with China's oft-stated desire to diversify the country's foreign assets. Beijing is hunting in particular for energy and commodity investments.

We may well see in future additional such changes in the composition of capital flows ... given the perception of risks and returns of different types of foreign assets, Kuijs said.

The forecast on reserves brings the World Bank broadly into line with those of private-sector economists. HSBC, for example, expects reserves to grow by $154 billion in 2009.

PLEASE THINK AHEAD

The report welcomed an unfolding surge in government-influenced investment, triggered by a 4 trillion yuan ($585 billion) stimulus package announced in November.

However, it is unlikely to lead to a rapid, broad-based recovery in China, given the current global environment and the subdued short-term prospects for market-based investment. China's economic growth is unlikely to rebound to a high single-digit pace before the world economy recovers to solid growth, it said.

A boom in bank lending in the first five months of the year would also support growth in coming quarters. While the full-year outcome might not meet the official target, it would be very respectable given the global setting, the report said.

On current projections it is not necessary, and probably not appropriate, to add more traditional fiscal stimulus in 2009, the bank said.

With its budget deficit set to leap to 4.9 percent of GDP this year from 0.4 percent in 2008, the government should instead keep some powder dry in case it is needed next year.

Policymakers should also have the confidence to emphasize forward-looking policies and structural reforms to promote service-driven consumption and energy efficiency in the world's third-largest economy, the bank said.

WEAK PRIVATE INVESTMENT

One of the key risks to the bank's growth forecast, which is broadly in line with private-sector projections, is that market-based investment will be lower than expected in light of excess capacity and poor profit prospects in many industries.

A full 6 percentage points of this year's projected 7.2 percent GDP growth will come from spending and investment that is either carried out or directly influenced by the government, with additional stimulus from lower tax revenues, the report said.

Government-influenced investment rose 39 percent in the first four months, up from an estimated 13 percent in 2008; by contrast, market-based investment rose just 12.6 percent, much less than last year's 20 percent increase.

Prospects for the property market were quite good, but the outlook for some other sectors was less favorable as extensive spare capacity was driving down producer prices and profits.

Thus, market-based investment may remain subdued for a while, particularly in manufacturing, where foreign sales make up between one-fourth and one-third of the total, the report said.

With net exports set to subtract from growth in 2009, after contributing 0.8 percentage point of last year's 9.0 percent rise in GDP, the bank forecast that China's current account surplus would shrink to 8.0 percent of GDP this year from 9.8 percent.

In an illustrative scenario of China's medium-term prospects, the bank said exports could grow 9 percent a year over the next decade, 10 percentage points less than in the past 10 years.

That in turn would lower GDP growth by 2 percentage points a year.

This is significant, but not dramatic, compared to average GDP growth of 10 percent in the previous decade, the bank said.

(Editing by Neil Fullick)

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