The World Bank, in its Quarterly Update released Friday, argues that despite the higher than expected growth in 2004, there are clear signs of a slowdown in China's domestic demand.

Bert Hofman, chief of the Economics Unit of World Bank Office in Beijing said, "The 9.5 percent growth for 2004 surprised many, but domestic demand and investment growth are clearly slowing down."

Domestic demand in China grew by only 8.5 percent in the second half of the year over the second half of 2003, compared to almost 11 percent in the first half of 2004, according to the report.

The reason that growth came out at 9.5 percent was the slowdown in imports, and the acceleration of exports.

"The trade balance ended the year with 32 billion US dollars in surplus, while back in April it was still balanced", said Hofman, noting that the slowdown in imports and waning consumer and producer price inflation were further signs of more sustainable growth levels.

The report sees the more sustainable growth as in part resulting from the policy measures taken during 2004.

The World Bank is optimistic on China's prospects for 2005. The report cites a good world economic environment and robust domestic demand as factors.

The World Bank predicts world GDP to grow with 3.2 percent, lower than the record year 2004, but still healthy.

The Bank report welcomes the switch from "proactive" to "prudent" macroeconomics policies, noting that there are still risks of a return to higher investment levels because of the prevailing low real interest rates and the incentives on local governments to pursue growth.

"Prudent monetary policies in our view mean that the PBC (the People's Bank of China, the central bank), should be prepared to raise interest rates again, if and when needed." Bert Hofman said. The report also argues that further interest rate reforms can improve rural finance.

Currently, lending rate limits still apply to rural financial institutions, making it unprofitable to lend to farmers.

Reforms in urban finances, land management, the inter-governmental fiscal system, and the performance evaluation for local governments are needed to redress the issue of local over-investment, the bank says.

The report sees 2005 as not the best year to move to a consumption-based Value Added Tax (VAT), because such a reform would encourage investment. It says a system is being currently tested in northeast China,

The report lauded the rural public finance reforms over the last few years, stating that Rural Tax-Fee Reforms has clearly worked to reduce the burden on the farmers.

The government introduced the Rural Tax-Fee Reforms in 2001, and, in addition, over the last few years many provinces have abolished the agricultural tax.

The report argues that more spending on public services, especially in the rural areas as the government is planning, will be good for equity, and could also bring up consumption.

The report, however, urges for better management of the transfers that have replaced the fees and taxes, and argues that some user fees are still warranted.

Further measures to increase consumption the report mentions are reforming the rural health system and solidifying the pension system.