Premier Wen Jibao, when asked about how the Chinese government would deal with the overheating economy as indicated by the expanding money supply, bank credit and fixed investment, in a Reuters interview in April 2004, said: “We need to take effective and very forceful measures to resolve those problems as soon as possible.” A year later, the Premier submitted a report to the National People’s Congress, emphasizing the need for China to pursue a people-centered development strategy and to promote a comprehensive and coordinated development between the economy and the society, between urban and rural areas, and among all regions. Clearly, the major challenge for the Chinese government is to formulate a set of policies that would slow down the rapid growth of the economy, and at the same time, reduce the urban–rural disparity and income inequality. This paper presents the results of a joint research with China’s DRC/State Council on macroeconomic and financial policies that will insure a soft landing and reduce the urban–rural disparity. Due to the economy-wide nature of the issue, a comprehensive ‘financial general equilibrium’ model is developed and used to simulate a set of policy scenarios. It is found that a standalone policy of capital account liberalization tends to enhance growth but worsen the income disparity, while reducing the growth of bank’s credit is likely to generate the opposite effects. By exploring a set of policy mix, it is revealed that there is room for China to tighten credit, and at the same time, liberalize the capital account. This will lead to a soft landing without worsening the income distribution and the rural-urban gap. The short-run increase in the rural-urban migration (among unskilled workers) will gradually decline and eventually cease. The simulation results generally support a gradual liberalization of the capital account.
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