* OECD says Chinese govt can afford to spend freely
* Deficit spending needed to rebalance economy, power reforms
* Urges real exchange rate appreciation, more flexible yuan
BEIJING, Feb 2 (Reuters) - China needs to run a continued fiscal deficit and let its real exchange rate rise to rebalance its economy towards domestic demand and thus sustain the impressive growth of recent years, the OECD said on Tuesday.
In only its second full-length study of non-member China, the Organisation for Economic Cooperation and Development maintained its November forecast of an acceleration in gross domestic product growth to 10.2 percent in 2010 from 8.7 percent last year.
The report highlights major challenges facing China, including the ageing of the population; income inequalities; fragmented social safety nets; the inability of small firms to access financing; and a lack of incentives for innovation due to weak protection of intellectual property rights.
But Richard Herd, the main author of the study, also pointed to the scope for further gains in productivity to sustain the "stunning" recent rise in living standards as workers move off the land and into cities.
"There's a very quick catch-up process in place at the moment," Herd said in an interview.
Despite its bullish 2010 GDP forecast, which is in line with the 10 percent growth projected by the International Monetary Fund, the OECD said near-term economic overheating was unlikely as the economy currently had ample spare capacity.
Consumer prices would rise 1.8 percent in 2010, an upward revision from its November forecast of a 0.1 percent increase.
The OECD said the fiscal deficit remained small despite Beijing's 4 trillion yuan ($585.9 billion) stimulus programme and advised against a return to the conservative spending policies that left the general government budget in surplus to the tune of over 5 percent of GDP in 2007 on the eve of the global downturn.
"Further out, maintaining strong domestic demand will require a continued fiscal deficit," the report said.
Durably lower government saving was needed to keep reducing China's current account surplus and to pay for further reforms in areas such as education, welfare assistance, pensions and health.
"Greater public spending on education in particular can help both to boost productivity and to reduce inequality," it said.
FREE THE YUAN
Developing domestic drivers of growth will go hand in hand with a reduced on exports, the OECD said.
"In the process, the real exchange rate will need to appreciate, as is normal for a rapidly developing economy where rising incomes push up the prices of non-tradeable goods and services," the report said.
Arguing that China will eventually require a flexible exchange rate regime with open capital markets, the OECD said a first step would be to link the yuan to a basket of currencies and to announce the composition of the basket.
The next stage could involve liberalising capital outflows and a degree of foreign investment in Chinese bond markets.
Making the yuan more flexible right now would likely push up the exchange rate, increase the labour share of income and the purchasing power of households and help reorient investment towards the non-tradables sector of the economy.
"However, it would also likely entail a short-term output cost that might warrant offsetting measures to boost domestic demand. In these circumstances, the authorities may be inclined to wait until inflation becomes a problem once again before allowing an appreciation," the OECD said.
NO BUDGET WORRIES
The Paris-based forum of industrial democracies dismissed the argument that the Chinese government cannot afford to spend freely because it has vast contingent liabilities.
"China's public finance position is remarkably strong and can readily accommodate a permanently higher level of government spending," the OECD said.
For a start, social security surpluses were of the same order of magnitude of gross government debt -- about 21 percent of GDP.
Moreover, the government does not carry the value of its stock holdings (worth 50 percent of annual GDP in mid-2009) on its balance sheet, nor the value of urban land it owns.
And given rapid economic growth, the gross debt ratio will barely budge despite the current stimulus spending, with government net debt not exceeding 3 percent of GDP in 2011.
"Beyond that horizon, and assuming an economic cruising speed of around 10 percent per annum over the medium term, the current level of public spending could be maintained, with the government still achieving a net creditor position over time.
"Hence, there is ample fiscal space to continue to step up public spending in the social sphere even as other types of stimulus spending are phased out," the OECD said. (Reporting by Alan Wheatley; Editing by Jonathan Hopfner)