* OECD says Chinese government can afford to spend freely
* Deficit spending needed to rebalance economy, power reforms
* Urges real exchange rate appreciation, more flexible yuan (Adds quotes from OECD chief economist, Chinese official)
By Alan Wheatley and Zhou Xin
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.
Near-term economic overheating was unlikely as the economy had ample spare capacity, the OECD said, forecasting that consumer prices would rise a modest 1.8 percent in 2010.
The OECD said China's 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 more than 5 percent of GDP in 2007.
"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.
"China is an enviable position that it is able to step up social and economic reforms in the context of a rapidly growing economy," Pier Carlo Padoan, the OECD's chief economist, said at a news conference in Beijing to launch the report.
FREE THE YUAN
Developing domestic drivers of growth would go hand in hand with a reduced reliance 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 would eventually require a flexible
exchange rate regime with open capital markets, the OECD said a
first step would be to link the yuan
Making the yuan more flexible right now would likely push up the exchange rate and boost the purchasing power of households. But it would also likely entail a short-term output cost.
"In these circumstances, the authorities may be inclined to wait until inflation becomes a problem once again before allowing an appreciation," the OECD said.
Indeed, Zhang Zhigang, a former vice-minister of commerce, said China must keep its exchange rate stable.
China was still a developing country with per capita GDP far behind that of developed nations, he told the news conference.
"Yes, any small progress multiplied by 1.3 billion will be a big achievement. But likewise, any small problem multiplied by 1.3 billion may be a huge challenge," Zhang said.
"China's technology is advanced enough to send astronauts into space, but most of China's farmland, especially in the west of the country, is still tilled by bulls," he added.
NO BUDGET WORRIES
The OECD dismissed the argument that China 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 Paris-based forum of industrial democracies said.
For a start, social security surpluses were of the same order of magnitude as gross government debt -- about 21 percent of GDP.
And given rapid economic growth, the gross debt ratio would 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.