People’s Republic of China: Selected Issues

This Selected Issues paper examines the decline in the revenue-to-GDP ratio for the People’s Republic of China. In common with most transition countries, China has experienced a sharp decline in fiscal revenues since the initiation of economic reforms, owing mainly to weakness in tax revenues. This paper describes the secular decline in the revenue ratio in China and reviews the factors behind the decline. It also compares China’s experience with that of other transition countries where revenues have tended to decline.

Abstract

This Selected Issues paper examines the decline in the revenue-to-GDP ratio for the People’s Republic of China. In common with most transition countries, China has experienced a sharp decline in fiscal revenues since the initiation of economic reforms, owing mainly to weakness in tax revenues. This paper describes the secular decline in the revenue ratio in China and reviews the factors behind the decline. It also compares China’s experience with that of other transition countries where revenues have tended to decline.

I. The Decline in the Revenue-to-GDP Ratio 1/

1. Introduction

In common with most transition countries, China has experienced a sharp decline in fiscal revenues since the initiation of economic reforms, owing mainly to weakness in tax revenues (Chart 1). 2/ The decline was particularly marked during the last ten years, with the revenue ratio falling from 26 percent of GDP in 1985 to 12 percent in 1995. 3/

CHART 1
CHART 1

CHINA REVENUE AND EXPENDITURE, 1985–95

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 041; 10.5089/9781451807776.002.A001

Sources: Chinese authorities; and staff estimates for 1995.

The revenue decline has not led to a widening of the state budget deficit (as a percent of GDP) because there has been an associated significant cutback in budgetary spending to low levels. The cuts in expenditure have been mainly in spending on social and physical infrastructure, and have been achieved by both a reduction in overall budgetary spending and a diversion of spending off budget. Off-budget spending has in part been financed by the extrabudgetary revenues of local authorities and quasi-fiscal operations, mainly consisting of so-called policy lending of the banking system. Quasi-fiscal operations have in turn placed a burden on monetary policy. Looking forward, the weakness in revenue will limit the ability of the authorities to respond to growing social and infrastructural spending needs, which are likely to increase over the medium term. Moreover, ongoing and planned reforms, including importantly in the state-owned enterprise (SOE) sector, may involve significant increases in budgetary expenditure that will require a corresponding increase in the revenue ratio if they are not to place an additional burden on monetary policy.

This paper describes the secular decline in the revenue ratio in China and reviews the factors behind the decline. It also compares China’s experience with that of other transition countries where revenues have tended to decline. There are both similarities and differences between the experiences. A notable feature in China, given the extent of the decline, is that the revenue ratio is currently very low in relation to most other countries.

2. The revenue decline in China

The revenue decline--that is, the decline in the share of revenue in GDP--has been broad based, being reflected across all the main tax categories. Taxes on income and profits, however, have declined by more than taxes on goods and services or customs duties.

a. Developments

During the 1985-95 period, each of the main tax categories contributed to the decline in the revenue ratio (Table 1). 1/ Revenues from taxes on income and profits fell by 6 1/2 percent of GDP, reflecting mainly a decline of 6 percent of GDP in enterprise income tax revenues. The decline reflected a weakening in revenue from the income tax on SOEs, which fell by over 5 percent of GDP. Revenues from taxes on goods and services declined more modestly, falling by 3 3/4 percent of GDP. General sales taxes (comprising excises, the VAT, and the business tax)--the main component of taxes on goods and services--declined by 3 percent of GDP. The decline would have been larger were it not for the VAT, which increased by 3 1/4 percent of GDP. 2/ Customs duties, which initially amounted to only 2 1/4 percent of GDP, declined by a further 1 3/4 percent of GDP during 1985-95.

Table 1.

China: Revenue Developments, 1985-95 1/

(In percent of GDP)

article image
Sources: Data provided by the Chinese authorities; and staff estimates.

Data were compiled according to the definitions contained in the IMF Manual on Government Finance Statistics, 1986.

Even though China’s VAT has been an important source of revenue, it has not performed as strongly as the VAT in some other Asian countries. China’s VAT differs from most other countries’ VATs in two important respects. First, in addition to consumption, its coverage includes domestic capital goods (i.e., capital goods are taxed but not creditable). 3/ Second, its coverage does not include most services (which are instead subject to the business tax). Adjusting for these differences, in 1994 the productivity of the VAT (defined here as the share of VAT revenue in GDP divided by the standard VAT rate) was less than 0.3 percent of GDP in China, compared with over 0.4 percent of GDP in a sample of Asian countries. 1/ (For example, if the standard VAT rate were 17 percent in all countries, the productivity difference of 0.1 percentage points would indicate that VAT revenue in China was 1.7 percent of GDP lower than in other countries.) The relatively low productivity may be attributed to a number of structural and administrative factors, including widespread VAT exemptions on imports, high claims for export VAT refunds, fraudulent invoices for claiming input tax credits, and the relatively low business tax rates on major services.

In sum, with the decline in tax ratios more pronounced for taxes on income and profits than for other categories, the composition of tax revenue has changed. The share of taxes on goods and services in tax revenue rose from 47 percent in 1985 to 69 percent in 1995, while that of taxes on income and profits fell from 34 percent to 18 percent and that of customs duties fell from 9 percent to 4 percent. 2/

b. Underlying factors

The longer-term decline in the tax ratio has resulted from the interplay of three main factors: a tax policy that has given extensive tax exemptions and concessions together with institutional changes that have lowered the “effective” tax rate for key sectors; changes in the structure of economic activity, which led to an erosion of important tax bases along with an increase in the importance of sectors not adequately integrated in the tax net; and weaknesses in tax administration. 3/ In addition, tax exemptions and concessions have often been granted on an ad hoc basis.

i. Tax policy and institutional changes

The tax system has included widespread tax exemptions and concessions. Various income tax incentives have been provided, including in particular to foreign-funded enterprises (FFEs). 4/ Until 1994, income tax incentives to FFEs included a lower standard tax rate (33 percent) than applied to domestic enterprises (55 percent). In Special Economic Zones, a lower rate of 18 percent (of which 3 percentage points represented income tax levied by local authorities) has applied to both FFEs and domestic enterprises. In other open economic areas, however, lower rates have applied only to FFEs. Tax concessions have also been provided to FFEs contracted to operate for more than ten years, provided that they are in selected sectors such as the high-technology, or highly export-oriented (i.e., with exports comprising more than 70 percent of output), or infrastructural sectors. In addition, local authorities can choose to offer exemptions on the 3 percent local income tax. Mainly as a result of such incentives, in 1994 tax revenue from FFEs amounted to only about 7 percent of tax revenue and less than 1 percent of GDP, even though FFEs accounted for 29 percent of exports and at least 6 1/2 percent of GDP. 1/ Under the domestic enterprise income tax, a variety of tax incentives are provided. 2/ The revenue loss from these incentives is estimated at about 0.2 percent of GDP. In addition, tax exemptions are often granted outside explicitly-stipulated incentive provisions, possibly with significant revenue implications.

Under the VAT, several refunds have been provided in addition to those warranted by the zero-rating of exports and VAT-exemption of some imports. 3/ These included refunds to FFEs established before 1994, on account of the guarantee given to these enterprises (effective for the period 1994-98) that the new tax system would not of its own account increase their tax burden relative to the old system, and refunds to local governments to honor temporary exemption agreements the latter had entered into with enterprises. The revenue forgone due to these refunds is estimated to have amounted to about 0.4 percent of GDP in 1994.

Various concessions are provided on trade taxes, especially to FFEs. Imports of machinery and equipment, vehicles used for production, and inputs for the production of exports are imported free of customs duty and VAT on imports. 4/ In addition, duty exemptions have often been provided on an ad hoc basis. Reflecting in part these exemptions and concessions, the effective tariff rate (that is, tariff revenue as a percent of the value of imports) is estimated at less than 5 percent compared with an average nominal tariff rate of 36 percent.

Institutional changes in the tax system, especially with regard to taxation of SOEs, have gradually reduced the budgetary obligations of the SOE sector. In effect, the income tax rate on SOEs was, over a ten-year period, reduced from 100 percent to 33 percent. Until 1984, all SOE profits and depreciation funds were regarded as part of budgetary revenue, representing an effective income tax rate of 100 percent. In 1984-85, with profit remittances being largely replaced by profit taxes and depreciation funds placed under the control of SOEs, the effective income tax rate on SOEs was lowered. In 1986-87, there was a further effective reduction as the contract responsibility system (CRS), which had been in place since the early 1980s, was extended to a large number of SOEs. By 1990, over 80 percent of industrial SOEs had adopted the CRS. The main feature of the CRS was tax payment according to negotiated tax contracts rather than a standardized tax schedule. 1/ The CRS was abolished in January 1994, as part of the tax reform, and the existing enterprise income taxes (on SOEs, collectives, and private enterprises) were merged into a unified domestic enterprise income tax which was levied at the standard rate of 33 percent. 2/

The reform process was accompanied by a gradual erosion of the central government’s control over fiscal policy. One consequence of the erosion was a shrinking of budgetary revenue, often accompanied by a buildup in extrabudgetary revenue. The complex, contract-based nature of intergovernmental fiscal arrangements--related to the sharing of revenue between central and local governments and the grants or transfers made by the central government--and the local management of tax administration (discussed below) led to a tendency among local governments to concentrate on local revenue bases and, where it was in their authority, to build them up at the expense of tax bases that were shared with the central government. 3/ The promotion of local revenue bases (including extrabudgetary revenue bases such as the retained earnings of local SOEs) included the setting up of locally-owned SOEs, granting various tax incentives and reliefs on the income tax of locally owned SOEs, and granting generous tax reductions and exemptions on indirect taxes (which were taxes shared with the central government). Local enterprises retained the corresponding resources as part of their extrabudgetary funds, which local governments often used for local projects.

ii. Structural and institutional changes

The traditional tax bases in China have been eroded by significant changes in the structure of economic activity, with the main sources of revenue declining in importance and the rapidly growing sectors not sufficiently integrated in the tax net. There are several ways of viewing the changes in the tax bases: including from the production side (the declining importance of the SOE sector), the income side (changes in the composition of factor income between wages and profits), and the expenditure side (the rising share of exports and consumption in GDP). 1/

• On the production side, the state sector, whose output has traditionally been a major part of the tax base, has declined in significance. The share of SOEs in gross industrial production fell by more than half during the past decade, from 70 percent in 1985 to 34 percent in 1994. The output of the rapidly growing nonstate sector, however, tended to be lightly taxed mainly due to tax exemptions.

• Concerning factor incomes, the share of profits (especially of SOEs), which traditionally made the main contribution to tax revenue, has declined relative to wages, which have been taxed relatively lightly. The erosion of the tax base partly stemmed from the continued weak financial performance of SOEs, with over 40 percent of SOEs being loss-making in 1994-95. Moreover, the share of wages in SOE industrial output increased from 11 percent in 1985 to 20 percent in 1994. Since revenues from social funds (which are based on payroll taxes) are not included in the state budget, while profit taxes are, a rising share of wages relative to profits has contributed to a weakening in budgetary revenue.

• On the expenditure side, the share of consumption in GDP has declined steadily, from 66 percent in 1985 to 57 percent in 1994 and 1995 (representing the counterpart in the national accounts to the steady rise in the national saving rate). 2/ This has adversely affected taxes on goods and services (which, as mentioned, are levied mainly on consumption and, to an extent, on capital goods). 1/ Also on the expenditure side, there has been strong growth in exports, whose share in GDP has risen significantly, from 9 percent in 1985 to 21 percent in 1995. 2/ Production of exports has, however, been relatively lightly taxed, in part on account of the concessions given to FFEs, so that exports have contributed more to GDP than to revenue.

iii. Tax administration

There have been significant weaknesses in tax administration. The 1994 fiscal reforms sought to address many of these weaknesses, but their full effects will be realized only over time and tax administration is still adapting to its new structure and tasks. 3/

A key problem was the lack of a nationwide tax administration. Unlike in most countries, the bulk of tax collection in China was undertaken by local governments rather than the central government. The State Tax Bureau and the tax bureaus at lower levels of government defined the tax laws for their subordinate administrations and granted tax exemptions and reliefs within their authority. At local levels, tax bureaus were matched by finance bureaus whose responsibilities included formulating and administering local budgets and representing the government as formal owner of local SOEs. The latter responsibility often led to finance bureaus having an interest in tax preferences and exemptions being granted to local SOEs, leading in turn to tensions with tax bureaus and complicating tax administration.

Other features of the tax administration system further weakened its effectiveness. First, the tax administration system was not organized on a functional basis but was instead based on types of taxes and enterprises. A tax official assigned to a given number of taxpayers was responsible for all of the tax functions--including collection, administration, and inspection--which often led to officials having more discretion than was appropriate. Second, the system made only limited use of tax self-assessment by taxpayers, with enterprises having little or no responsibility for computing their own taxes (this being done by tax bureaus instead). This hampered the enforcement of enterprise income taxes and also the administration of individual income taxes. Third, methods of tax payment were cumbersome and the audit system was inefficient. Audit selection and audit procedures, for example, did not limit audits to those most likely to default on their tax obligations, and were consequently not always well targeted. 1/

c. Fiscal reforms

The fiscal reforms launched in January 1994 were aimed at addressing the main weaknesses in the fiscal system, including with regard to revenue buoyancy, and included fundamental changes in the tax system, intergovernmental fiscal relations, and tax administration. Although a significant effect on revenue buoyancy has not yet been realized, the reforms involved changes whose effects will be important over the longer term. The then-existing multiple income taxes on domestic enterprises (including SOEs, collectives, and privately enterprises) were merged into a uniform tax, and the tax base was broadened. A new personal income tax applicable to both Chinese and foreign individuals (although with different deductions) was introduced, replacing the two separate taxes that had hitherto applied. The objectives of the tax included reducing the high tax rates on private business owners, with a view to increasing tax compliance. Indirect taxes were greatly simplified with the introduction of a broad-based VAT covering production, wholesale and retail trade, and imports.

The complex, contract-based intergovernmental revenue system was replaced by a more transparent stipulation of tax assignment and revenue sharing between the central and local governments. The reform aimed to strengthen the central government’s role in fiscal policy. An important objective was to raise the central government’s share in revenue (before transfers) to 60 percent over the medium term. The share increased from 34 percent in 1993 to 56 percent in 1994. The reform may in addition have helped overall revenue collection by curtailing the scope for ad hoc tax exemptions by local governments, including through standardization of deductions on important taxes (like the enterprise income tax) and changes in tax administration (discussed below). In March 1994, local governments were required to further strengthen revenue collection following passage of the Budget Law. The Law, among other things, effectively required local governments not to run budget deficits, by ruling out central government transfers, bond issues, or bank borrowing as sources of financing for local deficits.

The new intergovernmental fiscal arrangements were supported by a new structure of tax administration. Locally based tax administration was split between a National Tax Service responsible for collecting taxes that accrued wholly or in part to the central government, and Local Tax Services responsible for collecting taxes that accrued only to local governments. A much higher measure of self-assessment was introduced in major taxes, including the enterprise income tax.

3. China and selected transition countries: A broad comparison of the revenue declines

There are both similarities and differences between the experiences of China and other transition countries. Similarities include, first, the fact that a significant deterioration in fiscal revenue did also occur in several other countries during the process of transition. 1/ For example, in the Baltic countries and several other countries of the former Soviet Union during the initial years of transition (1991-93) revenue declined on average by 8 percentage points to 27 percent of GDP (Table 2). 2/ Second, the sources of the revenue decline in the other countries did, like in China, include aspects of the tax policy framework, including failure successfully to integrate dynamic sectors into the tax net; weaknesses in tax administration; and structural changes in the structure of economic activity leading to erosion of traditional tax bases.

Table 2.

Selected Countries: Revenue Developments, 1991-93 1/

(In percent of GDP)

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Sources: Richard Hemming and others (op cit., page 78); and Chinese authorities.

Subsequent to publication of the paper from which the main part of this table was drawn, there were revisions to the data. The revisions were not, however, large enough to affect the broad comparisons made in the present paper.

Excluding Russia.

There are, however, important differences between the experience in China and in other countries. First, a comparison of the level of revenue ratios indicates that the extent of the decline has been unusually large in China, with the result that the revenue ratio is low by international standards. In 1993, for example, it was only half of the average ratio in the transition countries listed in Table 2. In part, however, the levels are difficult to compare because, while China’s revenue ratio has declined over a sustained period, in the other countries the decline has been more recent. By way of comparison, in western Europe, the average ratio of tax revenue (alone) to GDP was 40 percent; in eastern Europe, the overall revenue ratio was 41 percent; in the former Soviet Union, it was 29 percent; and in a sample of Asian economies--Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, and Thailand--it was 22 percent.

Second, the composition of the revenue decline has been different in China than in many other countries. In the transition countries listed in Table 2, each of the major taxes contributed to the revenue decline, with the exception of trade taxes. 3/ The major contribution to the decline came from taxes on goods and services, especially the value-added tax (VAT). Enterprise income taxes also contributed but their role was less significant. In China, as discussed, the decline in the revenue ratio reflected declines in all of the major tax categories: taxes on income and profits (or direct taxes) and taxes on goods and services (or indirect taxes), as well as trade taxes (i.e., customs duties). The largest contribution came from enterprise income taxes, which accounted for nearly half of the fall in the overall revenue ratio during the 1985-95 period (and during the 1991-93 subperiod). Indirect taxes made a smaller contribution, accounting for little over a quarter of the revenue decline during 1985-95 (and rising marginally during 1991-93). In fact, the share of VAT revenues in GDP actually increased during the period (in part because of the broadening of its base in 1994).

In this respect, the experience of China may have been closer to that of the transition economies of central and eastern Europe, where the decline was in general more pronounced than in the countries listed in Table 2 and also accounted for mainly by taxes on income and profits. The revenue ratio in the central and eastern European transition countries fell by 10 percent of GDP during the 1989-91 period, and by a further 3 1/2 percent of GDP by 1993. All of these economies experienced declines of revenue relative to GDP during the transition process, although to widely varying degrees. 1/ During the period 1989-93, total’ general government revenue declined by 20-30 percent of GDP in Albania and Bulgaria; by about 20 percent in Romania; and by 5 percent in Hungary; but rose by 5 percent in Poland. In all cases, revenue losses from domestic turnover taxes and, like in China, from taxes on corporate income in particular accounted for the larger share of the overall decline in the revenue-to-GDP ratio.

Third, in terms of the sources of the decline, in most of the other countries, the immediate reason for the fall in revenue was believed to be the sharp fall in output, in contrast to China where real GDP has grown on average by 8-9 percent annually since the initiation of reforms. 2/

4. Conclusion

The ongoing decline in the revenue ratio in China is a cause for serious concern, including in terms of the additional resources needed for meeting prospective demands on the budget, the accompanying compression in spending on social and physical infrastructure, and the burden placed on monetary policy. Aspects of the tax system, in the areas of tax policy and institutions as well as tax administration, and structural changes have contributed to the revenue decline. The fiscal reforms launched in 1994 involved measures to improve the tax structure and institutions and to strengthen tax administration. Gains in revenue buoyancy have not materialized, however, as reflected in a further decline in the revenue ratio in 1994 and 1995. In part, this may have owed to lags in realizing the full gains of the reforms and the phasing in of some of the measures. Revenue performance has continued to be undermined, however, by widespread import tax exemptions, income tax concessions, and growing tax evasion and arrears, pointing to a need for significant further measures in the areas of tax policy and tax administration, in the direction indicated by recent efforts to scale back tax incentives and deepen implementation of fiscal reforms.

1/

Mr. Arora (ext. 36211) or Mr. Norregaard (ext. 36383) is available to answer questions related to this paper before the Board discussion.

2/

Owing to incomplete information for earlier years, the paper presents data relating only to the period after 1985. Information on budgetary financing operations, necessary for conversion of historical official data to GFS format, were not available for the earlier period. Official data do indicate, however, that the ratio of fiscal revenue to GDP rose from 29 percent in 1970 to 31 percent in 1978 and declined steadily thereafter.

3/

The definition of fiscal revenues referred to in this paper comprises the total budgetary revenues of the central and local governments.

1/

Tax revenue accounts for over 90 percent of overall revenue. Nontax revenue was a major source of revenue in earlier years, when it included a large share of SOE funds (mainly profit remittances and depreciation funds). It became less important after 1984 when SOE profit remittances were for the most part changed to taxes, and recently it has amounted to less than 1 percent of GDP.

2/

In part, the performance of the VAT reflected the widening of the VAT base through the inclusion of other indirect taxes during the 1994 tax reforms (discussed below), but it is notable that the VAT ratio increased even during the period before 1994.

3/

Capital goods imported by FFEs, representing a significant proportion of total imports, are, however, exempt from the VAT.

1/

The sample included Indonesia, Japan, Korea, the Philippines, Singapore, and Thailand. The adjustments made in estimating the VAT productivity for China involved inclusion of the revenue from the business tax and exclusion of the potential revenue contribution from capital goods (which were estimated by the authorities to contribute roughly one third of the tax base for the VAT).

2/

The share of other taxes remained unchanged at about 10 percent.

3/

See Wanda Tseng and others Economic Reform in China: A New Phase (Washington DC: IMF Occasional Paper No. 114, November 1994), Chapter IV, for a comprehensive discussion of weaknesses in the fiscal policy framework and of the fiscal reforms launched in 1994.

4/

See Chapter IV of SM/95/44, issued on March 9, 1995, for a summary of China’s foreign investment policies and incentives.

1/

In 1996, the authorities intended to significantly scale back the incentives system and to provide incentives mainly for investment in priority sectors, such as infrastructure, and in the inland areas.

2/

See Chapter V of Wanda Tseng and others (op cit.). Incentives under the domestic enterprise income tax are provided under 11 broad eligibility criteria.

3/

The broad-based VAT introduced in 1994 involved the zero rating of exports (in line with international practice), although, due to the rebates having been deemed excessive, the rate of refund on input VAT paid on production of exports was reduced from 17 percent to 14 percent in July 1995, and further to 9 percent in January 1996. In addition, some categories of imports, including, as mentioned, capital goods imported by FFEs, are exempt from the VAT.

4/

In 1996, it was intended that concessions on imports of machinery and equipment would be among the incentives to be terminated.

1/

Tax contracts were designed to balance the need for government revenue with the objective of increasing the autonomy and financial accountability of SOEs by giving them control over a larger share of their funds.

2/

SOE profits, apart from taxes, had also been subject to special levies. These levies were abolished in January 1994.

3/

An important related consequence was the shrinking share of the central government in total revenue. The share (before transfers) fell from 50 percent in 1985 to 36 percent in 1993.

1/

Lack of sufficiently detailed information concerning the various tax bases makes it difficult to quantify the relative importance of each of the factors referred to below. A further caveat to this discussion is warranted insofar as there is often, as in most countries, a discrepancy between the tax bases defined in tax laws and those to which the laws are applied in practice.

2/

These consumption estimates were derived residually, based on official data for investment and the external current account. In 1995, the authorities published an independent set of consumption data which only indicated a decline in the consumption-GDP ratio from 64 percent in 1985 to 59 percent in 1994.

1/

For example, if the standard rate of tax on consumption is 17 percent, then a reduction of 10 percentage points in the share of consumption in GDP would lead, to a first approximation, to a reduction in the revenue from consumption taxes of 1.7 percent of GDP.

2/

These data refer to exports of goods and nonfactor services.

3/

See Annex III of the forthcoming World Bank report, China: Updating Country Economic Memorandum, 1996 for a discussion of tax administration needs in China.

1/

Problems in tax administration have been an important factor behind indications of growing tax evasion and tax arrears.

1/

See Richard Hemming, Adrienne Cheasty, and Ashok Lahiri, “The Revenue Decline” (Chapter V) in Daniel Citrin and Ashok Lahiri (editors) Policy Experience and Issues in the Baltics, Russia, and Other Countries in Transition (Washington, DC: IMF Occasional Paper No.133, December 1995) for a comprehensive discussion.

2/

In the transition economies of eastern Europe, the decline in the revenue ratio was more pronounced. The ratio fell by over 10 percent of GDP during the 1989-91 period, and by a further 3 1/2 percent of GDP by 1993. See Gerard Belanger, “Eastern Europe: Factors Underlying the Weakening Performance of Tax Revenue”, IMF Working Paper WP/94/104, September 1994, for a discussion of the eastern European experience.

3/

The buoyancy of trade taxes was attributable in part to the replacement of wide-ranging quantitative trade restrictions by tariffs.

1/

See Gerard Belanger (op cit.).

2/

See Hemming and others (op cit.). In a few countries (Kazakstan, Tajikistan, Ukraine, and Uzbekistan), the revenue ratio increased, mainly owing to special factors.

People’s Republic of China: Selected Issues
Author: International Monetary Fund