People’s Republic of China: Selected Issues

This Selected Issues paper analyzes state-owned enterprise (SOE) development and reform in China. The paper discusses the role of state ownership in the Chinese economy, providing a “snapshot” of key features of the state sector, and a review of the growth, efficiency, and profitability of SOEs. The paper argues that economic performance in SOEs has declined in the last few years as evidenced by falling profitability, increasing losses, growing industrial inventories, and low rates of capacity utilization in some sectors. The paper also examines banking sector development and policy issues in China.

Abstract

This Selected Issues paper analyzes state-owned enterprise (SOE) development and reform in China. The paper discusses the role of state ownership in the Chinese economy, providing a “snapshot” of key features of the state sector, and a review of the growth, efficiency, and profitability of SOEs. The paper argues that economic performance in SOEs has declined in the last few years as evidenced by falling profitability, increasing losses, growing industrial inventories, and low rates of capacity utilization in some sectors. The paper also examines banking sector development and policy issues in China.

V. External Sector Opening1

A. Introduction

1. The gradual liberalization and opening of the external sector has been a key element of China’s economic reforms in the past two decades. Prior to 1978, China’s exchange and trade system was based on the foreign exchange and trade plans, which were integral parts of the overall economic planning system and regulated the allocation of foreign exchange as well as exports and imports. A high degree of autarky was an important objective. The role of imports was to fill domestic shortfalls in raw materials and capital goods, and exports were planned so as to generate the foreign exchange necessary to pay for imports, with the trade balance generally in moderate surplus.2 With external borrowing strictly controlled through the foreign borrowing plan, external debt in relation to GDP was very low,3 and the economy was practically closed to foreign direct investment.

2. Since the late 1970s, wide-ranging reforms have been introduced to open the Chinese economy. This chapter discusses the main features of this process, focussing on three key areas: the exchange system, the trade system, and foreign direct investment.4 Even though progress with external sector reforms has not always been even, much has been achieved. The exchange regime has been transformed into a market-based system with current account convertibility, and the trade system has been freed from the shackles of central planning. China’s “open door” policy towards foreign direct investment (FDI) within the framework of open economic zones5 has led to a steady rise and, since 1993, a surge in FDI inflows. Controls on other capital flows have been maintained, and although external debt has increased significantly, it has remained moderate in relation to the size of the economy.6 While these results are impressive, challenges lie ahead. In the trade system, tariffs are still high and nontariff restrictions numerous. In the area of foreign direct investment, the many foreign-funded enterprises (FFEs)7 established in recent years have yet to be fully integrated into the domestic economy.

B. Reform of the Exchange System

3. At the beginning of reforms in the late 1970s, foreign exchange was allocated administratively on the basis of the foreign exchange plan. Foreign trade was managed by a handful of foreign trading companies (FTCs), which executed the trade plan under the auspices of the Ministry of Foreign Trade, transactions between FTCs and domestic enterprises were carried out at a variety of different settlement rates,8 while FTCs and the Bank of China (BOC) traded at the official exchange rate, which then was determined on the basis of a basket of currencies. With the increasing decentralization of trade and the scaling back of mandatory planning, however, changes in the allocation mechanism of foreign exchange became necessary.

4. The transition to a market-based exchange system, like other reforms in China, was gradual and experimental, spanning a period of some 15 years. The transitional arrangements were based on three key elements: an exchange retention quota system, which gave firms with foreign exchange earnings the right of disposal over part of their earnings; varying types of arrangements for trading retention quotas, which eventually developed into a rudimentary foreign exchange market; and, associated with these arrangements, multiple exchange rates, which permitted a gradual increase in the share of transactions carried out at market-oriented exchange rates.

5. Foreign exchange retention quotas were introduced as early as 1979. While foreign exchange earnings from exports were subject to a general surrender requirement, the retention quota system allowed firms to obtain foreign exchange for imports at the official exchange rate equivalent to a certain proportion of their earnings. The quotas were initially relatively low, around 25 percent, but were raised significantly in the second half of the 1980s, particularly in 1988. By the end of the decade, a complex system of quotas differentiated by region, industrial sector, and type of exports (“in” or “above” plan) had evolved.9 Retention quotas were streamlined in 1991 with the introduction of a uniform quota of 80 percent for general commodities,10 and a clearly defined scheme for the allocation of quotas between FTCs, originating enterprises, and local governments, which previously had varied considerably.11 Some sectoral differentiation was, however, retained,12 and the central government reserved the right to buy back part of the quota allocated to FTCs and producing enterprises at the monthly average exchange rate at foreign exchange adjustment centers.13 The retention quota system applied mainly to domestic enterprises, while FFEs could chose to retain their foreign exchange earnings directly in foreign exchange accounts.14

6. In order to enhance the role of the retention quotas, trading mechanisms were needed. In 1980, some localities began to allow trading (swaps) of excess retained foreign exchange between firms. These swaps had to be carried out through the BOC at exchange rates that were permitted to fluctuate within narrow margins around the rate used for the surrender of foreign exchange. Given these constraints, as well as some restrictions imposed subsequently on the use of accumulated retention quotas,15 the scope of these early swap transactions remained limited.

7. Independent swap centers were set up on an experimental basis in 1985-86. Initially, access to these foreign exchange adjustment centers (FEACs) was restricted to FFEs16 and the exchange rate remained controlled. In 1988, however, trading at market-determined exchange rates was allowed,17 and all enterprises with retention quotas were granted access to FEACs. As a result, both the number of such centers and the volume of transactions expanded rapidly.18 In late 1991, all domestic residents were allowed to sell foreign exchange at the swap rate at designated bank branches, implying virtually unrestricted access to the market for sales. Access for purchases required, however, approval by the State Administration of Exchange Control (S AEC), and was guided by a priority list, which included key imports as well as foreign debt service payments.19 Nevertheless, although the swap centers were not fully integrated at the national level, they developed into a nascent foreign exchange market.20

8. The coexistence of different types of foreign exchange allocation mechanisms entailed multiple exchange rates during most of the transition period. In 1981, following the introduction of retention quotas, the system of multiple internal settlement rates employed earlier was replaced by a single internal settlement rate, which was more depreciated than the official exchange rate. This rate was used for all trade-related transactions (including initial swaps of retention quotas), while the official exchange rate applied to non-trade-related transactions. Subsequently, the official exchange rate was allowed to depreciate gradually toward the internal settlement rate and from early 1985 on, all transactions were carried out at the official exchange rate (Chart V.1).

CHART V.1
CHART V.1

CHINA: EXCHANGE RATE DEVELOPMENTS, 1980-1997 1/

Citation: IMF Staff Country Reports 1997, 072; 10.5089/9781451807783.002.A005

Sources: Data provided by the Chinese authorities; and staff estimates.1/ Monthly averages; downward movement indicates depreciation of the renminbi.2/ On January 1, 1994, the exchange rates were unified at Y 8.7 per U.S. dollar. Since then the rate has been determined in the interbank market.3/ These centers were established in late 1966, but the exchange rate in the centers became market-determined only in 1988.

9. A multiple exchange rate system reemerged soon with the establishment of the FEACs.21 The exchange rate prevailing in these centers was considerably more depreciated than the official rate, which applied to the surrender of export earnings, priority imports, and many non-trade-related transactions, including foreign exchange certificates (FECs).22 The gap between the official exchange rate and the swap market rate narrowed in 1990-91 with two devaluations of the official rate,23 but widened again in 1993 when the swap rate depreciated sharply against the background of an overheating economy and a deterioration in the trade balance. Initial efforts to cap the swap rate were soon abandoned and eventually gave way to a sweeping reform of the exchange system.

10. On January 1, 1994, the exchange rates were unified at the prevailing swap market rate, the retention quota system was abolished,24 and FECs were discontinued.25 Although domestic enterprises continued to be subject to a surrender requirement for trade- and non-trade-related foreign exchange receipts, they were allowed to hold foreign exchange accounts in connection with several types of transactions, such as foreign borrowing and stock issues and approved debt service payments.26 More importantly, access to the foreign exchange market for most trade and trade-related transactions no longer required SAEC approval.27 SAEC approval was still needed for non-trade-related current payments by Chinese nationals, such as travel expenses, and for FFEs that wished to access the swap market.28

11. Shortly after the unification of the exchange rates, in April 1994, a nationally integrated electronic trading system, the China Foreign Exchange Trading System (CFETS) was established to link major swap centers with the interbank market and overcome the fragmentation of the regional swap markets. The CFETS quickly developed into a unified wholesale foreign exchange market,29 even though the rules for participation differed for domestic and foreign banks,30 as well as domestic enterprises and FFEs.31 The exchange arrangement was a managed float, with the People’s Bank of China (PBC) intervening through purchases and sales of foreign exchange.32

12. Reforms in the exchange system since the 1994 unification have focused on the removal of the remaining restrictions on current payments and transfers to pave the way for acceptance of the Fund’s Article VIII. Regulations concerning FFEs’ access to the foreign exchange market were eased in 1995,33 and in 1996, the restrictions associated with the foreign exchange balancing requirement for these enterprises were removed.34 Limits on purchases of foreign exchange for current payments and transfers became indicative, with SAEC35 indicating access for all bona fide current transactions.36 Following these changes, China accepted the obligations of Article VHI effective December 1, 1996.

C. Reform of the Trade System

13. In the reform of China’s trade system over the past two decades, the expansion of trading rights and gradual phasing out of mandatory planning have played a key role. However, as the system became more decentralized and the plan was scaled back, other instruments to regulate exports and imports, such as tariffs and licenses, gained importance. At the beginning of the 1990s, China’s trade regime was characterized by a complex and rather intransparent system of high and widely differentiated tariffs as well as numerous, frequently overlapping, nontariff trade barriers (NTBs). Since then some progress has been made scaling back theses measures, but a broad-based liberalization lies ahead.

14. The proliferation of FTCs has been instrumental in the decentralization of China’s trade system. From a dozen of companies executing foreign trade in the late 1970s, the number of state-owned FTCs rose to 1,200 in the mid 1980s and to more than 9,000 in 1994.37

15. Although in the 1980s, FTCs still operated within the constraints of the existing planning system, their scope for trading on their own account increased as mandatory planning was scaled back. Moreover, the range of products in which individual FTCs were allowed to trade was expanded significantly over time.38 Nevertheless, with part of their business still subject to plan targets and many domestic prices of imports still under control,39 FTCs incurred substantial losses, which required budgetary subsidies averaging 2 percent of GDP per year in the second half of the 1980s.40 These losses declined after 1991, following a series of adjustment in domestic prices for imports,41 the abolishment of the mandatory export plan, and the elimination of budgetary subsidies on exports.

16. While FTCs are allowed to trade in a wide range of products, producing enterprises have been granted trading rights only for their own products and their inputs. Whereas FFEs have tended to have access to such direct trading rights from the outset, for a long time only a small number of domestic enterprises enjoyed this right.42 In recent years, however, access to trading rights appears to have increased, with direct trade by domestic producing firms accounting for 17 percent of exports and 8 percent of imports in 1994. Nevertheless, the share of producing enterprises with direct trading rights is still relatively modest.43

17. Along with the decentralization of the foreign trade system during the 1980s, mandatory planning was gradually scaled back. The export plan was split into mandatory and guidance components, while on the import side, the mandatory plan was supplemented by a list of priority imports for key national projects. By 1986, mandatory planning had been reduced to 60 percent of exports and 40 percent of imports. Some 20 percent of exports were subject to guidance,44 with the remainder handled as “above plan” exports. The import priority list covered 30 percent of imports, and the remaining 30 percent were controlled through licensing. Mandatory trade planning declined further in the late 1980 and was abolished in 1991 for exports and in 1994 for imports.

18. As decentralization progressed and the role of the mandatory trade plan declined, instruments such as licenses and tariffs, which had been of minor importance at the beginning of the reforms, became increasingly important in regulating exports and imports.45 Many products that had been under the mandatory trade plan continued to be controlled through canalization, which limited exports and imports to a relatively small number of FTCs.46 In 1992, after the abolition of the mandatory export plan, some 15 percent of exports were still subject to canalization. On the import side, canalization covered close to one third of total trade, although the scope of the mandatory import plan had been reduced to 18 percent of imports.47

19. NTBs such as licenses and quotas expanded during the 1980s. A complex system of frequently overlapping measures evolved, which often also applied to products subject to canalization.48 Import licensing was used to allocate quotas or influence imports in line with domestic or balance of payments objectives, while import controls were employed in certain sectors to protect domestic producers.49 Export licenses and quotas helped to influence the domestic supply of exportables, implement agreements with trading partners, and regulate export volumes in markets where China had a substantial market share. The share of imports subject to licensing appears to have approached one half in 1989,50 but declined subsequently to about one quarter in 1992. Half of the imports covered by licenses in 1992 were also subject to canalization. In addition, close to 8 percent of imports were affected by import controls (Table V.1). Export licensing was estimated to have affected close to two thirds of exports in 1987 but its scope declined significantly thereafter to about one half in 198951 and 15 percent in 1992.52

Table V.1.

China: Nontariff Measures, 1992 and 1996

article image
Source: World Bank estimates.

The measures are partly overlapping.

Based on 1992 trade weights.

Imports subejct to state trading can only be handled by a small number of FTCs.

Imports subject to designated trading can be handled by a larger, but still restricted, number of FTCs.

Licensing and quota restrictions are largely overlapping. At end-1996, all products subject to quotas were also subject to licensing requirements. Quotas are determined by the State Planning Commission (SPC).

Rights to import products subject to import tendering are sold to enterprises through a tendering process.

20. NTBs were complemented by an increasingly complex tariff system. Average import tariffs in China in the early 1990s were higher than in the mid-1980s53 and generally well above those in many other Asian countries (Table V.2). Tariff rates were widely dispersed, with rates above 100 percent for certain “nonessential” consumer goods, such beverages and tobacco, and rates in the 5-20 percent range for certain agricultural and industrial inputs, such as fertilizers and metals, as well as a number of capital goods.54 The impact of high import duties was, however, partly offset by a relatively generous, albeit complex, system of duty exemptions, mainly for imports related to export production, FFE imports, and border trade. Tariffs were also imposed on a significant number of exports, which increased during the 1980s

Table V.2.

China: Average Import Tariff Rates for China and Selected Asian Countries 1/

(In percentage points)

article image
Source: World Bank, World Development Indicators.

For the period 1990-93.

21. The complex system of tariffs and NTBs that evolved during the 1980s called for an new round of trade reforms. China’s application to resume its membership in the General Agreement on Tariffs and Trade (GATT), and bilateral negotiations with the United States55 provided additional impetus. Against this background, import tariffs have been reduced on several occasions in the past five years, starting with two rounds of tariff cuts in January and December 1992.56 The latest round of cuts was included in the April 1996 trade package, with reductions in tariffs covering almost two thirds of imports.57 As a result, the unweighted average import tariff fell from close to 40 percent at end-1992 to 23 percent at end-1996, while the weighted average tariff declined from 31 percent to 20 percent (Table V.3).58 The authorities envisage a further reduction in the unweighted average import tariff to around 15 percent, the developing country average, in the next few years.59 The tariff cuts have resulted in a reduction in the dispersion of tariffs. Moreover, they have been accompanied by a scaling back of duty exemptions.60 Nevertheless, tariff revenue in relation to imports has remained small, averaging less than 3 percent in the past 2 years.

Table V.3.

China: Import Tariffs, 1992-96

(In percent, at end-year)

article image
Sources: World Bank and staff estimates.

Calculated on the basis of 1992 import shares.

Ratio of imports subject to tariff concessions to total imports; based on c.i.f. customs values. Concessional imports include the following categories: imports for processing and assembling, imports for processing with imported materials, equipment and materials imported by FFEs, equipment for processing and assembling, compensation trade, and border trade.

Total budgetary tariff revenue as a percentage of import values (customs basis converted to f.o.b.). Budgetary tariff revenue includes also revenue from export tariffs, but the latter involves relatively small amounts.

22. Trade reform initiatives in recent years have also included steps to reduce NTBs. The lists of products subject to various types of nontariff measures have been shortened on several occasions. After the implementation of the changes included in the April 1996 trade package,61 the share of imports subject to nontariff restrictions was about one third, compared with more than one half in 1992. The share of imports subject to state or designated trading (canalization) declined from close to one-third in 1992 to 18 percent in 1996. Export licenses and tariffs have also been scaled back in recent years. Finally, in order to further expand trading rights, joint venture FTCs were, for the first time, allowed in 1996, albeit only on an experimental basis in Shanghai and a few other pilot cities.

D. Opening to Foreign Direct Investment

23. The opening of the economy to FDI has been the third pillar of China’s external sector reforms. Foreign investment was expected to introduce new technology, know-how, and capital, and help develop the export sector. In the process of opening the door to foreign investors, various types of open economic zones (OEZs) have played a key role. These zones have offered special tax incentives and a more advanced infrastructure than other regions. Their geographical locations, concentrated predominantly in the coastal regions, have facilitated outward oriented activities. Most importantly, the business environment in the zones has been more liberal than elsewhere, especially in the early stages of the reforms when central planning and price and investment controls still dominated the economic system. While OEZs were established to encourage both domestic and foreign investment, they have been particularly important in attracting foreign investors.

24. Following the enactment of the Foreign Investment Law in 1979, which defined the legal framework for foreign investment, four Special Economic Zones (SEZs) were set up in 1980, three in Guangdong Province and one in Fuijan (Box V.1).62 These SEZs remained the only open economic zones until 1984. New types emerged in the mid-1980s in the form of open coastal cities, several of which combined to form larger open development areas. These cities and areas were authorized to establish Economic and Technology Development Zones (ETDZs), which in many respects provided conditions similar to those in SEZs. In the second half of the 1980s, steps to improve the environment for foreign investment, especially in advanced technologies,63 were accompanied by a further expansion of open economic zones. Additional ETDZs were approved in open border cities and inland provincial capitals, and in 1988 Hainan became the fifth SEZ. The largest ETDZ, the Pudong New Area, opened in 1990. The first half of the 1990s saw a rapid proliferation of open economic zones, several of them without formal central government approval, in the context of a general broadening and deepening of economic reforms since 1992.

25. SEZs, and in varying degrees other types of open economic zones, have offered a less restrictive investment and trading environment than other parts of the country.64 Both local governments and firms have enjoyed a significant degree of autonomy regarding investment decisions.65 Restrictions on domestic and external trade have been fewer and tariff and tax concessions more generous than elsewhere.66 Firms in the zones have also benefited from more flexible labor relations67 and more liberal land use rights.68 On numerous occasions, open economic zones, in particular SEZs, have served as laboratories for experiments with new, market-oriented policies. Swap markets, stock trading, foreign banks, and joint-stock public enterprises were first introduced in SEZs.

26. In addition to a more open business environment, open economic zones have offered investors considerable tax concessions. Most types of zones have applied lower income tax rates, in general half the standard central government rate, to domestic as well as foreign investors. FFEs, however, have furthermore benefited from generous tax holidays, in particular for export-oriented activities, high-technology projects, and investment in infrastructure (Box V.2). These tax holidays generally also apply to foreign investors outside the zones, which are subject to the same standard income tax rate as domestic enterprises. SEZs and other types of open economic zones, notably ETDZs and HTDZs, have tended to offer more generous exemptions and reductions on tariffs and indirect taxes for imports, particularly for raw materials, intermediate and capital goods.69 Some of these exemptions have, however, been scaled back in recent years in an effort to level the playing field between regions.70

27. While the open economic zones have offered favorable business conditions to foreign as well as domestic investment, in a number of areas, such as direct and indirect taxation and management autonomy, foreign investors have been at an advantage. However, they have also faced special constraints. In particular, the foreign exchange balancing requirement, which in the past entailed restrictions on FFEs’ access to the foreign exchange market,71 combined with constraints on access to the domestic market largely limited their business scope to export-oriented activities. Moreover, in the early phases of the reform process, foreign investment was mainly restricted to joint ventures. These constraints were eased in the second half of the 1980s. With the introduction of swap centers, trading of retained foreign exchange earnings became possible, FFEs were granted limited access to the domestic market, and wholly foreign owned enterprises were allowed outside SEZs. These policy changes, together with the expansion of open economic zones, laid the ground for the surge in FDI inflows since 1992.

28. The evolution of China’s policies towards foreign investment is reflected in the structure of FDI inflows (Table V.4). In the early 1980s, more than half of total foreign investment went into joint ventures in natural resource exploration (development joint ventures). The importance of such projects dwindled quickly and since the mid 1980s their role has been negligible. At the same time, until the mid-1980s, policies towards wholly foreign owned enterprises remained reserved, with contractual and equity joint ventures in export processing and similar activities accounting for almost all FDI inflows. The structure of foreign investment changed significantly in the late 1980s after important reforms in the exchange system and the adoption of a more forthcoming approach toward wholly foreign owned enterprises. Since 1989, establishments of wholly foreign owned enterprises have on average accounted for nearly one third of FDI inflows into China.

Table V.4.

China: Structure of Foreign Direct Investment

(In percent)

article image
Sources: China Statistical Yearbook, various issues; and China Foreign Economic Statistics 1979–91.

Shares in total contracted amounts.

Shares in utilized amount.

29. The regional distribution of FDI inflows illustrates the dominant role played by the open economic zones in the process of opening to foreign investment. While in the initial phase a substantial share of FDI was under the control of central government departments, the importance of the central government declined rapidly in the late 1980s and has been negligible in recent years. Most of the remaining FDI inflows, between half and two thirds of total FDI, have been accounted for by a handful of coastal provinces in which the majority of the open economic zones are located. Guangdong, where three of the first four SEZs were established, absorbed on average almost 40 percent of FDI during 1983-92. Its share has declined somewhat in recent years as other provinces with clusters of open economic zones have gained importance but it remains the largest recipient of FDI inflows into China.

E. Policies Toward Other Capital Flows

30. While China has pursued an “open door” policy toward foreign direct investment, other capital account transactions have remained subject to controls to limit the growth of external debt and avoid complications for domestic monetary policy. Liberalization of capital account transactions is a medium term objective, and the authorities have taken the view that the appropriate sequencing of reforms requires further progress in other areas, notably in the areas of financial sector and trade reform, before capital account opening can be addressed.

31. China maintains controls on most transactions involving capital or money market instruments (Table V.5). Equity purchases in China by nonresidents are limited to special shares, which are reserved for foreign investors (“B” shares). Nonresidents are not permitted to issue capital or money market securities in the domestic market, although sales of collective investment securities are possible, subject to approval. Purchases abroad of capital and money market instruments by Chinese nationals are restricted to special financial institutions that are permitted to borrow abroad, and to a few authorized industrial and trade enterprises. Stock and bond issues abroad are also limited to selected institutions and require prior approval.

Table V.5.

China: Capital Account Regulations, End-1996

article image
article image

1989 “Regulation on Outward Direct Investment” and 1990 “Implementation Procedures on Outward Direct Investment.”

Interim “Regulations Guiding Foreign Investors” and “Directions for Foreign-Funded Enterprises” were issued by the State Planning Commission and other relevant agencies in 1995.

Including capital market securities, money market instruments, collective investment securities and financial certificates.

32. The foreign borrowing plan, which is drawn up annually, has remained the framework for controlling foreign borrowing.72 The plan sets mandatory ceilings for all medium- and long-term borrowing73 by central government departments, provincial governments, and enterprises (except FFEs). Only a few selected financial institutions are allowed to borrow directly in international capital markets through bond issues, while a somewhat larger, but still restricted, set of entities, including a few nonfinancial enterprises, are permitted to engage in commercial foreign borrowing. Most enterprises thus have only indirect access to foreign borrowing through domestic financial institutions. Short-term liabilities, such as interbank borrowing and trade credit, are generally controlled through ceilings.

33. As a result of these controls, capital flows, other than FDI, have been modest, averaging around one percent of GDP annually over the past 15 years. While external debt has risen steadily, it has remained moderate in relation to the size of the economy, peaking at 20 percent of GDP in 1993 and declining thereafter to 14 percent in 1996. Debt-service payments have amounted to just over 10 percent of exports of goods and nonfactor services in recent years, and the share of short-tern debt in total debt, which was relatively high in the early 1980s, has fallen to 10 percent at the end of 1996.

F. Results of External Sector Reforms

34. Nearly two decades of reforms have significantly transformed China’s external sector. The transition from a centrally planned and controlled exchange regime to a market-based exchange system with current account convertibility has been a remarkable achievement and has played a key role in the opening of the economy. Significant progress has also been achieved in the reform of the trade system where the planning framework has been successfully dismantled, although the lowering of tariff and nontariff trade barriers remains a challenge. Finally, the door for foreign investors has been opened gradually and now provides access on a scale that would have seemed unimaginable at the beginning of the reform process.

35. While the visible changes in the exchange, trade, and investment regime are useful indicators of the extent of the transformation of China’s external sector, the results of the reforms ultimately need to be judged by the effective changes they have engendered in terms of greater openness to foreign trade and investment. As regards foreign direct investment, the results have been spectacular. After increasing slowly but steadily during the 1980s, FDI inflows began to surge in 1993, averaging nearly $35 billion annually and accounting for some 15 percent of total domestic fixed investment in the past four years (Chart V.2). Since 1993, China has on average absorbed nearly half of total annual FDI inflows into developing countries, compared with 15-20 percent in the 1980s. The proliferation of FFEs and their strong export orientation resulted in a rapid expansion of FFE exports, which grew at an average annual rate of 65 percent during 1986-96, increasing their share in total exports (customs basis) from 2 percent in 1986 to over 40 percent a decade later. Given their heavy concentration in the export sector, the role of FFEs in the overall economy is not as dominant. Nevertheless, by 1995, FFEs accounted for close to 15 percent of industrial value added. China’s “open door” policy has no doubt achieved its objective to promote export growth through foreign investment.

CHART V.2
CHART V.2

CHINA: THE ROLE OF FOREIGN DIRECT INVESTMENT, 1982-96

Citation: IMF Staff Country Reports 1997, 072; 10.5089/9781451807783.002.A005

Sources: Data provided by the Chinese authorities; and Fund staff estimates.1/ Exports of foreign-funded enterprises (foreign-owned enterprises and joint ventures) in percent of total exports (customs basis).

36. Openness to foreign trade has also increased considerably since the initiation of reforms. Merchandise exports as a share of GDP have risen from 8 percent in 1982-83 to over 20 percent on average in the past four years (Chart V.3). Similarly, the import/GDP ratio has increased significantly (Chart V.4). While China’s trade shares are still lower than in other east Asian countries, they are substantial, given the size of the Chinese economy. However, since the late 1980s, the growing openness of the Chinese economy as reflected in rising export and import shares has mainly been due to the rapid expansion of FFE trade. For the other sectors of the economy, the export/GDP ratio was broadly unchanged at around 15 percent from 1988 to 1995 and has declined in 1996. The ratio of imports to GDP for the “non FFE” sectors has declined since 1988. By 1996, it had fallen well below 10 percent, comparable to the level in the mid 1980s.

CHART V.3
CHART V.3

CHINA: EXPORT TO GDP RATIOS FOR CHINA AND SELECTED ASIAN COUNTRIES, 1982-96 1/

Citation: IMF Staff Country Reports 1997, 072; 10.5089/9781451807783.002.A005

Sources: Data provided by the Chinese authorities, IMF, World Economic Outlook; and Fund staff estimates.1/ Merchandise exports (customs basis; in percent of GDP).
CHART V.4
CHART V.4

CHINA: IMPORT TO GDP RATIOS FOR CHINA AND SELECTED ASIAN COUNTRIES, 1982-96 1/

Citation: IMF Staff Country Reports 1997, 072; 10.5089/9781451807783.002.A005

Sources: Data provided by the Chinese authorities, IMF, World Economic Outlook; and Fund staff estimates.1/ Merchandise imports (customs basis; in percent of GDP).

37. The developments in export and import ratios suggest that the direct effects of China’s external opening have mostly been reflected in the FFE sector and have so far failed to permeate the whole economy. This result reflects the focus of external sector reforms, which have emphasized the promotion of FDI in special zones and predominantly outward-oriented activities, while lagging in the opening of the rest of the economy through comprehensive trade liberalization. The orientation of external sector reforms has had a profound impact on regional income developments. Provinces which have received large shares of FDI inflows due to their open economic zones have tended to grow much more rapidly than other regions. Guandong, the province in which the first three SEZs were established, increased its share in total output from 5 percent in 1983 to more than 9 percent in 1995,74 while per capita income in the province rose from 126 percent of the national average in 1987 to 163 percent in 1994. As some of the regions with high concentrations of open-economic zones had few advantages at the outset, external sector reforms have, to some extent, helped level income disparities among the coastal regions.75 They contributed, however, to growing disparities between the coastal regions on the one hand and inland provinces on the other.

38. In view of the considerable regional differences in economic growth, the focus of economic policies has begun to shift toward the regions that have tended to lag behind. In this context, external sector policies will have to address two main challenges. They will have to achieve a better integration of FFEs into the domestic economy and open the domestic “non-FFE” sectors. The former will require a leveling of the playing field for domestic and foreign-funded enterprises and among different regions, the latter will require a broadening and deepening of trade reform.

Open Economic Zones in China

Since the beginning of economic reforms, a variety of open economic zones have emerged, which have offered a more liberal investment and trade regime than other areas, as well as special tax incentives. While open to both domestic and foreign investors, these zones have played an important role in attracting FDI, although most of the investment in the zones has come from domestic sources.

Special Economic Zones (SEZs)

SEZs were the first, and until 1984 only, open economic zones. Four SEZs were established in 1980, three (Shenzhen, Shantou, and Zhuhai) in Guangdong Province near Hong Kong, one (Xiamen) in Fuijan Province, close to Taiwan Province of China. In 1988, Hainan Province became the fifth SEZ.

SEZs have enjoyed considerable autonomy in their investment policies regarding both infrastructure projects (provided they can be financed locally) and investment approvals (for projects up $30 million). They have offered preferential income tax treatment, and exemptions from import licenses (for FFEs automatically, for domestic enterprises subject to approval) as well as tax and tariff concessions for raw materials, intermediate and capital goods (concessions for the latter were rescinded in 1996). Within SEZs, sales of locally produced goods have been free from duties and taxes, and sales of imported goods have been subject to a reduced tariff, with full tariffs and duties applying to sales outside SEZs (except exports).

Open Coastal Cities (OCCs)

In 1984, 14 cities in the coastal regions with already established industrial bases and infrastructure became OCCs and were opened to foreign investment. Although not separate customs areas and less independent than SEZs, OCCs have enjoyed greater flexibility in investment and tax policies than other regions in China. Several OCCs and the surrounding counties have created larger “development areas,” such as the Pearl River delta and the Yangtze delta (including Shanghai).

Economic and Technology Development Zones (ETDZs)

Within the 14 OCCs, special areas were set aside for ETDZs, offering tax incentives similar to those in SEZs. Further ETDZs in the Yangtze valley, as well as border and inland cities, were subsequently approved by the State Council. The largest ETDZ, the Pudong New Area, opened in 1990.

High Technology Development Zones (HTDZs)

HTDZs emerged in the early 1990s. In most features similar to ETDZs, HTDZs have placed particular emphasis on attracting investment in high technology industries by providing additional tax concessions.

Free Trade Areas (FTAs)

The first two FTAs were established in the early 1990s in Pudong and Shenzhen, and a number of others have been opened since then. Exports and imports can be traded freely within FTAs and enterprises are free to engage in bonded entrepot trade as well as export-oriented production.

For a detailed description of the different types of open economic zones in China, see Wall, Jiang, and Yin (1996).

Income Tax Treatment of Domestic and Foreign-Funded Enterprises

Standard Income Tax Rates

Domestic enterprises: 33 percent.

FFEs: 33 percent, 1/ FFEs with contracts for operating periods of 10 years or more are exempt from income tax for 2 years after the first profit is realized, and eligible for a 50 percent reduction in their tax liability in the following 3 years. FFEs that export at least 70 percent of their annual output remain eligible for a 50 percent reduction after these 5 years. Advanced-technology FFEs receive a 50 percent reduction for 3 years after the initial 5 years.

Special Economic Zones

Domestic enterprises: 18 percent.

FFEs: 18 percent, 1/ and the same 2-year exemption, 3-year reduction as under the standard rate. Export-oriented and advanced-technology FFEs pay 10 percent (instead of 15 percent) after the initial 5-year exemption and reduction period has expired. FFEs engaged in infrastructure projects in Hainan (airports, harbors, docks, railroads, highways, power plants, and water conservation) and with contracts for operating periods of 15 years or more are eligible for a 5-year exemption period followed by 5 years at a reduced rate (10 instead of 15 percent) after the first profitable year.

Open Coastal Cities and Areas, Open Border Cities, Inland Provincial

Capitals, and Yangtze River Open Cities

Domestic enterprises: 33 percent.

FFEs: 27 percent, 1/ and the same 2-year exemption, 3-year reduction as under the standard rate. For projects with foreign investment of $30 million or more (registered capital) and a long recovery period, knowledge-or technology-intensive projects, and energy, transportation or harbor construction projects, the 24 percent component may be reduced to 15 percent.

Economic and Technology Development Zones

Domestic enterprises: 18 percent.

FFEs: 18 percent 1/ for all production-related FFEs, with the same 2-year exemption, 3-year reduction as under the standard rate. For export-oriented and advanced-technology FFEs, the same extended reductions as in the SEZs apply.

High Technology Development Zones

Domestic enterprises: 18 percent

FFEs: 18 percent, 1/ and the same exemptions and reductions as under the standard rate for high-or new-technology enterprises.

1/ Includes a 3 percent local government component on which local governments may grant reductions.

References

  • Bell, Michael W., Hoe Ee Khor, and Kalpana Kochhar,China at the Threshold of a Market Economy,” IMF Occasional Paper 107 (Washington: International Monetary Fund, 1993).

    • Search Google Scholar
    • Export Citation
  • Department of Trade and Materials Supply of the State Statistical Bureau of the People’s Republic of China, “China Foreign Economic Statistics, 1979–91,” (Beijing: China Statistical Information and Consultancy Service Center, 1992).

    • Search Google Scholar
    • Export Citation
  • Lardy, Nicholas R.,Foreign Trade and Economic Reforms in China, 1978–90,” (Cambridge: Cambridge University Press, 1992).

  • Lardy, Nicholas R.,China in the World Economy,” (Washington, Institute for International Economics, 1994).

  • Mehran, Hassanali, Marc Quintyn, Tom Nordman, and Bernard Laurens,Monetary and Exchange System Reforms in China: An Experiment in GradualismIMF Occasional Paper 141 (Washington: International Monetary Fund, 1996).

    • Search Google Scholar
    • Export Citation
  • State Statistical Bureau of the People’s Republic of China, “China Statistical Yearbook,” Various Issues, (Beijing: China Statistical Information and Consultancy Service Center).

    • Search Google Scholar
    • Export Citation
  • The Editorial Board of the Almanac of China’s Foreign Economic Relations and Trade, “Almanac of China’s Foreign Economic Relations and Trade 1992/93,” (Hong Kong: China Resources Advertising Co., 1992).

    • Search Google Scholar
    • Export Citation
  • Tseng, Wanda, Hoe Ee Khor, Kalpana Kochhar, Dubravko Mijaljek, and David Burton,Economic Reform in China: A New PhaseIMF Occasional Paper 114 (Washington: International Monetary Fund, 1994).

    • Search Google Scholar
    • Export Citation
  • Wall, David, Jiang Boke and Yin Xiangshuo,China’s Opening Door,” (London: The Royal Institute of International Affairs, 1996).

  • World Bank, “China: Foreign Trade Reform,” (Washington: The World Bank, 1994).

1

This chapter was prepared by Ms. Schulze-Ghattas (ext. 37618), who is available to answer questions related to the chapter before the Board discussion.

2

China’s exchange and trade system at the beginning of the reform period is described in Wall, Jiang, and Yin (1996), and Bell, Khor, and Kochhar (1993).

3

In 1980, China’s external debt amounted to just 1½ percent of GDP. See Bell, Khor, and Kochhar (1993).

4

While some of the regulations governing other capital account transactions have also been changed, full capital account liberalization has been seen as a task to be addressed once the reforms in other areas, notably in the state enterprise and financial sectors as well as the trade regime, are more advanced.

5

The term “open economic zones” is used as a generic term for a variety of different types of areas and zones that were established to attract foreign investment and technology.

6

In 1996, outstanding external debt was equivalent to 14 percent of GDP.

7

The term foreign-funded enterprises is used to describe fully foreign-owned enterprises as well as joint ventures.

8

For a detailed description of China’s reforms in the foreign exchange system, see Bell, Khor, and Kochhar (1993), World Bank (1994), Wall, Jiang, and Yin (1996), and Mehran, Quintyn, Nordman, and Laurens (1996).

9

The differentiation of retention quotas appears to have had a significant impact on the relative export performance of different industrial sectors. See Wall, Jiang, and Yin (1996).

10

Excluding commodities such as crude oil and petroleum derivatives.

11

Sixty percentage points of the retention quota were to accrue to the FTC, 10 percentage points to the originating enterprise, and 10 percentage points to the local government. Producing enterprises with direct trading rights were allowed to retain the share of the FTC.

12

Exports of special commodities, such as mechanical and electronic products, were eligible for a 100 percent retention quota, of which 80 percentage points accrued to the FTC, 10 percentage points to the originating enterprise, and 10 percentage points to the local government.

13

The “buy back” option applied to 20 percentage points of the FTC share and the foil share of the producing enterprise. The role of foreign exchange adjustment centers is discussed below.

14

In a few locations, however, cash retention schemes were introduced for domestic enterprises on an experimental basis.

15

In 1984, faced with a decline in official reserves, the central government effectively froze enterprises’ accumulated retention quotas. See World Bank (1994).

16

FFEs were subject to a foreign exchange balancing requirement, i.e., they were obliged to ensure self-sufficiency in foreign exchange. In 1986, this requirement was modified to apply to the sector as a whole, allowing individual enterprises to meet shortages by purchasing foreign exchange from other FFEs. FEACs were set up to facilitate this exchange. For a detailed description of the system, see Tseng et al. (1994), p.9, and Khor (1993).

17

The People’s Bank of China had, however, the right to intervene through purchases or sales of foreign exchange.

18

By late 1988, 80 swap centers had been established.

19

Regulations for purchases of foreign exchange at the swap centers were issued by the State Administration of Exchange Control in early 1989.

20

As a result of regional segmentation, exchange rates in different swap centers varied.

21

Although the system was characterized by two exchange rates, the official rate and the swap rate, exporters effectively faced a variety of different exchange rates due to the differentiation of retention quotas.

22

Foreign exchange remitted or brought into the country by foreigners was converted at the official exchange rate into yuan-denominated FECs, which could be used for domestic purchases, generally at lower prices than domestic currency purchases.

23

The arrangement for the official exchange rate was formally described as a managed float, but the exchange rate of the renminbi vis-a-vis the US dollar was unchanged from mid-1986 to end-1989.

24

Enterprises with outstanding retention quotas were allowed to purchase foreign exchange at the official exchange rate of December 1993 until end-1994.

25

Existing FECs were with drawn from circulation at the official exchange of end-1993. The conversion was to be completed by mid-1995, but some small remaining amounts were converted through mid 1996.

26

Foreign exchange accounts were also permitted for individual foreign and Chinese nationals, FFEs, and other foreign entities, such as embassies and international organizations.

27

Foreign exchange could be purchased at designated financial institutions upon presentation of the relevant documentation.

28

Although from April 1994, FFEs were required to obtain SAEC approval to open a foreign exchange account, they continued to be free to remit profits from their foreign exchange accounts. Foreign employees of FFEs were free to transfer their salaries (net of taxes and living expenses) abroad.

29

The CFETS is based on membership, which is open to domestic banks (head offices as well as branches), foreign banks, and a number of nonbank financial institutions. The system provides trading and settlement services to its members. By assuming responsibility for settlement, the CFETS effectively assumes the credit risk in each transaction. Transactions in swap centers that are not directly linked to the system take place at the exchange rate established in the CFETS. For a detailed description of the system, see Mehran, Quintyn, Nordman, and Laurens (1996).

30

While designated domestic banks and their branches are allowed to trade on their own account, other domestic financial institutions and foreign banks can only trade on behalf of their customers.

31

Domestic enterprises have only access to the bank retail market, which is subject to different settlement arrangements than the wholesale market, while FFEs can trade directly, through their banks, in the wholesale market.

32

For a detailed description of the system see International Monetary Fund (1995), Appendix I.

33

FFEs no longer required approval for accessing the foreign exchange market, provided their transactions were within the limits of their pre-approved annual foreign exchange plans.

34

On April 1,1996, the restrictions arising from the SAEC’s authority to freeze the foreign exchange accounts of FFEs and subsequently deny them access to the foreign exchange market were removed. Nonetheless, FFEs remained subject to an annual exchange control examination, which focused on the enterprises’ compliance with their contractual obligations and China’s exchange regulations. FFEs could be denied access to the foreign exchange market upon failure of the examination. The “Regulations on the Sale and Purchase of and Payment in Foreign Exchange” of July 1, 1996 eliminated the restrictions on FFEs’ access to the foreign exchange market for current payments and transfers, as well as most remaining restrictions on current payments and transfers, such as the nontransferability of investment income by nonresident Chinese emigrants, and the non-transferability of proceeds from sales of personal items by nonresidents.

35

Shortly after acceptance of Article VIII, the name of SAEC was changed into State Administration of Foreign Exchange (SAFE).

36

The policy to approve all bona fide requests for foreign exchange for current payments and transfers was announced in an official-statement on November 28, 1996 and subsequently incorporated in the “Foreign Exchange Administration Regulation of the People’s Republic of China.

37

World Bank (1994), pp. 24 and International Trade Centre (1995), p.22. The number of FTCs increased rapidly after 1984, when the provincial branches of national FTCs were allowed to become independent, and provinces were permitted to set up their own FTCs. By 1988, FTCs were estimated to number more than 5000, but in the subsequent consolidation phase, a series of FTCs were closed or merged.

38

In the late 1970s, each FTC specialized in a certain range of products. FTCs are allowed to trade in most product that are not subject to designated trading.

39

While domestic prices of products imported under the mandatory plan were generally insulated from foreign prices, other imports were priced on the basis of the agency system, i.e., importing FTCs charged their customers foreign prices (converted into national currency) plus tariffs, taxes, and handling fees.

40

One of the objectives of the foreign trade contract system established in 1988 was to control budgetary subsidies to FTCs. Under the system, national FTCs and provincial administrations signed contracts with the central government, which stipulated targets for foreign ex the CFETS quickly developed into a unified wholesale foreign exchange market, change earnings as well as limits for subsidies. See World Bank (1994), p.26.

41

The domestic prices of a number of products imported under the mandatory plan were raised and linked to foreign prices in 1989-90, see World Bank (1994). According to Lardy (1995), by 1991, prices of some 90 percent of imported goods were based on world market prices.

42

In 1992, only 538 domestic enterprises had trading rights for their own products and inputs. See World Bank (1994), p. 114.

43

See International Trade Centre (1995), p. 22.

44

Export targets under the guidance plan were allocated to provincial governments, which were relatively free in determining how to achieve them.

46

Products subject to canalization were grouped into two categories. Category I products could only be handled by a small number of designated FTCs, category II products could be traded by a somewhat larger, but still limited, number of FTCs. Products that were subject to mandatory trade planning were generally also canalized. However, the coverage of canalization did not decline in line with mandatory planning.

47

See World Bank (1994), p.28.

48

In 1992, more than half of the imports subject to licensing were also subject to canalization. See World Bank (1994), p.65.

49

In 1992, import controls applied to a range of products in the machinery and electronics sector. Imports of such products required special approval by the State Council Machinery and Electronics Import Control Office.

50

See Lardy (1992), p.44.

51

See Lardy (1992), p.44.

52

World Bank (1994), p.68.

53

The unweighted average import tariff in early 1992 (after a round of cuts at the beginning of the year but before further tariff reductions implemented later in the year) was 43 percent, some 5 percentage points higher than in 1986. See World Bank (1994), p.49.

54

See World Bank (1994), pp. 51-52.

55

Following lengthy negotiations, China and the United States signed a memorandum of understanding in October 1992, in which China agreed to remove by 1997 import quotas, controls and licensing requirements on a wide range of products. In addition, to enhance the transparency of the trade system, China promised to publish and make readily available all laws, regulations, and decrees governing external trade, and to clarify the responsibilities of different government departments and agencies involved in trade.

56

In January 1992 China also introduced a new tariff schedule based on the Harmonized System.

57

The April 1996 trade package also introduced a tariff quota system with low “in quota” tariffs for a number of agricultural products.

58

The weighted average tariff is estimated on the basis of 1992 import shares and “in quota” tariffs for products under tariff quotas.

59

This objective was announced at the November 1996 APEC meeting.

60

In 1996, duty exemptions on imports of capital goods were revoked, but existing exemptions were subsequently grandfathered until mid 1998.

61

The trade package of April 1996 eliminated NTBs on 176 items.

62

The development of the different types of open economic zones is described in Bell, Khor, and Kochhar (1993); “People’s Republic of China—Background Paper,” (SM/95/44, Supplement 1, 3/9/95); and Wall, Jiang, and Yin (1996).

63

In October 1986, “Provisions of the State Council of the People’s Republic of China for the Encouragement of Foreign Investment” were issued. Special tax incentives for high-technology investment were introduced, wholly foreign owned firms were allowed outside SEZs, and FFEs were granted access, on a limited scale, to the domestic market.

64

A number of ETDZs, in particular the larger ones like Pudong, have offered conditions similar to those in the SEZs.

65

SEZs, and subsequently also other open economic zones, have been granted autonomy, within certain limits, to approve investment projects and draw up their own infrastructure development plans, provided the latter can be financed from local sources.

66

SEZs have been treated as separate customs areas and have enjoyed significant privileges in the area of external trade, such as exemptions from licensing requirements, customs duties and internal indirect taxes for approved imports of raw materials, intermediate goods, and capital goods (exemptions for the latter were canceled in 1996).

67

Firms in open economic zones have greater scope than firms outside for dismissing employees and hiring workers on short-term contracts. In addition, more advanced government social security systems have helped enhance labor market flexibility. See Wall, Jiang, and Yin (1996).

68

Markets for land use rights developed first in the SEZs. In 1990, FFEs were allowed to purchase land use rights.

69

In SEZs, approved imports of raw materials, as well as intermediate and capital goods, have been exempt from tariffs and indirect taxes. Until 199S, sales of imported and locally produced goods inside the zone (with the exception of certain consumer durables) were subject to half the standard tariff and tax rates, with the full rates applying to sales to the domestic market outside the zone. Similar tariff concessions, except for those on sales within the zone, have been extended to ETDZs and HTDZs, but not to other parts of open coastal cities.

70

In 1995, the tax and tariff reductions on sales within SEZs were canceled, and in 1996 the tariff exemptions on imports of capital goods were revoked, with existing exemptions grandfathered until mid-1998.

71

In 1996, FFEs were assured access to the foreign exchange market for current payments and transfers irrespective of their compliance or non-compliance with foreign exchange balancing requirements.

72

For a detailed description of the system of external debt management, see “People’s Republic of China—Background Paper,” (SM/95/44, Supplement 1, 3/9/95).

73

Loans with a maturity of one year or more.

74

The figure for 1983 refers to the share in gross agricultural and industrial output, while the figure for 1995 refers to the share in GDP.

75

Fujian, where one of the original SEZs is located, was initially much less developed than many other regions. In 1987, its per capita GDP was below the average for the whole country; by 1994 per capita GDP in the province had risen to 1.4 times the national average.

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