People’s Republic of China: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that China has continued its rapid economic growth and integration into the global economy. Real GDP grew by 9.1 percent in 2003, underpinned by strong fixed investment and exports, which registered growth rates of 20 percent and 29 percent in real terms, respectively. Consumption growth declined somewhat from 2002, reflecting the impact of the SARS epidemic in the second quarter. Significant progress has been made in structural reforms. In the banking sector, restructuring plans are being put in place for the two state banks that were recently recapitalized.

Abstract

This 2004 Article IV Consultation highlights that China has continued its rapid economic growth and integration into the global economy. Real GDP grew by 9.1 percent in 2003, underpinned by strong fixed investment and exports, which registered growth rates of 20 percent and 29 percent in real terms, respectively. Consumption growth declined somewhat from 2002, reflecting the impact of the SARS epidemic in the second quarter. Significant progress has been made in structural reforms. In the banking sector, restructuring plans are being put in place for the two state banks that were recently recapitalized.

I. Recent Economic Developments and Outlook

A. Introduction

1. In concluding the 2003 Article IV consultation, Executive Directors cautioned that continued strong investment activity and rapid money and credit growth could lead to a buildup of economic imbalances. They called for stronger action to rein in excessive credit growth and curb potential overinvestment in some sectors of the economy. They observed that increased flexibility of the exchange rate over time would be in the best interest of China. Directors also urged the authorities to stick to budgeted levels for spending and to use additional revenues to reduce outstanding VAT refunds owed to exporters and to further consolidate the fiscal position. They cautioned that the medium- and longer-term fiscal outlook remains a source of vulnerability and welcomed the authorities’ intention to keep the level of the fiscal deficit roughly unchanged in nominal terms over the next few years. They emphasized that medium-term prospects depend critically on the pace of structural reforms. Since the Article IV consultation, China has tried to rein in credit and investment growth, conducting monetary and fiscal policies in a manner broadly consistent with the Executive Board’s recommendations.

2. In March 2004, the 2nd plenary session of the 10th National Peoples’ Congress emphasized the importance of a more balanced approach to development and the need to push ahead with structural reforms. The meeting cautioned against excessive investment in some sectors, and focused more on social and environmental development, as well as measures to address the widening regional and rural-urban income disparities. Policy initiatives to raise farmers’ incomes, develop the inland regions, and enhance the social safety net were unveiled. The government also signaled its determination to increase the pace of structural reforms by rolling out a wide range of measures including in the financial and SOE sectors and the fiscal area.

B. Economic Developments

3. Real GDP growth was slightly above 9 percent in 2003, led by strong investment and export growth, leading to concerns that overinvestment in some sectors might lead to a more generalized overheating (Figure 1 and Table 1).1 Fixed capital formation is estimated to have increased by about 20 percent in real terms—the fastest rate since 1993—reaching 44 percent of GDP. Consumption growth is estimated to have declined somewhat from 2002 (annual retail sales growth in real terms dropped 1 percentage point to 9 percent), reflecting the impact of the SARS epidemic in the second quarter. Nevertheless, the overall impact of SARS was short-lived, as economic activity rebounded quickly in the second half of the year, with GDP growth reaching 10 percent (year-on-year) in the fourth quarter. Export growth reached 35 percent in 2003, up from 22 percent in 2002, as China continued to make significant gains in market share in major industrialized countries. Imports were even more buoyant, as strong demand for raw materials (e.g., steel, aluminum, copper, and fuel), inputs for exports, and agricultural products helped to push import growth to 40 percent in 2003.2

Figure 1.
Figure 1.

China: Growth and Demand Indicators

Citation: IMF Staff Country Reports 2004, 351; 10.5089/9781451807769.002.A001

1/ Prior to January 2004 fixed-asset investment includes investment by state-owned units and others. After January 2004 it refers to state-owned units and others, urban collectives, and urban private-owned enterprises.
Table 1.

China: Summary Indicators

Nominal GDP (2003): US$1,410 billion

Population (2003): 1.292 billion

GDP per capita (2003): US$1,091

Quota: SDR 6,370 million

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

IMF staff estimate. For data up to 2002, the implicit deflators from the production GDP was used. For 2003, consumption was deflated with CPI, investment with implicit deflator for fixed investment.

Central and local governments, including all official external borrowing. Figures for 2004 are budget estimates.

Banking survey.

For 2004-05, includes errors and omissions.

Includes gold, SDR holdings, and reserve position in the Fund.

Official data sources. The coverage and classification of official external debt data were modified in 2001. Categories of debt previously not covered are now included.

Annual averages (1990 = 100), using revised weights.

4. Growth momentum remained strong in the first quarter of 2004. Real GDP grew by 9¾ percent (year-on-year). Industrial production growth was particularly strong at 18 percent, and fixed asset investment grew by an estimated 36 percent in real terms. Reflecting continued strong domestic demand, imports increased by 41 percent (year-on-year; customs basis) in the first five months, while exports rose by 33 percent.

5. CPI inflation rose to 4.4 percent (year-on-year) in May 2004, led by food price increases. Excluding food, inflation turned slightly positive, following price declines in the previous two years.3 The increase in food prices partly reflects supply-side factors, including reductions in the area under cultivation and the effects of drought and floods in parts of China last year. Strong investment demand in China and increasing world commodity prices have led to a surge in raw material prices, and in the producer price index, but these factors have not yet been reflected in manufactured consumer goods’ prices. These prices have continued to decline, but at a slower pace than previously.

6. China’s role in international trade and, in particular, in the region’s production chain continued to grow. Total exports and imports reached 60 percent of GDP in 2003, and China became the fourth largest exporter in the world. China’s growing role in the global production of manufactured goods and rising domestic demand are contributing to the pick-up in growth in several regional economies, as well as pushing up international prices for many key commodities. Imports from Asia grew rapidly, and China’s trade deficit with the region increased further, largely offsetting the country’s trade surplus with the United States and the euro area. The overall trade surplus was $45 billion (3 percent of GDP; balance of payments basis), about the same level as in 2002.

7. China’s overall external position has continued to strengthen (Tables 2-4 and Figure 2). The current account surplus increased by ½ percentage point in 2003 to 3⅓ percent of GDP, as the balance on invisibles shifted into a small surplus. Official reserves increased by $162 billion in 2003. With the use of $45 billion to recapitalize two state-owned commercial banks, the level of reserves stood at $412 billion at year end (equivalent to about 9 months of imports). Almost half of the increase in reserves was accounted for by net non-FDI capital inflows, which have been attracted by a combination of interest rate differentials favoring renminbi-denominated assets and speculation about an appreciation of the currency. External debt increased to nearly $200 billion in 2003, but remains modest relative to exports and GDP. In the first five months of 2004, China registered a trade deficit of $9 billion (custom basis), compared with an overall trade surplus of $2 billion in the same period last year. Sizable capital inflows have continued as foreign exchange reserves increased by another $55 billion despite the trade deficit.

Table 2.

China: Balance of Payments

(In billions of U.S. dollars)

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Sources: Chinese authorities and IMF staff calculations

2003 figure includes the counterpart transaction to the US$ 45 billion of foreign exchange reserves used for bank recapitalization.

Includes counterpart transaction to valuation changes.

Table 3.

China: External Debt

(In billions of U.S. dollars)

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Sources: Chinese authorities, Bank for International Settlements, Organisation for Economic Cooperation and Development and Fund Staff estimates.

Significant changes in coverage and classification of official external debt data were made in 2001. Categories of debt previously not covered are now included, especially under short-term debt (e.g., trade credit).

Table 4.

China: Indicators of External Vulnerability

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Sources: Chinese authorities and Fund staff estimates and projections

Shanghai Stock Exchange, A share.

The sum of the current account, FDI inflows, and identified non-FDI flows from BIS data less reserve accumulation.

Based on BIS debt data until 2000, and on official data from 2001 on.

Based on official debt data unless otherwise indicated.

Debt of banking sector not included.

Figure 2.
Figure 2.

China: External Indicators

Citation: IMF Staff Country Reports 2004, 351; 10.5089/9781451807769.002.A001

8.During the course of 2003, China’s real effective exchange rate, as estimated by the staff, depreciated by 6½ percent, while the nominal effective exchange rate depreciated by 8 percent, reflecting the depreciation of the U.S. dollar against other major currencies. In the first five months of 2004, it is estimated to have appreciated by 1.4 percent in nominal effective terms and 2.7 percent in real effective terms. The one-year non-deliverable forward rate appreciated by about 5 percent during 2003, but it depreciated by 4 percent in the first five months of 2004, suggesting that speculative pressures may have diminished somewhat.

China: Sources of Reserve Accumulation, 1998–2003

(In billions of U.S. dollars)

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Sources: Staff estimates for analytical purposes based on data provided by CEIC, PBC, SAFE.

For 2003, staff estimates of the reserve change include the $45 billion used for bank recapitalization. The official figure for foreign reserves increased by $116.8 billion in 2003.

9. Reflecting growing concerns about overheating, the authorities took a series of monetary and administrative measures to curtail investment. The push for investment by new local government leadership beginning in the second half of 2002 was fueled by substantial excess liquidity in the banking system. While the People’s Bank of China was concerned about rapid credit growth already evident in early 2003, its policy response was delayed by the SARS epidemic in the second quarter of that year. Sustained capital inflows, which grew substantially in magnitude in the latter part of 2003, further complicated the conduct of monetary policy. With the end of the SARS outbreak in July, the PBC announced an increase in the reserve requirement by 1 percentage point effective in September 2003, and by a further ½ percentage point in April 2004, and it engaged in moral suasion to reduce credit growth to banks. The authorities also tightened lending standards in sectors experiencing overinvestment (in particular, metals production, cement, automobiles, and real estate). In addition, the PBC raised short-term relending and rediscount rates by 0.6 and 0.3 percentage points, respectively, in March 2004. The PBC also intensified its sterilization operations in 2004. While only about one-third of inflows were sterilized in 2003, the PBC sterilized about two-thirds of its foreign exchange purchases from January to May 2004.

10. While money and credit growth slowed, they remain above the authorities’ targets (Table 5, Figure 3). As of May 2004, M2 growth declined to 17.5 percent and credit growth to 18.6 percent, but they still exceed the authorities’ respective targets for the full year of 17 percent for M2 and an increase of RMB 2.6 trillion (16 percent) for lending. However, the extent to which credit growth has actually slowed is unclear. While the month-on-month seasonally adjusted rates of growth in credit have declined, part of the slower rise in the stock of outstanding loans may simply reflect an acceleration in the write-off of existing nonperforming loans (NPLs). Moreover, measures taken thus far have had little impact on interbank interest rates and the average excess reserve ratio for the banking system remains relatively large at around 3 percent as of May 2004. Thus, to the extent that credit growth has slowed, it appears to be more due to the effects of administrative measures, rather than to the impact of indirect monetary instruments.

Table 5.

China: Monetary Developments

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Sources: The People’s Bank of China; and staff calculations.

Starting 2002, includes foreign currency operations of domestic financial institutions and domestic operations of foreign banks. In addition, some items were moved from Other Items Net to Net Credit to Government.

Twelve-month change as a percent of beginning-period stock of monetary liabilities.

2002 growth rates are based on data that exclude the revisions made in 2002 (see footnote 1).

The growth rates are corrected for the transfer of NPLs from banks to the AMCs.

The growth rates are based on official announcements, which correct for the definitional changes in the series.

Twelve-month change as a percent of beginning-period reserve money stock.

In percent of total bank deposits. 2003-04 excess reserve figures are averages provided by the authorities.

Figure 3.
Figure 3.

China: Macroeconomic Policies

Citation: IMF Staff Country Reports 2004, 351; 10.5089/9781451807769.002.A001

1/2004Q2 covers April and May.2/ 2004 covers the first two months of the year.

11. The fiscal deficit declined in 2003 by about ½ percentage point to 2.5 percent of GDP. 4 The deficit was ¼ percent of GDP lower than the budget on account of revenue overperformance, part of which was saved, while the remainder was used to reduce outstanding tax refunds owed to exporters. Total revenue was 15 percent higher than in 2002 and 1 percentage point of GDP higher than the budget projections, reflecting stronger-than-expected output and import growth. Revenues from VAT and import duties were particularly strong. Total expenditure rose by 12 percent from 2002 and exceeded the budget by RMB 95 billion (¾ percent of GDP) reflecting, among other things, higher capital and social expenditures, SARS-related expenditures, and natural disaster relief.

12. In line with the authorities’ stated fiscal policy objective, the 2004 budget holds the nominal deficit at its 2003 budgeted level. This implies, on the basis of the staffs GDP forecast, that the deficit relative to GDP would be roughly the same in 2004 as its outturn in 2003. Revenue is budgeted to increase by 9 percent, but this is likely to be a conservative estimate in part because it is based on an assumption of 7 percent real GDP growth. While total expenditure is projected to decline by almost 0.3 percent of GDP, expenditure in the rural sector is budgeted to increase by about RMB 30 billion to finance policy initiatives such as compensation of local governments for a reduction in the agricultural tax, the so-called “fee-to-tax” reforms,5 and the provision of increased direct subsidies to grain farmers. Capital expenditure is to be curtailed significantly, reflecting a lower issuance of construction bonds (by RMB 30 billion) than in the 2003 budget. During the first five months of 2004, revenue increased by 32 percent compared with the same period of 2003, while expenditure increased by 14 percent.

C. Macroeconomic outlook and Risks

13. The staff projects that real GDP growth will average around 9 percent in 2004, with growth slowing to an annual rate of 7½ percent (y/y) in the fourth quarter of the year. This forecast is based on the assumption that macroeconomic policy tightening will be effective in bringing about a substantial reduction in investment growth, engineering a “soft landing” of the economy. Export growth is also expected to ease from the exceptionally high levels reached last year. In contrast, consumption would pick up moderately, aided by the continuing development of the consumer credit market and efforts to boost rural incomes. Import growth would decline, reflecting the slowdown in export and investment growth, although import growth would remain higher than export growth. Consequently, the current account surplus would decline from 3¼ percent of GDP in 2003 to 2½ percent of GDP in 2004. CPI inflation is expected to be 3½ percent in 2004, with inflationary pressures dissipating during the year as food price increases ease and demand pressures diminish.

14. The Chinese economy is not yet assured of a soft landing despite the measures taken to reduce credit and investment growth, and overheating and inflation remain serious possibilities. This has prompted concerns that a boom/bust cycle similar to those experienced by China in the past could develop (Box 1). Despite the administrative actions taken, strong incentives remain at local levels to maintain high rates of investment. There is also a risk of a premature easing of policies once there are indications that the economy is slowing, which was a problem during the cycle in the mid-1990s. Furthermore, signs of overheating could be temporarily masked by the buildup of excess capacity in some sectors. This, in turn, could delay the implementation of additional measures necessitating a much sharper tightening of policies later, particularly if inflation begins to rise sharply. Nonperforming loans could rise significantly as credit growth is reined in and the economy slows, prompting a further cutback in bank lending and contributing to a sharper reduction in economic growth. Spillover effects on other countries in Asia of a sharp drop in Chinese growth would be significant but manageable (Box 2).

15. China’s medium-term prospects are favorable, provided that near-term risks are handled effectively and structural reforms implemented expeditiously (Table 8). Structural reforms, particularly in the enterprise and financial sectors and labor markets, are needed to address macroeconomic vulnerabilities, maintain strong productivity growth and increase the market orientation of the economy. These would help China maintain an average annual rate of GDP growth of 7-8 percent, create greater employment opportunities, reduce fiscal risks, and better integrate the country into the global economy. The external position should remain relatively strong, with the current account surplus largely unchanged relative to GDP and continued sizable FDI inflows.

Table 6.

China: State Budgetary Operations 1/

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Sources: Ministry of Finance; People’s Bank of China; National Bureau of Statistics; and staff estimates.

The coverage is central government, provinces, municipalities, and counties.

Tax revenues are net of refunds for VAT and business taxes paid on inputs. As of end-2003, refunds amounting to roughly RMB 250 billion had been claimed but not paid. The IMF definition is not adjusted for tax refund and wage arrears in the absence of adequate data.

Includes external borrowing excluded from the budget and unbudgeted “fiscal stimulus” spending (see Table 7).

Table 7.

China: Official and IMF Budget Definitions

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Sources: Ministry of Finance; and staff calculations.

Tax revenues are net of refunds for VAT and business taxes paid on inputs. As of end-2003, refunds amounting to roughly RMB 300 billion had been claimed but not paid. The IMF definition is not adjusted for tax refund and wage arrears in the absence of adequate data.

Assumption for 2004 budget.

Assumptions for 2003 preliminary and 2004 budget.

Table 8.

China: Medium-Term Scenario

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

Exludes errors and omissions up until 2003, included erros and omissions from 2004 onwards.

The coverage and classification of official external debt data were modified in 2001. Categories of debt previously not covered have since been included.

Lessons from Earlier Economic Cycles

Since the initiation of economic reforms, China’s economic growth has been marked by periods of cyclical surges in economic activity and inflation, followed by periods of retrenchment. In the 1980s, two cycles ended with hard landings. Particularly notable is the 1986-90 cycle. This cycle began with an early relaxation of monetary and fiscal policies due to concerns that stringent policies, adopted during the previous cycle, were causing problems for SOEs. Inflation rose to 19 percent in 1988, and the authorities responded with a heavy reliance on administrative measures. Inflation was quickly brought under control, but growth slowed sharply, and the administrative measures adopted had adverse implications for resource allocation.

The 1991-97 cycle was initiated by a rise in central and local government spending and an easing in bank credit policies. By 1992, an investment boom was underway (similar to the present boom, see table), with real GDP growth exceeding 14 percent. Demand pressures led to a pick up of inflation, boosted by liberalization of food prices and public sector wage hikes. The authorities responded in mid-1993 with a “16-point” plan to cool the economy. The measures included raising interest rates, tightening central bank credit to banks, and limiting investment approvals. But the credit squeeze hit SOEs hard, prompting calls for a relaxation of policies. The authorities then temporarily reversed the tightening in late 1993. This easing and the exchange rate devaluation of 1994 resulted in inflation rising to a peak of over 24 percent in 1994.

The authorities eventually achieved a soft landing of the economy, with inflation in single digits by 1996 and only a modest slowdown in growth. Factors contributing to the soft landing included: structural reforms to increase the market orientation of the economy; a record grain harvest in 1996 that reduced food prices; the buildup of excess capacity that put downward pressure on prices; and greater use of indirect monetary policy instruments. While a soft landing was achieved, the rapid pace of credit growth in 1992-96 contributed to the weakness of the financial sector today. Most of the non-performing loans in the banking system date from this period, as banks funded SOEs with little regard for credit risk.

Several policy lessons can be drawn from the earlier cycles. First, earlier action to rein in credit and investment growth would have restrained the upswings, contained inflation, and mitigated the eventual NPL problems. Second, consistent implementation of monetary tightening actions, rather than premature easing of policies, would have been more effective in restraining domestic demand and bringing inflation down. Third, greater commercialization of banks and SOEs would have supported the effectiveness of monetary policy. Fourth, increased use of indirect monetary policy instruments rather than administrative measures would improve resource allocation and could also help control the cycles.

China: Comparison of the 1991-97 cycle with the current cycle

(In percent change)

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Sources: Data provided by the Chinese authorities, and staff estimates.