The staff report for the 2005 Article IV Consultation on the People’s Republic of China highlights economic developments, policy discussions, and structural reforms. A larger external current account surplus, together with strong capital inflows, led to a further sizable increase in gross official reserves. A disorderly unwinding of global current account imbalances would also threaten China’s growth, as economic activity in all countries would likely suffer lingering adverse effects. Executive Directors commended the authorities for the success in sustaining high economic growth rates and for their efforts to guide the economy.

Abstract

The staff report for the 2005 Article IV Consultation on the People’s Republic of China highlights economic developments, policy discussions, and structural reforms. A larger external current account surplus, together with strong capital inflows, led to a further sizable increase in gross official reserves. A disorderly unwinding of global current account imbalances would also threaten China’s growth, as economic activity in all countries would likely suffer lingering adverse effects. Executive Directors commended the authorities for the success in sustaining high economic growth rates and for their efforts to guide the economy.

I. Economic Developments and Outlook

A. Background

1. This year’s discussions took place at a time when China’s policymakers face significant challenges on the domestic front and growing international pressures. Serious concerns emerged in the last two years that China’s rapid rate of investment growth since early 2002 may be creating overinvestment in certain sectors. Coupled with a rise in inflation in 2004, this was seen as potentially fueling a more generalized overheating of the economy like the one in the early 1990s. The associated rapid growth in bank credit also raised the specter of substantial new nonperforming loans (NPLs) being created, adding to the large stock of existing NPLs, much of which was created in the early 1990s. While a series of tightening measures have helped to slow the pace of investment growth, it remains high, and substantial liquidity remains in the banking system

uA01fig01

Inflation

(Percent change, 3mma, y/y)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

2. Since mid-2004, China’s external position has strengthened further with continued strong reserve accumulation. This has been perceived as pointing to increasing currency undervaluation and has focused international attention on China’s contribution to global imbalances. Against this background, a sharp increase in textile exports to industrial countries after the expiration of MFA quotas at end-December 2004 has sparked increased protectionist pressures in some trading partner countries.

B. Recent Developments

3. At 9½ percent, GDP growth in 2004 was broadly the same as in 2003, but its composition shifted modestly away from investment in the course of the year (Table 1). Investment growth moderated somewhat in response to stricter enforcement of administrative controls and tightening of monetary conditions directed at restraining its pace. Net exports increased its contribution to output growth, while consumption remained strong. Private consumption grew by nearly 8 percent, a faster pace than in 2003, supported to a large extent by rising rural income. Despite lay-offs of nearly 1½ million, due to the continued restructuring of state-owned enterprises, the urban unemployment rate edged down by 0.1 percentage point to 4.2 percent in 2004, as job creation remained strong.

Table 1.

China: Summary Indicators

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

IMF staff estimate.

Central and local governments, including all official external borrowing.

Banking survey.

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

For 2005, 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. Economic activity has maintained its momentum in the first five months of 2005. GDP in the first quarter grew at 9.4 percent rate (year-on-year), with the contribution from net exports increasing, as export growth remained strong and import growth moderated. Real fixed asset investment grew by around 23 percent, similar to the average level in 2004. Retail sales growth remained robust, suggesting continued strong consumer demand.

uA01fig02

Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig03

Contribution to Real GDP Growth

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig04

Demand Indicators

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig05

External Trade

(Percent change, 3mma, y/y)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

5. Despite continued strong output growth, inflation has come down. After peaking at 5¼ percent (year-on-year) in Q3 2004, headline CPI inflation fell sharply in late 2004, largely due to a reversal of food price increases as agricultural production rose. Supply-side factors—such as increased capacity from strong investment, persistent productivity gains, and reduction in tariffs—also served to kept non-food prices rises in check. Headline inflation remained relatively subdued during the first five months of 2005, running at 1(¾) percent (y/y) in May. After rising rapidly in the first part of 2004, PPI inflation has declined in recent months, reflecting some easing in world commodity prices and raw materials demand in China.

uA01fig06

Current Account Balance

(In US$ bn)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

6. The external current account surplus rose by 1 percentage point to 4¼ percent of GDP in 2004. On the trade front, export growth remained strong throughout the year, but import growth slowed, particularly imports of raw materials and machinery and equipment, due to the moderation in investment growth and an increase in the supply of some domestic import substitutes. As a result, the trade surplus rose by 0.4 percentage point of GDP (Table 2). Private transfers also rose, probably reflecting speculative inflows in anticipation of a renminbi appreciation.

Table 2.

China: Quarterly 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.

7. China’s trade balance strengthened further in the first five months of 2005. In particular, the trade balance during January-May shifted to a sizeable surplus in contrast to the deficit registered in the same period of 2004. Exports during this period rose by 33 percent (y/y) while imports increased by only 13¾ percent, mainly reflecting continued weak demand for raw materials and machinery and equipment. Chinese customs data suggest that total textiles exports grew at roughly the same rate as in 2004 (at an annual rate of around 20 percent), but importing country data indicate that the United States and the European Union registered a surge in textiles from China. The United States has imposed safeguards against textile imports from China, while the European Union has come to an agreement with the Chinese authorities to limit the growth of textile exports.1 National income accounts data suggest that the increase in the external current account surplus reflected rising domestic savings that exceeded investment. China’s already high overall savings rate rose further to around 49 percent of GDP in 2004 fueled by strong corporate profits, with the contribution of retained earnings rising to close to half of the total. In contrast, household savings, although still high, are estimated to have declined relative to GDP in the last few years.2

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Contribution to Change in Reserves

(In US$ bn)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig08

Inflows and Exchange Rate Expectations

(In US$ bn)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

1/ Implied appreciation; in percent; RHS.
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External Debt

(In US$ bn)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig10

Real and Nominal Effective Exchange Rates

(June 1997=100)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

8. The larger external current account surplus, together with strong capital inflows, led to a further sizable increase in foreign official reserves (Table 3 and 4). International reserves increased by $206 billion in 2004 and by a further $81 billion in the first five months of 2005, bringing the level at end-May to nearly $700 billion.3 While FDI inflows (mainly from Hong Kong SAR, Korea, and Japan) remained strong, a substantial portion of the reserve accumulation was accounted for by net non-FDI capital inflows (including errors and omissions) largely attracted by the prospects of a renminbi appreciation. The renminbi has depreciated in both real and nominal effective terms since mid-2004, and by end-April 2005, it was about 18 percent below its previous peak in February 2002.

Table 3.

China: External Debt

(In billions of U.S. dollars)

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Sources: Chinese Authorities and staff calculations.

The breakdown of debt by debtor and coverage of entities were changed in 2001. In addition, loans from foreign governments to policy banks are moved from debt of government category to debt of Chinese-funded financial institutions from end-2003 onward. The adjustment was $15.2 billion at end-2003.

In 2001, trade credits and loans borrowed by foreign funded financial institutions are included. Their stock at end-2001 was 38.7 billion.

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.

9. Real estate prices have continued to rise, with particularly large increases in certain areas of fast-growing cities such as Shanghai. Some of the rise in housing prices is due to the cumulative impact of liberalization steps in land markets undertaken since 1998, but anecdotal evidence suggests that speculators are also quite active in the market. Concerned with speculative pressures, the People’s Bank of China (PBC) raised mortgage interest rates in March 2005. In May, the authorities also announced a new set of property-related measures aimed at curbing speculation in residential and commercial markets.4 Despite the rise in real estate values, affordability indices have generally improved as household incomes have outpaced price increases.

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Property Prices

(1997=100)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig12

Affordability 1/

(March 2001 =100)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

1/ Affordability is defined as the ratio of household income to housing price.

10. During the course of 2004, the PBC took several steps to reduce liquidity in the banking sector and slow lending growth. The steps taken included intensifying open market operations, raising the reserve requirement ratio and short-term re-lending and rediscount rates, increasing bank deposit and lending interest rates (for the first time in 9 years), and eliminating the ceiling on lending rates. These were supplemented with credit allocation guidance provided by the PBC and the China Bank Regulatory Commission (CBRC) to influence banks’ lending decisions. These measures helped reduce broad money growth to 14 percent and loan growth to 12½ percent by April 2005, down by about 5½ and 8½ percentage points, respectively, from their growth rates in 2003 (Table 5).

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.

uA01fig13

Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig14

Liquidity Indicators

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

uA01fig15

Reserve Money Growth

(Quarterly, in RMB bn)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

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Money and credit growth

(In percent, Q/Q, SAAR)

Citation: IMF Staff Country Reports 2005, 411; 10.5089/9781451807806.002.A001

11. Nevertheless, considerable liquidity remains in the system at present, as evidenced by a still high excess reserve ratio and low interbank interest rates. In March 2005, the PBC cut the interest rate it pays on excess reserves held at the central bank, adding to downward pressures on interbank rates and reducing interest rates on central bank bills. The build-up in official reserves also continues to add substantially to liquidity. While the PBC stepped up its open market operations to sterilize most of the inflows beginning in late 2004, for the year as a whole only about half of the liquidity arising from the increase in international reserves was sterilized (as the trade surplus and capital inflows remained high). Overall, despite the liquidity in the banking system and some loosening of administrative controls,5 credit growth remains relatively constrained owing to continued lending guidance to banks provided by the PBC and the CBRC and restrained lending by the large state-owned banks (SCBs) that are undergoing restructuring.

12. Strong revenue overperformance allowed for a further decline in the fiscal deficit in 2004. The deficit fell to 1½ percent of GDP (official definition; 1¾ percent according to the IMF definition; Tables 6 and (7), about one percentage point of GDP below its targeted level in the 2004 budget and the 2003 outcome. Once again, revenue was substantially above its budget projection by 1¾ percentage points of GDP, reflecting strong activity and continued improvements in tax administration. About half of this revenue overperformance was used to finance increases in social expenditures and subsidies and to clear up old government liabilities, including arrears on VAT refunds to exporters.6 The remainder was unspent, partly because some transfers to local governments were made late in the year. During the first four months of 2005, gross revenue (excluding VAT refunds) grew by about 21 percent relative to the same period last year, compared with a budget forecast for 2005 of an 11 percent rise, while expenditure growth was broadly in line with the budget.

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 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 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 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 arrears in the absence of adequate data.

Assumption for 2005.

C. Macroeconomic Outlook and Risks

13. Staff projects GDP growth to slow slightly during the year and to average around 9 percent in 2005. This forecast assumes that appropriate macroeconomic policies will be in place to further slow investment growth. Export growth will remain strong, but slow from its current pace, with the growth in textile exports depending on the extent of safeguard measures imposed by China’s trading partners. Import growth should pick up in the remainder of the year—with orders that were temporarily put on hold in anticipation of a currency appreciation brought on stream as inventories are depleted—but will remain below its 2004 level, reflecting slower investment growth. Consumption growth is expected to remain relatively strong as household credit facilities continue to expand and rural incomes rise further, reflecting cuts in rural taxes and government efforts to stabilize domestic grain prices. The external current account surplus would increase by nearly 2 percentage points to 6 percent of GDP, mainly reflecting a higher trade surplus. Inflation should average around 3 percent in 2005. Slower food price increases are likely to be only partially offset by a rise in non-food prices as some of last year’s rapid producer price increases is passed through to consumer prices and certain administered prices are raised.7

14. A significant risk remains that macroeconomic policies will not be sufficiently tight to curb investment growth. In particular, there is a need for monetary policy to prevent a surge in credit growth as large capital inflows add liquidity to the banking system, increasing the odds of tipping off a boom-bust cycle and igniting inflationary pressures. Given the continuing volatility in world oil markets, a further sharp increase in oil prices would adversely affect growth both directly and indirectly if this leads to a more pronounced slowdown in global demand. Growing protectionist sentiments in China’s major markets, presents another key risk. Moreover, a disorderly unwinding of global imbalances would threaten China’s growth, as economic activity in all countries would likely suffer lingering adverse effects.

15. China’s medium-term prospects are generally favorable provided near-term risks are well managed and further structural reforms are implemented. The illustrative medium-term scenario presented in Table 8 suggests that GDP growth could average 7-8 percent annually, if structural reforms are advanced in the financial sector to improve intermediation of savings and in the state-owned enterprises and the labor market to maintain strong productivity growth. Fiscal reforms could also contribute to promote a more effective use of China’s high domestic savings. Better financial intermediation and reforms to China’s pension and health care systems would help to raise private consumption by further improving credit facilities and reducing the need for large precautionary savings. However, unless enterprise profits fall sharply or SOEs pay substantially more dividends to their shareholders (particularly the government), corporate retained earnings would remain high. Modest fiscal consolidation over the medium term, which is needed to ensure sustainability of public finances, will add to overall savings. With investment growth projected to decline, which is desirable and intended by current government policies, China’s current account surplus would not be expected to narrow substantially in the medium term in the absence of a change in the real exchange rate. In particular, real appreciation would help raise consumption as households’ purchasing power strengthened and renminbi prices of foreign goods declined. However, following convention, the real exchange rate is assumed to remain unchanged in the illustrative scenario presented here. In general, the extent of any change in the real exchange rate, the form that it might take (the relative contribution of changes in China’s inflation rate versus changes in its nominal exchange rate), and the consequent impact on China’s external balance are uncertain, depending to a large degree on the structural reforms that would be adopted in the medium term.

Table 8.

China: Illustrative Medium-Term Scenario

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

Excludes errors and omissions up until 2004, included errors and omissions from 2005 onwards.

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