People’s Republic of China: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund
Publication Date:
31 Oct 2006
eISBN:
9781451807813
ISBN:
9781451807813
Language:
English
Keywords:
ISCR; CR; credit growth; investment growth; liquidity in the banking system; US$ rate; growth; broad money; central bank; nominal exchange rate; short-term debt; debt relief; Commercial banks; Global
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Prospects for the future remain favorable, provided that policy actions are taken to address the risks and challenges that China faces. The government recognizes the need to contain investment and credit growth, and has tightened the monetary policy in response. Greater exchange rate flexibility will play a role in contributing to an orderly process for resolving global current account imbalances. Center-local fiscal relations need to be reformed, and such reform will help to rebalance the economy and spread the benefits of growth.

Abstract

Prospects for the future remain favorable, provided that policy actions are taken to address the risks and challenges that China faces. The government recognizes the need to contain investment and credit growth, and has tightened the monetary policy in response. Greater exchange rate flexibility will play a role in contributing to an orderly process for resolving global current account imbalances. Center-local fiscal relations need to be reformed, and such reform will help to rebalance the economy and spread the benefits of growth.

I. Economic Developments and Outlook

A. Background

1. This year’s discussions took place against the backdrop of continued strong economic performance in China, as well as growing challenges. High output growth has been maintained, led by investment and exports, and inflation has remained low. In the period ahead, while key risks and challenges facing the economy are in some ways the same as over the past couple of years, the need to address them has increased as imbalances in the economy have widened. Last year’s concern that rapid investment growth is leading to overcapacity in some sectors has increased. Abundant liquidity in the banking system is touching off a new surge in lending and investment, with the probable consequence of creating new non-performing loans (NPLs) and undoing some of the progress made in reforming the banking sector. China’s increasing integration into the global economy also poses challenges. As China’s export market share has continued to rise, frustration in many trading partner countries with China’s slow pace of exchange rate appreciation has been mounting. This runs the risk of exposing China to renewed protectionist measures. The gap between incomes of rural and urban areas continues to widen, and concerns are emerging that reform may be proceeding too fast, raising the risk that progress could stall if these concerns are not addressed.

A01ufig01

China: Trade Balances

(In US$ bn; custom data)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

2. Policy changes are needed to address both domestic and external challenges. If China is to sustain rapid and stable economic growth the economy needs to be rebalanced away from heavy dependence on export-led growth toward self-sustaining domestic demand, and the opportunity to share in the benefits of growth needs to be spread more equitably across all levels of society.

3. The authorities are aware of these challenges. In the annual National People’s Congress held in March, the government stressed the need to improve the investment structure, advance reforms in the health care, pension, and education systems, and provide more support to the rural areas and the less-developed regions. These reforms are aimed at boosting consumption by reducing precautionary savings. Along with policies to reduce energy intensity of production, the government aims to support a growth strategy that is more balanced than that in recent years (Box 1).

Rebalancing Growth in China

Shifting the composition of growth away from exports and investment towards increased consumption is a key element of the government’s overall strategy to rebalance growth.

Chinese households consumed less than 40 percent of GDP in 2005.1 However, this was not always the case. The consumption-to-GDP ratio stood at 51 percent in 1980 when the liberalization of China’s economy had just begun, but has steadily declined since then. The decline is somewhat surprising given that real consumption grew at an annual average rate of 8 percent during this period. However, it was outpaced by real GDP which grew at around 10 percent each year.

Much of this decline in the consumption-to-GDP ratio has coincided with the fall in the share of disposable income to GDP. A falling share of wage and investment income relative to GDP, and in recent years that of the government transfers have been the main causes behind the decline in the disposable income ratio. While the average wage rate has risen at a rapid pace, it has lagged productivity growth. Much of the decline in investment income has resulted from continued low saving deposit interest rates, weak equity prices, and a lack of investment alternatives.

A01ufig02

Disposable Income and Consumption

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

Sources: National Bureau of Statistics of China, and staff estimates.

At the same time, households save close to 30 percent of their disposable income, a much higher ratio than might be expected given China’s income level and its demographic structure. A large part of this reflects strong precautionary savings given the significant uncertainties surrounding public pensions and rising health care and education costs. The underdeveloped financial market has also played a role, as it offers few consumer credit facilities and insurance instruments, and thus limited scope for households to borrow against their future income or pool risks.2

National savings have steadily increased, largely driven by rising enterprise and government saving rates. National savings rose to over 50 percent of GDP in 2005. The market-oriented reforms of enterprises and the favorable external environment produced a rapid rise of corporate profits in recent years. Most of these profits have been kept as retained earnings rather than returned to shareholders. In particular, the state-owned enterprises, which account for about half of total corporate profits, do not pay dividends to the government, and instead use these funds to invest. Government savings also rose in the past several years, reflecting buoyant revenue performance. Government consumption has increased less, with the spending on social areas, such as health and education, falling behind that in most other countries as a share of GDP. As a result, the share of publicly provided household consumption has also declined.

A01ufig03

Domestic Savings by Sectors

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

Sources: National Bureau of Statistics of China, and staff estimates.
1/

The data in this box are based on the unrevised expenditure side numbers. The expenditure-based GDP data have been revised only for 2004 and 2005, and thus there are no consistent time series based on the new methodology.

2/

The Selected Issues paper discusses household consumption and savings behavior.

B. Recent Developments

4. Output growth continues to be strong. Based on the revised official data, GDP growth in 2005 reached nearly 10 percent, roughly the same as in the previous year (Table 1 and Box 2). Indicators for the major components of demand suggest that output growth in 2005 could have been much higher than officially estimated. Consumption growth has remained high, and investment growth showed signs of increasing beginning in the second half of the year. The contribution of net exports to growth also increased significantly during 2005.

Table 1.

China: Summary Indicators

Nominal GDP (2005): US$2,225 billion

Population (2005): 1.308 billion

GDP per capita (2005): US$1,702

Quota: SDR 6,370 million

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

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.

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. Trade credit data since 2001 was revised in 2005.

Annual averages (2000 = 100).

Recent Revisions in China’s Official GDP Figures

Based on a comprehensive economic census of businesses, China increased the estimate of GDP in 2004 by 17 percent. Based on the 2004 data, a standard statistical technique (the trend-deviation method) was then used to estimate revised data back to 1993. Real GDP growth was raised by an annual average of about ½ percentage point (see figure below) and the 1993-2004 average for GDP growth increased to 9½ percent.

The bulk of the upward revision came in the service sector, which increased by almost 50 percent. As a result, the share of the service sector in 2004 GDP increased by 9 percentage points to 41 percent. Manufacturing’s share of output was revised up by only 4 percent as a result of the census.

The revised data show higher GDP implicit price inflation, especially in recent years. In particular, estimated inflation in the service sector increased substantially, with the 2000-04 average annual implicit inflation for this sector nearly doubling from 1¾ to 3½ percent in the revised data.

A01ufig04

China Real Production-Based GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

With regards to expenditure side estimates of GDP, only 2004 data have been revised and published so far, and the 2005 preliminary data using the new methodology have recently been published. The largest revisions were to government consumption and inventories. As a result, the GDP shares of household consumption and gross fixed capital formation both fell slightly, with each accounting for about 40 percent of GDP.

5. Economic activity maintained its momentum in 2006, with further evidence of acceleration in investment. GDP grew by 10¼ percent (year-on-year) in the first quarter. Total nominal fixed investment increased from 25.7 percent in 2005 to 29.8 percent in the first half of 2006. Net exports continued to be strong, although the pace of import growth has accelerated. Indicators also suggest that consumption growth remained high.

A01ufig05

Fixed Asset Investment

(rolling 4 quarters, y/y growth in percent)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

6. Inflation remains subdued. After peaking at 5¼ percent (year-on-year) in mid-2004, headline CPI inflation fell to 1½ percent in May 2006, largely driven by a significant moderation of food price inflation, as agricultural production returned to more normal levels. Non-food inflation also was held down by partly offsetting movements in major components. Price declines have persisted in such items as clothing and household durable goods, reflecting rising capacity and contributing to oversupply in some products, as well as declining unit costs owing to continuing strong increases in productivity. This has been more than offset by price increases in services—including health care, education, and household maintenance—and rising fuel costs. Producer price inflation continues to fall from its peak of 8½ percent in late 2004 to about 2½ percent in May 2006, reflecting some easing in materials prices, especially as new production capacity in steel, chemicals, and coal has come on stream.

A01ufig06

Inflation

(Percent change, 3mma, y/y)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

7. The external position strengthened substantially in 2005. The trade surplus was the main driver, surging to $134.2 billion compared to $59 billion in 2004 (BoP basis, Table 2−3). Export growth remained strong throughout most of the year, but import growth slowed sharply in the first part of the year before picking up in the second half. The overall slowdown in import growth resulted in a large increase in the current account surplus in 2005 to over 7 percent of GDP, up from 3½ percent in 2004. This slowdown largely reflected a switch away from imports toward domestically produced inputs, a moderation in investment demand for machinery, and some reduction in raw material inventories. Export growth was robust given strong world demand and China’s increasing role in the processing trade. The expectation of the renminbi appreciation may have played a role in the rise of the trade surplus, although the impact is unlikely to have been very large.1

A01ufig07

External Trade

(Growthrates inpercent, 3mma, y/y)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

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. 2005 include bank capitalization and foreign exchange swap, estimated at $28.8 billion.

Includes counterpart transaction to valuation changes.

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 atend-2003. In 2001, trade credits and loans borrowed by foreign funded financial institutions are included. Their stock at end-2001 was 38.7 billion. In 2005, switching to sample based estimation increased trade credit for 2001 onwards and by $14.7 billion for 2001 compared with methods used previously.

8. The trade surplus continued to rise in 2006, with the $61 billion surplus in the first six months of 2006 up 50 percent from the same period last year. Import growth has picked up somewhat, driven mostly by primary products and machinery, while export growth remains strong. Last year’s agreements to limit exports to the United States and the EU of textiles and apparel, which are a small share of China’s total exports, appear to have had a very limited impact on China’s export growth thus far.2

9. Foreign official reserves accumulation has continued at a rapid pace. Reserves increased by $208 billion in 2005, broadly in line with reserve accumulation in 2004, and by a further $106 billion in the first five months of 2006, bringing the level at end-May to about $925 billion (Table 4).3 Reserve accumulation in the second-half of 2005 was increasingly driven by trade flows, in contrast to the situation in 2004 and the first half of 2005 when speculative inflows played a larger role. Net FDI inflows, at $68 billion in 2005, increased compared to 2004 despite a jump to $10 billion in China’s foreign investment abroad. Over the period, non-FDI capital flows sharply reversed to an outflow of $22 billion in 2005 (including errors and omissions), compared to an inflow of $85 billion in 2004. The renminbi has fluctuated significantly in both real and nominal effective terms reflecting the volatility of the U.S. dollar against other currencies, and in May 2006, it was about 15 percent below its previous peak in February 2002.

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.

Based on official data on short-term debt at original maturity and medium and long-term debt repayment in the BOP.

Based on official debt data unless otherwise indicated.

Debt of banking sector not included.

Staff estimates.

China: A Decomposition of the Reserve Buildup

(In billions of U.S. dollars)

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Staff estimates.

Includes errors and omissions.

10. The equity market has been buoyant in 2006, while the rapid growth in property prices has eased. Progress in equity market reforms, especially in reducing the overhang of non-tradable shares, has helped boost the market—as of mid-June the index for the Shanghai Stock Exchange had increased 35 percent over its end-2005 level. Nevertheless, the market is still 25 percent below its end-2000 level. Property price growth peaked at over 10 percent in the fourth quarter of 2004, and by end-2005 growth had slowed to 6½ percent, partly reflecting the government’s control measures. Prices in Shanghai, particularly in certain sections of the city, declined sharply. However, concerns of a rebound in property prices in other urban areas have recently surfaced, with the authorities launching new policies to regulate the property sector, including measures to limit luxury housing developments.

11. Less than full sterilization of foreign exchange reserve accumulation has left substantial liquidity in the banking system, and credit growth appears to be accelerating. While broad money (M2) growth has increased since mid-2005, reaching a WA percent annual rate by the end of the year, credit growth, averaging around 13½ percent in 2005, remained relatively subdued, reflecting more cautious lending by the large state-owned commercial banks undergoing restructuring and moral suasion on the part of the PBC (Table 5). Broad money growth continued to rise in the first part of 2006, and lending growth picked up as well. By May, M2 and lending were growing at rates of 19 and 15 percent respectively. In response, the PBC increased the benchmark lending rate in April by a modest 27 basis points, and administrative controls and lending guidance were increased.

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.

Reserve requirements were raised by ½ percentage point in June and further administrative measures and lending guidance were initiated. The PBC also introduced a new series of central bank bills that are being sold on a mandatory purchase basis at below market interest rates to banks with fast lending growth. Short-term interest rates have risen somewhat since early November as the PBC stepped up open-market operations, but they still remain below the 2½-3 percent levels of 2004.

A01ufig09

Central Bank Bill, 3 Month Interest Rate

(in percent)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

12. Strong revenue overperformance allowed for a further decline in the fiscal deficit in 2005. At 1.3 percent of GDP, the deficit was lower than the 1½ percent of GDP recorded in 2004 and was ½ percent of GDP better than budgeted (Table 6–7). Revenue, growing at a rate of 20 percent, exceeded budget projections by ¾ percent of GDP, reflecting particularly strong income tax and VAT receipts. In a repeat of developments in 2004, part of the revenue overperformance was used to increase spending on social programs and clear pending liabilities, including repaying all remaining arrears on VAT refunds. As in 2004, local governments recorded a large surplus (about ½ percent of GDP), in part reflecting late transfers from the central government. The 2005 outturn continues the trend of fiscal consolidation over the last few years. If the timing of the build-up and repayment of VAT refund-related arrears is accounted for, the pace of consolidation would be much faster than what the cash-based data show, with the 2005 outturn being near balance.4 The budget outturn through April 2006 shows that revenue performance continues to be very strong, exceeding the growth rate projected in the 2006 budget.

A01ufig10

Fiscal Balance

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 394; 10.5089/9781451807813.002.A001

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. 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 claimed but not paid. The IMF definition is not adjusted for tax refund arrears in the absence of had been adequate data.

C. Macroeconomic Outlook and Risks

13. Staff projects GDP growth to remain around 10 percent in 2006. This forecast assumes that appropriate macroeconomic policies will be in place to constrain investment growth. However, recent data for investment and exports point to the increasing possibility that GDP growth could exceed 10 percent. Even if policy actions are taken now to constrain investment, the main impact of tightening measures on growth are likely to be experienced in 2007. The outturn in the first five months of 2006 also suggests that export growth may not slow as much as generally expected, which not only would boost GDP growth, but would result in a further widening of the external current account surplus.

14. Inflation is expected to remain below 2 percent in 2006. Although consumption growth has remained strong, much of the economy’s rapid growth rate has been driven by investment. This has continually added to the economy’s productive capacity and in some sectors, such as automobiles and steel, it has led to overcapacity. At the same time, the substantial liquidity in the banking system and the associated acceleration in credit growth have been largely confined to financing investment and not consumption. Moreover, although wage rates have risen in recent years, with substantial underutilized labor resources in the economy, the wage increases have been relatively modest. Indeed, wage and disposable income as a share of GDP remain significantly below even their early 2000 levels (Box 1). As a result, despite the rapid overall growth, inflation has been subdued and is likely to remain so in the near term. Falling prices in sectors with overcapacity offset the likely rise in services inflation and upward adjustments in certain administered prices.5 As nontradables make up much of the households consumption basket, an appreciation of the currency is unlikely to have a significant direct downward impact and with overcapacity confined to certain sectors at present, the risk of generalized deflation appears small. The risk of a sharp rise in inflationary pressures is also limited, given that consumer credit facilities remain limited.

15. A significant risk remains that macroeconomic policies will not be sufficiently tight to contain investment growth. In particular, there appears to be a need for monetary policy to be tightened further to prevent a surge in credit growth from tipping off a boom-bust cycle and an associated rise in banks’ nonperforming loans. There is also a risk that, as in the past, it may be difficult to slow investment growth in the run-up to the scheduled change in government in early 2008 (when positions in all levels of government are shuffled). Among other major risks to the outlook, 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.6 Growing protectionist sentiments in China’s major markets also present a major risk. Moreover, a disorderly unwinding of global imbalances would threaten China’s growth, as economic activity in partner countries would likely suffer lingering adverse effects. Although less immediate, avian flu remains a threat.

16. China’s medium-term prospects are favorable, but the savings-investment gap would remain large unless further structural reforms and policy changes are implemented to rebalance growth. The illustrative scenario presented in Table 8 suggests that GDP growth could average around 9¼ percent annually, but the saving-investment gap would remain high at around 6 percent of GDP. To reduce this gap, reforms and policies are needed to rebalance growth away from heavy reliance on investment and exports toward domestic consumption by improving intermediation of savings through further banking sector reform and capital market development, and continuing reforms in the state-owned enterprises and the labor market to maintain strong productivity growth. In addition, reforms to China’s pension, education, and health care systems, along with a shift in public expenditures toward these areas, are important in helping to increase private consumption by reducing the need for large precautionary savings. These reforms and policy changes would reduce the saving-investment gap over time, but it would also critically depend on how the real exchange rate might change in the coming years.7

Table 8.

China: Illustrative Medium-Term Scenario 1/

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

Following convention, the scenario assumes a constant real exchange rate and a continuation of the current policy framework including fiscal policy.

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