People's Republic of China
2011 Article IV Consultation

In this study, China’s economic developments and policies are discussed. Economic growth has been increased by expanding infrastructure and real estate construction. The policy measures outlined in the twelfth five-year plan and implementation of financial reform are important for China’s balanced global growth. The price-based tools of monetary policy, improvement over monetary policy framework, and interest rate structure are encouraged. The financial sector assessment program and the importance of well-sequenced financial liberalization and reforms, which are part of China’s rebalancing strategy, are ascribed.


In this study, China’s economic developments and policies are discussed. Economic growth has been increased by expanding infrastructure and real estate construction. The policy measures outlined in the twelfth five-year plan and implementation of financial reform are important for China’s balanced global growth. The price-based tools of monetary policy, improvement over monetary policy framework, and interest rate structure are encouraged. The financial sector assessment program and the importance of well-sequenced financial liberalization and reforms, which are part of China’s rebalancing strategy, are ascribed.


A. Overheating and Inflation

1. The global context. The authorities indicated that they saw multiple downside risks to the global outlook. In particular, officials underlined the inward spillovers and risks to China arising from high levels of public debt in the United States, the United Kingdom, and elsewhere; the slow pace of recovery in many large industrial economies; and the increasing divergence across the European Union (particularly related to sovereign risks in the Euro periphery). They also reiterated their concerns about the scale of global liquidity and the potential for increased volatility in capital flows. Finally, they pointed to the counter-productive rise in trade protectionism in recent years, linking it to sub-par growth in the larger economies. It was against this global backdrop that the 12th Five-Year Plan had been prepared (Box 1) and macroeconomic and financial policies were being decided.


Trade frictions rose during the global recession

Advanced Economy Unemployment Rates and Trade Complaints

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

2. Growth. Despite the external risks, China’s economy remains on a solid footing, propelled by vigorous domestic and external demand. Wage and employment increases have fueled consumption, the expansion in infrastructure and real estate construction has driven investment upward, and net exports are once again contributing positively to economic growth (Figure 1). There has been some sequential slowdown in activity in recent months, in part a result of policy tightening, but this had already been built into staff forecasts.

Figure 1.
Figure 1.

Toward Strong and Sustained Growth

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; and staff estimates.

3. Inflation. Over the past year, consumer price inflation has been a pressing social and economic issue. At end-May, inflation was 5½ percent with a broadening of price pressures beyond just fresh food (Figure 2). The authorities indicated that they have responded to the upswing in inflation with a range of policy measures including monetary tightening, efforts to increase food supply and deal with transportation bottlenecks, as well as the use of existing price controls on some items. It now looks as if the supply shocks that precipitated the recent inflationary upturn are dissipating and the policy measures taken to counter price pressures are having an impact. Barring further food price shocks, and assuming the ongoing tightening of monetary policy is continued, there was general agreement that inflation should soon peak although there were still upside risks to inflation, mostly from adverse weather conditions affecting food prices and from higher global commodity prices. Staff also noted that some part of current inflation was likely being suppressed by administrative measures. This may stifle the appropriate supply response to higher prices and could lead to the inflationary dynamic showing more inertia and persistence during this cycle.

Figure 2.
Figure 2.

Prospects for China’s Inflation

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; and staff estimates.

Highlights From China’s 12th Five-Year Plan

Coverage. The 12th Five-Year Plan is a high level strategic document that outlines the directions for policy and reform in the coming years and sets specific targets on certain areas (such as growth, urbanization, energy use, and others). In many areas, though, the plan does not yet detail the concrete steps that will be put in place to achieve these social and economic goals.

Themes. Rebalancing growth from exports to consumption remains a central theme of the plan with an emphasis on “accelerating the transformation of the pattern of economic development” by enhancing productivity, supporting innovation, and investing in human capital. The priority has also shifted away from the absolute level of growth toward its quality and impact on “people’s livelihood.”

Internal balance. The government has promised increased support for agriculture and the service sector as well as a more balanced regional development by harnessing urbanization and supporting the relocation of industries to the interior.

Household income. To boost consumption, the plan targets a needed growth in disposable income—for both urban and rural residents—that outstrips that for the economy as a whole, reversing the secular decline in household income as a share of GDP.

Safety net. There are plans to further increase the coverage of the health and pension systems and provide low income housing for up to 20 percent of urban households.

Technology and environment. The plan targets moving up the value chain in manufacturing through technological upgrade and promoting investment in strategic industries. There is also a continued emphasis on clean energy and increases in input costs to better price pollution externalities.

Financial reform. Over the next five years, the government intends to move toward more market-based interest rates and capital account convertibility.

4. Labor. Official data shows double-digit increases in nominal wages and there are signs of labor mismatches, both geographically and skills-related. There is, however, significant heterogeneity across the labor market. Anecdotal indications are that jobs are migrating from the coastal regions into the interior provinces, in part due to demographic reasons, improved prospects in inland provinces, and frictions to labor mobility created by the household registration scheme. The premium for skilled or experienced labor is growing but unskilled labor has much less pricing power in the labor market. Unemployment among university graduates is becoming an important social issue with many college graduates ill-equipped for the workplace. At the same time, companies report being increasingly constrained by a lack of skilled labor. This growing skills gap is a pressing issue without a clear near-term solution and one that is feeding into growing income inequality.


Labor costs are growing broadly in line with productivity

China Unit Labor Cost and Industrial Profit Margin

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

5. Cost pressures. There are some signs that higher wages and broader cost pressures could be starting to feed through the production chain, pushing up the prices of manufacturing exports. The authorities felt that the transition underway in the labor market was an important development and could represent a significant force in economic rebalancing. They argued that this change was likely to continue and accelerate, driven by demographic factors and policies to increase the minimum wage, improve the social safety net, and strengthen workers’ rights. Staff agreed that there were some signs of a tightening labor market and rising cost pressures. Nevertheless, China continues to have a structural labor surplus with significant unemployment and underemployment. At an aggregate level, it still appears that wage pressures are mostly being absorbed by productivity gains; manufacturing unit labor costs are rising only slowly and corporate profit margins are not being compressed by rising costs. While changes in the labor market will help with rebalancing, this would be a gradual process and would need to be complemented with reforms in a range of other areas. In addition, while export prices were rising, this was also a feature of other Asian economies and may be driven more by a pass-through of rising global commodity prices than by country-specific cost pressures.


As in the rest of Asia, export prices have rebounded

Export Prices

(In percent, year-on-year 3mma growth)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

B. Property Bubbles

6. Developments. The government’s efforts to slow the rapid pace of increase in property prices appear to be having the desired effect. In the first five months of this year, residential property prices on average rose 7 percent over those of the previous year and transaction volumes have been discretely lower. Market participants indicated that the restrictions on purchases of properties for investment purposes have had the biggest impact. There is also some evidence that people are shifting more into renting property with rents now catching up with prices in the larger cities. In addition, commercial real estate prices have been rising quickly, particularly in the larger coastal cities (Figure 3). Despite the slower rate of increase in house prices, real estate investment has held up well, in part bolstered by an ongoing expansion in the construction of housing for lower income groups (the government has a goal of building or refurbishing 10 million units of social housing this year).

Figure 3.
Figure 3.

Is There a Property Bubble in China?

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Sources: Bloomberg; CEIC Data Company Limited.; Centaline Property Agency Limited; and staff estimates. Benchmark house price is derived from a no-arbitrage condition equating rental to home-ownership costs.

7. Assessment. Despite some success in calming down the property market, prices are high as a share of household income, particularly in some of the larger cities, and staff remains concerned about the potential for a property price bubble in China. The property sector occupies a central position in the Chinese economy, directly making up 12 percent of GDP and is highly connected to upstream industries (like steel and cement) and downstream producers of appliances and other consumer durables. Direct lending to real estate (developers and household mortgages) makes up around 18 percent of banks’ credit portfolio; property is a sizable component of household and corporate balance sheets; and for local governments—which account for 82 percent of public spending—property-related revenues (including budgetary funds) are important. A property bubble, therefore, would pose serious macroeconomic and financial stability risks.

8. Policies. Staff did not see imminent risks of a material downturn in the property sector. However, with the slowdown in transaction volumes there could be stress on the balance sheets of some property developers; this could prompt consolidation in the sector. Staff maintained that as long as the cost of financing is low and other investment options are sparse, the propensity for property bubbles will remain and the government will have to take progressively tighter administrative measures to stem demand and dampen house price inflation. Decisively mitigating the risk of a property bubble will require a higher cost of capital, financial market development, and the introduction of a broad-based property tax. The authorities recognized the risks and also emphasized their concerns related to the impact of worsening housing affordability on inequality and social stability. There was broad agreement that the government will need to continue to provide affordable urban housing to lower-income households for many years to come.

C. Credit and Banking Risks


The growth in bank lending has slowed

New Lending

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

9. Developments. Following the massive injection of credit stimulus in response to the global financial crisis, the central bank and the bank regulatory agency moved in 2010 to rein in loan growth. Despite this shift in policy, monetary and credit growth last year overshot their targets. In addition, off-balance sheet credit expanded (through trust funds, guarantees, and other means). However, since late 2010, there has been a renewed effort to tighten credit conditions and a steady, albeit moderate, increase in deposit and loan rates.


Interest rates and reserve requirements have moved higher

Interest Rates and Reserve Requirements

(In percent)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Selected Banking Indicators

(in percent)

article image
Source: CBRC.

10. Assessment. Stress tests—conducted by the authorities as part of the FSAP process—suggest that the banking system is generally capable of absorbing significant downside risks. However, given the large expansion in credit in the past 2½ years, a coordinated shock on multiple fronts (including lower growth, a sharp real estate downturn, and higher interest rates) would leave some of the smaller private banks with insufficient capital to meet regulatory requirements. The key risks to credit quality remain concentrated in loans to local government financing vehicles, off-balance sheet lending, and, to a lesser extent, credit to the property sector. A full assessment of these various risks is, however, hampered by serious data gaps, weaknesses in the information infrastructure, and constraints on the FSAP team’s access to confidential data.

11. Policies. To counter these credit risks, the bank regulatory agency indicated it is in the process of requiring that banks assess their credit portfolio in a downside scenario and ensure that lending to local government vehicles meets certain minimum collateral requirements. The authorities also said that efforts to catalog and determine the risks and potential contingent fiscal liabilities arising from the recent surge in lending to local government financing vehicles were nearing completion. Banks had been asked to raise the capital requirements and provisioning for such loans and significant time has been spent conducting on-site examinations and increasing the regulatory and supervisory scrutiny of credit risks. In addition, banks are now being required to bring much of their trust-related lending back on balance sheet by year-end. Despite these efforts, staff argued that credit quality risks remain, potentially implying significant contingent liabilities.

D. Near-Term Macroeconomic Policies

12. Fiscal policy. The significant monetary and fiscal stimulus put in place in late 2008 has been effective in offsetting the growth impact of the collapse in external demand. There was broad agreement that with growth now self-sustaining, it is fully appropriate to gradually unwind the fiscal stimulus. Staff argued that the fiscal position should return to broad budget balance in the next one to two years, allowing fiscal policy to be modestly countercyclical. Should growth prospects deteriorate, a slower or delayed path of fiscal consolidation would be warranted. The authorities indicated that budget decisions would be taken on an annual basis at the time of the National People’s Congress and would very much depend on the prevailing economic situation. They underlined their commitment to devote more resources to social expenditures and rural development and to raise the minimum threshold of the personal income tax. Even with a reduction in the deficit over the near-term, staff argued that there should still be ample scope to reallocate fiscal resources toward tax and spending policies that promote private consumption.

13. Monetary policy. Given the cyclical outlook for the economy, evident price pressures, and the potential for a worsening of bank credit quality in the coming years, staff and the authorities agreed that monetary stimulus should be withdrawn and the target of 16 percent M2 growth by end-year (down from 19.7 percent at end-2010) represented a steady return to more normal monetary conditions that was well calibrated to the current macroeconomic environment. Achieving this goal would help mitigate the risks to bank balance sheets posed by the very rapid expansion of lending that had occurred over the past two years.

14. Monetary tools. The central bank has used both reserve requirements and higher interest rates to slow credit but still relies heavily on direct administrative limits on loan growth. The central bank has also introduced a supplemental “dynamically differentiated reserve requirement,” which varies across banks and through time based upon the pace of credit growth at the bank, the capital adequacy ratio, and other factors. Staff argued that this focus on quantity limits has limited the supply of bank credit but with little impact on the cost of capital or demand for new loans. In addition, with guaranteed loan-deposit rate margins, the banks still have strong incentives to expand lending. As a result, the control of monetary aggregates through direct limits on bank lending is already being disintermediated. There has been a significant rise in off-balance sheet provision of loans (e.g. through trust funds, leasing, bankers’ acceptances, inter-corporate lending, and other means) and a growing intermediation of credit through nonbanks and fixed income markets. In addition, over the past several months, there have been large loan inflows from offshore entities recorded in the balance of payments (as Chinese companies go abroad to offset credit restrictions at home). Such avenues were already partially counteracting the impact and effectiveness of monetary tightening and that tendency was likely to increase in the coming years. The central bank indicated that it was committed to moving gradually to more price-based tools of monetary policy, noting that loan and deposit rates had been increased four times since October. The central bank was also now monitoring a broader measure of “social financing”—which includes bank loans, off balance sheet lending, as well as funds raised in the equity and bond markets—in order to better judge financial conditions. They felt that the existing array of tools and the expanded scope of their surveillance would be sufficient to contain disintermediation risks. They also indicated that, to some degree, lending limits could be viewed as an effective microprudential device in a system where risk management and risk monitoring were still insufficiently developed.


Bank loans have fallen as a share of total financing

Social Financing

(In trillion RMB)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

E. Cross-Border Renminbi

15. Developments. Over the past year, the offshore use of the renminbi has grown tremendously. With the expansion of renminbi trade settlement, monthly settlement volumes reached RMB 134 billion in April (or around 7 percent of total trade). At the same time, the volume of renminbi deposits in Hong Kong SAR stood at RMB 511 billion at end-April (representing 8 percent of the Hong Kong deposit base). Finally, the development of renminbi financial products offshore has moved quickly with a range of instruments, spot markets, and derivatives now available. This has included the issuance of around RMB 155 billion in renminbi bonds in Hong Kong SAR.


Offshore renminbi deposits and trade settlement have expanded rapidly

RMB Trade Settlement for Cross Border Trade

(In billion)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Note: Staff estimates for 2010Q4.

16. Assessment. Despite the progress to date, the use of renminbi for trade settlement remains very one-sided, with 89 percent of settlement covering imports. Most issuance of financial instruments has been by Chinese entities with only limited use of the renminbi by nonresidents as a funding currency. In addition, the stock of available renminbi instruments is still small relative to the volume of renminbi that is building up offshore. As a result, much of the renminbi ends up being deposited at the Hong Kong clearing bank. The authorities recognized that progress in building the offshore market would need to be accompanied by a steady expansion in the avenues for those funds to flow back to the Mainland. In particular, they highlighted that they have already allowed around RMB 50 billion to be invested into onshore interbank bond markets and a similar amount to return as inward FDI. There are also discussions underway for a “mini-QFII” scheme that will allow, subject to quota, approved institutions to invest their renminbi in onshore capital markets.

17. Policies. The one-sided growth in cross-border activity has led to further upward pressure on international reserves and revealed the tension between achieving a greater global role for the renminbi at the same time as the currency is undervalued. Despite the relatively small size of the offshore market (it now represents around 10 percent of China’s monetary base or less than 1 percent of M2), there were already growing signs of two-way linkages between the onshore and offshore markets (Box 2). The authorities indicated that they were very closely monitoring the transactions taking place across the capital account—in both renminbi and foreign currency—and were ensuring that all cross-border flows were consistent with the regulations and were being used only to finance activity in the real economy. They also noted that, while the process of internationalization of the renminbi was demand driven, it was still being managed very carefully—in both the Mainland and Hong Kong SAR—to ensure stability.

The Links Between Onshore and Offshore Renminbi Markets

The renminbi holds significant potential to become widely used internationally due to China’s large economic size, diversified trade structure and network, and high growth rates. Yet, nonresident access to renminbidenominated assets remains limited. Despite this, in a historically unprecedented process of market development, renminbi trade settlement with nonresidents has expanded rapidly and the issuance of renminbidenominated assets in Hong Kong SAR is growing. This could have implications for the links between offshore and onshore markets even with binding capital controls in place.

Using a multivariate GARCH model, the links between the offshore renminbi markets in Hong Kong SAR (CNH) and the onshore renminbi (CNY) spot and forward markets were examined.1


The movements in CNH and CNY are highly correlated and the connection between the two markets was stabilized following the activation in October of the renminbi swap line between the People’s Bank of China and the Hong Kong Monetary Authority.

  • Developments in the onshore spot market exert an influence on the offshore spot market but the reverse is not true.

  • Nevertheless, offshore forward markets do seem to move ahead of onshore forwards. In particular, today’s CNH 3-month forward rate has a predictive impact on tomorrow’s CNY forward rate but not vice versa. This could be due to either price discovery being faster in the Hong Kong markets (due to their full integration with global markets) or, potentially, that onshore market participants may be looking to the CNH market for pricing signals in setting onshore rates.

  • There is also evidence of two-way volatility spillovers between CNY and CNH, especially in the forward markets.


China Bilateral Exchange Rates

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Summary of GARCH Results

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Values indicate change due to a 1 percent change in explanatory variable *, **, *** indicate statistically significant coefficient with 10%, 5%, and 1% confidence level, respectively.

The results suggest that the ongoing process of RMB internationalization is already leading to spillovers from offshore to onshore markets despite the wide-ranging capital controls. These linkages are only likely to grow as the market develops and liquidity improves.

1 See J.S. Kang, S. Maziad and S. Roache, “Renminbi Internationalization: Offshore-Onshore Links,” IMF Working Paper (forthcoming).


A. Social Safety Net

18. Developments. Since the eruption of the global financial crisis commendable progress has been made in expanding China’s social safety net with significant resources allocated to improving the pension, healthcare, and education systems. This will certainly help rebalance toward private consumption. In particular, a new rural social pension system has been introduced and now covers 60 percent of counties In addition, healthcare spending has been substantially increased to build health facilities, train personnel, and achieve near-universal coverage of basic health insurance. Finally, the government is about to expand the existing social pension scheme to include the urban unemployed with nationwide coverage expected by 2012.

19. Policies. Despite progress, gaps in the safety net still remain. The health system continues to create incentives for precautionary saving because of high out-of-pocket expenses and inadequate coverage for catastrophic illnesses. At the same time, there is a need to increase the generosity of social benefits, consolidate the complex and fragmented patchwork of various national, provincial, government and occupational pension schemes, and achieve universal pension coverage for urban, migrant, and rural workers.

Social Policies Already Taken To Promote Rebalancing

  • Increases in the basic pension, social transfers, and unemployment benefits

  • Launch of a new rural pension scheme

  • Introduction of a new social pension system for urban residents

  • Full portability of pension benefits

  • Increased subsidies for health insurance and coverage of a core set of prescription drugs

  • Significant investments in new hospitals, community health facilities, and the training of healthcare personnel

  • Implementation of the Labor Contract Law and increases in minimum wages

B. Input Costs

20. Labor. There was broad agreement that labor markets will continue to evolve in the coming years as the demography shifts and skills are increasingly in demand. This will be a potentially important, albeit slow-moving, force going forward. In particular, it should lead to labor gaining a stronger negotiating position, with higher wages and more of the gains from growth redistributed from the corporate sector to households. This is a positive development and will help with rebalancing. Indeed, for consumption to grow at a faster pace than output, there needs to be a sustained increase in nominal wages in excess of nominal GDP. There was general agreement that attention should be paid to avoiding the growing skills gap, putting a particular prominence on improving the education system and vocational training. Staff argued that the government could further facilitate the increase in household income by significantly reducing social contribution rates (which can be in excess of 40 percent of wages) and replacing them with other forms of general revenue (for example, higher dividends from state corporations, an expansion in the VAT base to cover services, or increases in energy taxes). In addition, staff recommended that fundamental reform of the household registration scheme should be considered.

Staff Recommendations on Further Policies For Rebalancing 1/

  • Liberalizing the financial system and developing new markets and financial instruments.

  • Further reducing the taxation of labor income through lower social contributions.

  • Continuing to improve access to high quality healthcare, reduce out-of-pocket expenses and strengthen coverage for catastrophic illness.

  • Raising the costs of various factor inputs such as land, energy, pollution, and capital.

  • Appreciating the exchange rate.

  • Reforming corporate governance, reducing monopoly power in key sectors, and boosting dividend payouts to the budget from state-owned corporations.

  • Improving labor mobility by reforming the household registration system.

1/ See People’s Republic of China—2010 Article IV Staff Report for details.

21. Other factors of production. The staff and authorities agreed that there remain distortions in factor pricing in several areas (Box 3). The authorities underlined the steps already being taken to raise energy prices and link them more closely to global costs and agreed there was scope to raise the cost of many inputs to production in order to ensure a more efficient allocation of resources and a more appropriate pricing of externalities. Officials also noted that the latest Five-Year Plan places particular emphasis on protection of the environment and energy conservation and efforts would continue to dissuade pollution and excessive energy use through higher prices and greater taxation of resource use. Staff made the case that the cost of capital in China was also very cheap especially when compared with the returns that capital can generate. The authorities, though, believed assessing the appropriate cost of capital in China was exceedingly difficult, complicated by the other factor cost distortions that were in the system. Certainly, the productivity of capital was high but, in part, that was due to the underpricing of other factors of production (such as energy) and insufficient environmental protection. It may also be the case that the apparent high investment-GDP ratio—which has risen to close to 50 percent and some viewed as a sign that capital was too cheap—could be overstated due to the under-recording of both consumption and service sector output in the national accounts.


The cost of capital is well below its marginal product

Imputed “Subsidy” to Capital

(In percent of the marginal product of capital)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

1/ Includes Indonesia, Korea, Singapore, and Taiwan Province of China.Source: Background Paper, “Competitiveness, Overcapacity, and Sustainability Risks.”

C. The Role of the Exchange Rate

22. Assessment. Staff continues to believe that the renminbi remains substantially below the level consistent with medium-term fundamentals. At this point, there is little reason to change the assessment made during the 2010 Article IV consultation. Reserve accumulation has been significantly larger than foreseen at the last Article IV (reserve levels at end-March were already above what staff had previously forecast for end-2011 and are well above the level needed for precautionary purposes). Despite progress in appreciating against the U.S. dollar, the real effective exchange rate has depreciated over the past year.1 Finally, despite the important progress made in many policy areas, staff does not yet see in place the critical mass of measures that will be needed to decisively change the incentives for saving and investment and achieve a lasting decline in the current account surplus (Box 4). Nonetheless, the low trade surpluses recorded in the first five months of this year could be an indication that this year’s current account surplus will be smaller than expected.


The exchange rate has depreciated in real effective terms over the past year

Real Effective Exchange Rate

(Index 2005=100, Increase=appreciation)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

23. Policies. Staff advocated a stronger exchange rate as a key ingredient to accelerate the transformation of China’s economic growth model. The work of the spillover team would suggest that movement on the exchange rate alone may have only modest direct effects in addressing global imbalances. However, staff argued that this fails to take into account the fact that the undervaluation of the currency is holding back progress in other areas that would help safeguard against near-term risks and promote economic rebalancing. For example, the undervalued currency reduces the scope for running a more proactive and independent monetary policy with higher real interest rates. Similarly, the significant and sustained need to absorb liquidity from large-scale foreign currency intervention constrains the government’s ability to move safely ahead with financial liberalization. The undervalued exchange rate also creates distortions in relative prices that act as a headwind to the government’s efforts to raise household income and to develop the service sector. A faster pace of renminbi appreciation would open the way to move ahead in many areas that were highlighted in the 12th Five-Year Plan. This, in turn, would facilitate a decisive shift to a more balanced, equitable, and sustainable growth model.

24. The authorities’ view. The authorities disagreed with the staff’s exchange rate assessment. They underlined the progress that has been made in continuing to improve the mechanism for setting the exchange rate. At the same time, the trade outturns in the first five months of this year show that imbalances were clearly declining and in a sustained way. The authorities also argued that, despite recent improvements, the balance of payment statistics still under-recorded current account outflows from non-remitted income on nonresidents’ investments in China. They also felt there was a generally weak relation between the movements in the current account and the level of the real exchange rate and so any assessment of the degree of undervaluation should not be based upon uncertain forecasts of the future current account. Instead, a broader view needed to be taken on the path of the real exchange rate. Relative prices were indeed adjusting in China, including through rising labor costs and increased enforcement of labor rights, demographic changes, higher energy costs, and enhanced environmental protection. Further, nontradable prices were moving higher, notably for housing. These developments were, perhaps, not fully reflected in CPI-based measures of the real exchange rate. Finally, the authorities underscored that the currency was converging toward its equilibrium and expected that this process would continue over the medium term.

Are Factor Costs Too Low in China?

China’s growth model relies on various low-cost factor inputs, including land, water, energy, labor, and capital. This offers Chinese firms a competitive edge and creates incentives for capital intensive means of production. Studies estimate the total value of China’s factor market distortions could be almost 10 percent of GDP.1

Land and water. In China, all land belongs to the state and local governments have the discretion to sell industrial land use rights to companies for up to 50 years. In many cases industrial land is provided for free to enterprises to attract investment. For water, the price in China is about one third of the average of a sample of international comparators.


World Water Prices

(In $/cub.m.)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001


Intenational Comparison Retail Price of Gas

(U.S. dollar per litre)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Energy. Cross country data on the cost of energy shows that the price of gasoline in China is relatively low, although similar to that in the U.S. For electricity, the cost is also somewhat below the average of international comparators although discussions with private counterparts reveal that many companies are able to negotiate significant discounts to the regulated price. Having said this, China is making progress in bringing energy costs in line with international levels: oil product prices have been indexed to a weighted basket of international crude prices; natural gas prices were increased by 25 percent in May 2010; and preferential power tariffs for energy-intensive industries have been removed.

Capital. By various cross-country measures, the cost of capital appears low in China. Using data on 37,000 firms across 53 countries, staff estimates show that the real cost of capital—defined as a weighted average of the real cost of bank loans, bonds, and equity—faced by Chinese listed firms is below the global average.2


Real Cost of Capital


Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Capital looks especially cheap when compared to its high productivity in China. In particular country-specific estimates of the marginal product of reproducible capital (i.e., capital adjusted for land) show China as an outlier and well above the average real loan rate.


International Comparison: Marginal Product of Capital Adjusted for Land vs Average Real Interest Rate (2004-10)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

1 See Y. Huang, “China’s Great Ascendancy and Structural Risks: Consequences of Asymmetric Market Liberalization” (2010) and Y. Huang and K. Y. Tao, “Causes and Remedies of China’s External Imbalances” (2010).2 See N. Geng and P. N’Diaye, “Determinants of Corporate Investment in China: Evidence from Cross Country Firm-level Data,” 2011, IMF Working Paper (forthcoming).

Prospects for the Current Account

Previous forecasts. At the time of the 2010 Article IV consultation staff had forecast that China’s current account surplus would decline to 5 percent of GDP in 2010 (down from 6 percent of GDP in the previous year) and gradually rise to around 8 percent of GDP by 2015.


Current Account Balance: Forecast and Data Revisions

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Outcomes. The balance of payments data for 2010 show that the current account surplus leveled off in 2010 at around 5¼ percent of GDP. The evolution of the current account surplus was dominated by two factors (i) a deterioration in the terms of trade and a ramp up in the volume of raw material imports; and (ii) a revision in the accounting for non-remitted income on FDI investments that lowered the current account by ¾ and ½ percent of GDP in 2009 and 2010, respectively. Despite these countervailing forces, the 2010 outturn was still ¼ percent of GDP higher than staff had forecasted a year ago.

The outlook. Looking ahead, the staff’s forecast assumes a steady fiscal consolidation at the level of the general government, continued recovery in external demand, and, importantly, a real effective exchange rate that remains at current levels. In addition, the recent changes in accounting methodology have been incorporated into staff forecasts. The forecasts themselves are underpinned by various modeling techniques, including a Bayesian Vector Autoregression (BVAR) model, the Fund’s Global Integrated Monetary and Fiscal (GIMF) model, and a time series model fitted to Chinese and global data (Figure 4).

  • The BVAR model suggests a reversal of the current account surplus to 8½ percent of GDP over the next two years.

  • GIMF simulations show that the combination of stronger global demand and steady fiscal consolidation could lift the current account surplus to around 7 percent of GDP by 2016.

  • The staff’s non-structural time series model shows that stronger demand for China’s exports, the expected improvement in the terms of trade assumed under the latest World Economic Outlook, and a lack of exchange rate appreciation, would lift China’s current account surplus to around 6¾ percent of GDP by 2016.

What do market analysts expect? The median long-range forecasts of private analysts show the current account will fall to below 3 percent of GDP by 2015. However, it is important to note that these forecasts assume, on average, a real effective appreciation of 23 percent over the next five years.


Medium-Term Current Account: Private Analysts Forecasts

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Current forecasts. Putting together all these inputs, staff now forecast that the current account surplus will reach 5½ percent of GDP this year and rise to 7½ percent of GDP over the medium term.

Figure 4.
Figure 4.

How is the Current Account Shaping Up?

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; and staff estimates.


A. Motivation

25. Emerging tensions. Much has already been done to reform China’s financial system (Box 5). However, as touched upon earlier in this report, over the horizon of the 12th Five-Year Plan China will encounter a fundamental and structural shift in important aspects of its economic system. Demographic changes will mean the labor force will gradually start shrinking, leading to a steady rise in labor costs, a rising skills premium, and potentially altering inflationary dynamics. China will continue to face the risk of property bubbles, driven by low interest rates, robust growth prospects, and a lack of alternative investment vehicles. Finally, the ongoing process of financial innovation and disintermediation into non-bank areas will pose a growing and formidable challenge to China’s ability to exert macroeconomic control through administrative means. This potential combination—of rising inflationary pressures, already-high prices in the property market, and a weakening of direct monetary control—poses significant risks to financial and macroeconomic stability. In addition, the current system for financial intermediation continues to hold back rebalancing and the development of the service sector, generating industrial overcapacity that could present negative implications for long-run growth prospects.

26. A time for action. This argues for China to immediately move ahead with financial liberalization and reform, a position that is fully consistent with the 12th Five-Year Plan. This will be a complex, multi-year undertaking and starting now will ensure that the process can be largely completed within the horizon of the Five-Year Plan. Continuing to delay could mean that the financial system, instead, evolves in an uncoordinated and disorderly fashion, outpacing supervisory capabilities and revealing regulatory gaps. Indeed, the risk is high that developments proceed on a timetable driven not by careful, pre-emptive, and concerted policy planning but rather by the pace of market disintermediation and innovation. This would create liquidity stress, growing cross-border capital flows, and both asset price and macroeconomic volatility. Given the increasing complexity of China’s financial system, an ad-hoc or poorly configured approach would be especially risky, for both China and the global economy.

Recent Achievements In Financial Sector Reform

Over the last decade, China has made considerable progress in moving toward a more liberal and market-based financial system.

Bank Commercialization. Banks’ internal risk management and accounting practices have been strengthened, with foreign strategic partners helping to implement international best practices. The main banks have been listed on foreign markets, helping to strengthen investor oversight and control and ensure compliance with international accounting standards. A large volume of bad loans—over 15 percent of GDP in 1999—was carved out and placed in asset management companies while the banks were recapitalized with government support.

Regulation and Supervision. The regulatory infrastructure has been significantly improved with the establishment of individual regulators for insurance, banking and securities markets. Within these agencies, capacities for supervision have been strengthened, and a regulatory infrastructure that meets international standards has been put in place. Laws on new companies, trusts, securities and investment funds have also been enacted, providing a modern framework for capital market development.

Fixed Income. Interest rates on a range of fixed income instruments have been allowed to be determined more by market forces. In addition, an interbank bond market was established to allow corporations to raise funds from securities markets, reducing their dependence on the banking system for credit.

Financial Centers. Shanghai has become a critical part of the global financial infrastructure. Best practices and state of the art trading platforms have been adopted in key markets and equity market liquidity increased by making a larger proportion of shares tradable. Shanghai’s market capitalization now stands at around US$3 trillion, the sixth largest equity platform in the world. Shenzhen has also launched the Growth Enterprise Board giving small- and medium-size companies access to equity financing with streamlined listing procedures.

All these measures have bolstered the health and soundness of China’s financial sector, helping it escape the global crisis relatively unscathed and enabling it to expand operations abroad. Nevertheless, as acknowledged in the 12th Five-Year Plan and outlined in the FSSA, a broad-ranging financial reform agenda still remains.

B. A Proposed Roadmap for Reform

27. Principles. There is no optimal, predetermined path that financial liberalization and reform should take in China and any plan should be flexible enough to adapt to unforeseen situations as reforms proceed. Nevertheless, international experience would suggest that certain key elements and a basic sequencing will be needed to mitigate the potential risks that will arise as the financial system becomes freer and more market-oriented. A broad roadmap—which includes appreciating the renminbi, absorbing liquidity and strengthening monetary management, improving regulation and supervision, developing financial markets and products, liberalizing interest rates, and finally opening up the capital account—is laid out below.

28. The exchange rate. First, by allowing the exchange rate to appreciate there will be genuine, market-driven, two-way movement of the currency, reducing the pressure from capital inflows. This will provide greater scope for the People’s Bank of China to exercise macroeconomic control through a more market-based and counter-cyclical monetary policy. A stronger renminbi will lessen the pace of foreign reserve build-up, translating into significantly less liquidity pressure in domestic markets and a diminished need to use higher and higher reserve requirements and issuance of central bank paper to absorb this liquidity. With structurally less liquidity generated by the balance of payments, financial reform can safely move ahead in various areas.

29. The monetary framework. As appreciation continues, the central bank can begin to absorb the significant liquidity overhang that is currently present in the financial system. This will need to involve a steady increase in the entire structure of deposit, loan and interbank rates and a much more aggressive use of open market operations to reach a point where the central bank no longer needs to rely on administrative limits on new lending and, instead, credit can be allocated by price-based means. As liquidity conditions tighten, interbank and central bank paper rates should move well above the deposit rate and monetary policy can be conducted largely through indirect instruments. Tighter liquidity conditions will create incentives for banks to improve their internal liquidity management functions and focus more on assessing risk-return trade-offs in allocating loans. At the same time, the central bank should move to reserve averaging to ease liquidity management challenges faced by the banks and allow reserves to operate as an effective buffer in times of short-term stress. With a more flexible exchange rate and the likely instability in monetary aggregates as financial reform proceeds, China will have to adopt a new framework for monetary policy decision making. For an economy of China’s size, importance, and complexity, the preferred alternative would be an institutional design that establishes objectives on growth, inflation and financial stability and uses a combination of monetary and macro-prudential tools to achieve those goals.

30. Regulation, supervision, and financial stability. The government should continue to increase the commercial orientation of the banking system, bolster its crisis management capabilities, and strengthen supervision to identify and manage macro-financial vulnerabilities (Box 6). Supervisory and regulatory improvements will be needed to address the gaps that will inevitably emerge in a more liberalized setting. This should include routine stress testing, increased oversight for systemic institutions, an improved resolution framework, and better data quality and collection. Interagency regulatory and supervisory coordination should become more ongoing and systematic, including through the establishment of an interagency financial stability committee.

31. Financial market development. Strengthening nonbank channels for financial intermediation will be an important objective to create competitive discipline on the banks, offer companies alternate avenues for project financing, and provide households with a broader range of financing and investment possibilities. Building on the significant progress made in the last several years, the FSSA outlines several areas to further expand nonbank financial intermediation (Box 7). A well-working fixed income market, in particular, will be essential in facilitating growth in pension, insurance, mutual funds, and other institutional investors. Expansion of nonbank areas of intermediation will, however, need to largely move in tandem with reform of bank-based intermediation. Failure to do so could create incentives for a migration of resources out of the banks (into bonds, equities, trusts, leasing, and wealth management products), with the accompanying supervision and regulatory challenges and the potential for destabilizing the banking system.

32. Interest rate liberalization. With the liquidity overhang absorbed, a robust market-based monetary framework in place, and a financial system that is less dependent on the banks, China will then be able to move away from the current system where loan and deposit rates are regulated by the central bank. It will be essential to ensure that, unlike in the unsuccessful cases of interest rate liberalization, this does not translate into an unintended loosening of monetary and credit conditions (Box 8). This will be complicated since the ongoing financial reform and liberalization will make money demand difficult to predict. In addition, it will be important to use regulatory and supervisory tools to ensure that the banks do not engage in overly aggressive competition or unsafe practices to attract deposits, expand lending, or compress margins to gain market share. The authorities should begin by gradually raising the ceiling on deposit rates. As deposit rates rise the floor on loan rates will steadily become less binding, increasing the cost of capital and allowing lending decisions to be determined more by market forces. Greater freedom to set loan and deposit rates will create incentives for the banks to better manage and price risk and make money market rates more representative of true financial conditions. At the same time, a market-determined system of interest rates will provide valuable price signals for macroeconomic policymaking, as well as strengthen the transmission mechanism for monetary policy.

33. Capital account liberalization. With these various reforms in place, China could then proceed to dismantle the extensive system of controls on capital flows that is currently in place, fully internationalizing the renminbi, and moving the currency toward being “freely usable.” The early stages of capital account liberalization should focus on removing restrictions on more stable, long-term sources of financing such as direct investment flows. Full liberalization—including short-term flows—should wait until the bulk of financial sector reforms, discussed above, have been implemented. The existing framework of QFII and QDII could provide a useful means to open up the capital account, with the quotas steadily expanded and judiciously targeted at particular asset classes. Eventually these quotas would become nonbinding and could then be removed altogether.

C. The Authorities’ Views

34. Importance of reforms. The authorities emphasized their commitment to continued financial liberalization and were in broad agreement with the scope of the reforms outlined by the mission. Indeed, they noted that the 12th Five-Year Plan highlighted many of these core areas including interest rate reform, improving the framework and transmission of monetary policy, strengthening regulation and supervision, developing alternatives to bank finance, reforming the exchange rate regime, and liberalizing the capital account. The authorities acknowledged the importance of sequencing and viewed the roadmap suggested by staff as a clear and helpful framework for organizing the wide-ranging reform process that China now faces. However, they indicated that the sequencing of reforms would follow a path determined by circumstances and progress in many areas could move in a complementary and parallel way. They indicated it would be difficult to design a definitive ordering of reforms ex ante and emphasized that reforms would take time and be preconditioned on a stable and supportive macroeconomic environment. The authorities did, however, underscore the risks of an uncoordinated approach to financial liberalization and were looking carefully to the experiences of other countries for potential lessons.

35. Monetary management. The absorption of liquidity, associated with large balance of payments inflows, was recognized as a key challenge to monetary management and healthy asset market development. The authorities agreed that revisions would be needed to the monetary framework in order to manage the complicated trade-offs between growth, inflation, financial stability and structural changes in the economy. Indeed, these trade-offs were likely to become more complex in the coming years. Over time, greater emphasis would be given to inflation as an end-goal and to short-term interest rates as a means to achieve that target. Macro-prudential tools would also be drawn upon, as needed, to manage financial risks.

36. Interest rate liberalization. The authorities recognized that ensuring banks face hard budget constraints would be an important prerequisite for a more commercially-oriented banking system that adequately prices risk and efficiently allocates credit. As interest rates are liberalized, preventing disorderly competition among banks for market share would be a priority. In this context, those banks with better-developed risk management capabilities could be allowed greater flexibility in determining deposit and lending rates at an early stage. In addition, bankruptcy laws and resolution mechanisms would need to be in place. Moral hazard issues would potentially be important given the systemic size of many banks and social importance of others (like the rural credit cooperatives). Care would also need to be taken not to precipitate potentially destabilizing capital inflows from higher interest rates.

37. Regulation and supervision. The authorities agreed that the capacity of the regulatory agencies to monitor and contain evolving risks will need to be bolstered, as will the crisis management framework. In particular, they highlighted that a deposit insurance scheme is a priority and that capacity was now being built to undertake a range of regular stress testing exercises with the banks. Both of these will help to strengthen the robustness of the financial system.

38. Capital account liberalization. The authorities recognized that full capital account convertibility will need to be handled carefully, particularly as managing the process successfully would hinge on other measures, such as continuing to reform the exchange rate setting mechanism and having more market-determined interest rates. They identified several pre-requisites, notably stable macroeconomic conditions, a strong regulatory and supervisory framework, and broad, deep and liquid financial markets. They were also receptive to the idea of phasing in the opening of the capital account based on the nature of flows, with longer-term capital such as FDI considered before shorter-term flows. Even as the capital account is liberalized, they stressed that some tools would still be needed to manage risks to financial stability, notably those associated with volatile short-term capital flows. Finally, while they viewed full convertibility of the capital account as an important goal, they noted that significant progress had already been made in the development of cross-border renminbi activity and that process would continue on a separate track.

Key Financial Stability Reforms

The principal areas identified by the Financial System Stability Assessment (FSSA) to improve the framework for financial stability include:

  • Establish a Financial Stability Committee to help coordinate across agencies on systemic risks and adapt to the changing perimeter for regulation as innovation reshapes the financial landscape and creates new channels of intermediation.

  • Clarify the objectives and strengthen the mandates for the central bank and regulatory agencies with greater operational autonomy, improved accountability, adequate resources in terms of skilled staff and funding, and effective enforcement and resolution powers.

  • Put in place a crisis management framework that allows for effective oversight, early intervention, and an orderly exit for weak or failing financial institutions (including systemically important institutions and financial conglomerates) and a clear definition of the role of the state in providing fiscal support.

  • Transition to a formal deposit insurance scheme that will clearly define the limits of state support.

  • Set clear limits on central bank emergency liquidity support that is restricted to solvent banks facing short-term liquidity problems.

  • Ensure that the central bank’s standing facilities operate immediately and automatically, with common conditions and collateral requirements, for all domestically incorporated institutions.

Key Reforms to Deepen Financial Intermediation

The principal areas identified by the FSSA to develop and deepen intermediation include:

  • Bonds. The government should adapt its bond issuance strategy so as to help improve the existing market making activities across all maturities of the yield curve. Reforms should aim to increase the connectivity between the exchange-traded and interbank markets and ensure a coordinated regulatory approach between the two markets. The government could also consider permanently authorizing bank trading of bonds on the stock exchanges and allowing corporate bond issuers that meet the appropriate (disclosure-based) listing standards to decide whether to list on the interbank or exchange-traded bond market. Finally, creditworthy sub-national entities should be allowed to issue bonds to raise financing.

  • Money markets. The PBC should further upgrade the operational framework for the repo market to increase market liquidity. Operational restrictions that make instruments less efficient (such as not being able to automatically rollover open repo positions) should be re-considered. Leverage risk should be controlled through prudential regulations. Addressing tax and regulatory hurdles that limit the size of the outright repo market would also be important. The availability of suitable hedging tools should be encouraged to help market liquidity providers manage risk, with interest rate derivatives particularly important in the near-term.

  • Equities. The nature and scope of investable instruments should be broadened to create a more balanced institutional and retail investor base, improve liquidity, and strengthen price discovery. Residual legacy constraints and anomalies relating to nontradable, “A” and “B” shares should be addressed and the current free float of shares in public companies expanded. Building a smooth conduit between the private and public offer segments will be critical to sustainable funding for SMEs.

  • Insurance. The insurance sector is still a relatively small part of the financial system but is growing rapidly and most of the insurers licensed in the past decade continue to lose money. This growth, combined with the low returns available on insurance company assets, is putting strains on the sector’s capital adequacy and solvency. Consolidation of the sector is needed with stronger solvency requirements, more comprehensive risk-based capital requirements, and clearer voluntary wind-up and exit rules. Insurers should be allowed to hedge asset-based market and credit risks, including through asset management companies. Subject to prudent risk management, quantitative limits on pension fund allocations could be relaxed to allow for a greater diversification away from bank deposits and toward bonds and equities. Stronger actuarial oversight of non-life claims provisioning is also needed.

  • Mutual funds. The scope of fixed-income instruments available to mutual funds could be broadened to include lower-rated issues (within prescribed parameters) and medium-term notes. This would broaden their appeal and enhance their competitiveness while supporting access of private companies to direct funding. There is also a need for an assessment of whether development of the mutual funds sector is being prejudiced by a more conservative regulatory approach than applied to the wealth management industry.

Financial Liberalization and Reform: Lessons From International Experience

Experiences. Many countries have reformed their financial sectors in recent decades. While financial liberalization has generally helped spur long-term growth, inappropriate design of reforms has also resulted in disruption or even crises. There is no unique blue-print, but international experience suggests the need for a carefully-calibrated approach.1

Key Lessons for China

  • Significant financial sector fragilities should be addressed ahead of major liberalization, including recapitalization or restructuring of systemic institutions and corporate governance enhancements.

  • Regulatory and supervisory frameworks need to be upgraded early and continuously. Virtually all post-liberalization crises can be traced to inadequate supervision or regulations not keeping up with changing financial landscapes.

  • Liquidity must be absorbed, relative prices adjusted, and reliance on indirect monetary tools increased before interest rates are liberalized and quantitative lending restrictions are lifted.

  • Monetary policy needs to guard against an excess supply of credit as interest rate constraints are removed. In successful cases of liberalization, credit expansion was mitigated by a deliberate containment of liquidity and increases in real interest rates.

  • Interest rate liberalization is a key catalyst in achieving broader reform goals. Market based interest rates enhance competition, efficiency, and risk management. At the same time, implicit guarantees of financial institutions and borrowers should be withdrawn to prevent moral hazard.

  • Strict regulation and proactive supervision is also needed to prevent banks from excessively focusing on building market share to the extent that it undermines their financial rates of return.

  • Broader financial development must not run too far ahead of financial reform. This could serve to precipitate an erosion in monetary control and increased pressure on banks. That said, capital market development should not be left too late, as it serves to enhance competition, increase the efficiency of capital allocation, and promote longer-term capital flows.


Private Credit

(percent of GDP)

(T = time of interest rate liberalization, normalized to equal 100)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001


Real Interest Rates

(In percent; 3 year average, post-interest rate liberalization)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

1 Staff examined the liberalization experience of several of China’s G-20 peers—including Argentina, Australia, Canada, Indonesia, Japan, Korea, Mexico, Turkey and the U.S.—as well as that of the Nordic countries and other emerging markets. In addition, see Reinhart and Rogoff (2008), “Banking Crises: An Equal Opportunity Menace” and IMF (1999), “Sequencing Financial Sector Reforms: Country Experiences and Issues.”


39. An Alternative Scenario. Many of the reforms assumed in this alternative scenario are outlined in the 12th Five-Year Plan. While detail is still lacking as to how such policies will be designed and implemented (particularly those related to financial and corporate sector reform, the medium term fiscal position, and the path for the exchange rate), if fully implemented in a coherent way, such reforms have the potential to successfully lead to a significant transformation in economic incentives and the structure of the Chinese economy. To summarize the potential impact these policy changes may have, an illustrative macroeconomic scenario is described below and quantified in the Table below.

40. Household Savings. A strengthening of the pension and healthcare systems, over time, will lessen the precautionary motive for saving. Lower social contributions and reduced taxation of labor income, an expansion of employment (driven by a shift of production toward more labor and skills-intensive service industries), a more appreciated exchange rate, higher deposit rates, and access to a broader—and higher return—range of savings vehicles will combine to boost household income. As households obtain a larger share of the benefits from economic growth and reduce their need for self-insurance, consumption will begin to rise faster than output and household savings will fall (Box 9).

41. Corporate Savings. A higher cost of borrowing, rising wages, a more appreciated currency, a weakening of the oligopoly power of firms in some sectors, and greater market discipline (leading to higher dividend payouts) will all reduce the excess rents currently accruing to firms and lessen corporate saving (Box 10). In addition, as financial development broadens the access to and predictability of corporate financing, smaller companies will reduce their need for precautionary saving to fund future investment projects.

42. Investment. As the cost of capital rises to be more in line with the returns generated from investment, the overall level of capital formation will decline. Gross capital formation will be further lowered by an increase in various other factor costs. At the same time, a more appreciated exchange rate will provide the price incentives necessary to shift investment away from a continued expansion of export capacity and toward sectors that serve the domestic consumer. The net result would be a shift to a more labor-intensive means of production, focused on nontradables and services, with corresponding benefits in terms of lower energy usage, less excess capacity, lower pollution, and higher employment.

43. The external imbalance. The net effect of reforms on the external accounts will imply a steady reduction of the current account surplus. As domestic consumption picks up, the demand for imports will rise and a greater proportion of China’s production of tradable goods will be sold into the local market rather than sent abroad. The trade surplus will fall in U.S. dollar terms. In addition, the more appreciated exchange rate will, eventually, lessen the incentives for capital inflows and reduce the pace of reserve accumulation.

44. Growth and employment. Over a longer horizon, transformation of the economic model may lead to growth that is modestly lower than the historical performance. However, that growth will be more sustainable, inclusive, and have a bigger positive impact on people’s livelihoods. Consumption possibilities will be enhanced, environmental degradation will fall, and the economy will generate far higher levels of job growth. Indeed, over the past decade, under the export-oriented model, employment growth in China has been disappointing relative to international comparators. Over the near term, the shift toward domestic consumption is likely to reduce growth somewhat as the economy adjusts to the various elements of reform and, in particular, as it takes some time to build productivity in the service industries to substitute for lost output in export industries. However, China has the resources and capacity to cope with the implications of such a near-term slowdown.


China’s high growth has not been very job-intensive

Average Employment Growth, 2004-10

(In pecent; Industrial countries and emerging markets)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Illustrative Rebalancing Scenario1

article image

As discussed in the text, assumes an appreciation of the exchange rate in line with long-run market consensus forecasts, a higher cost of capital, lower labor taxes, improvements in the social safety net, financial liberalization, and an increase in a range of factor costs.

Interest Rate Liberalization and Household Saving Behavior

Context. China’s urban household saving rate has been rising steadily from around 19 percent of disposable income in 1996 to close to 30 percent in recent years. To rebalance China’s economy, it will be essential to arrest this upward trend and create incentives for households to save less. Financial reform and interest rate liberalization offer the potential to contribute to this effort.


Household Consumption

(In percent)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Methodology. To examine the potential impact that financial reform and a higher cost of capital could have on saving behavior, research was undertaken using data from 31 Chinese provinces over the period 1996-2009 to examine the impact of interest rate liberalization on urban household saving rates.1

Results. Key results from the analysis include:

  • The figure shows the annual deviation of urban saving rates and real interest rates from their province-specific averages during 2003-2009. Urban saving rates tend to fall when real interest rates rise. A one percentage point increase in the real rate of return on bank deposits would lower the urban household saving rate by 0.6 percentage points with the income effect outweighing the substitution effect.

  • The response to changes in the real rate of return on savings is largely driven by movements in the interest rates on bank deposits.

  • The negative relationship between savings and interest rates has strengthened over the last several years.

  • The relationship is robust to the inclusion of variables that proxy for other influences on saving such as life cycle considerations and self-insurance against income volatility.


Deviation from Provincial Average

(In percent, 2003-2009)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Conclusions. China’s households save to meet a multiplicity of needs—pensions, health expenditures, purchase of durables and real estate, and to insure against income volatility. Research would suggest that individuals may well behave as if they are targeting a particular absolute level of savings. A rise in real interest rates increases the return on bank deposits and makes it easier for households to achieve this targeted level of savings accumulation. This leads higher deposit rates to reduce the share of disposable income that is saved. If an increase in real deposit rates is combined with other measures to raise household income and change incentives to save, the impact could be even larger.

1 See M. Nabar, “Financial Development and Household Saving in China,” IMF Working Paper (forthcoming).

Corporate Investment, Savings, and Financial Reform

Using firm-level data for a panel of over 50 countries the impact of financial sector reform on corporate investment and savings was examined.1 The results from the panel, cross-country, firm-level data were cross-checked using a similar model estimation but using a panel of cross-country macroeconomic data.

Corporate Investment

  • Real interest rates have a negative impact on investment. At the aggregate level, a 100 basis points increase in real interest rates reduces corporate investment in China by about 0.4 percent of GDP. The effect for China is much larger than the average of the other 52 countries in the panel. The estimated impact of interest rates changes on corporate investment is about half as big when estimated using firm-level data. This could possibly reflect the smaller reliance of this sample (which are large, listed enterprises) on bank-intermediated financing.

  • Exchange rate appreciation also lowers investment. A 10 percent appreciation would reduce total investment by around 1 percent of GDP. The large concentration of manufacturing companies in the firm-level sample means that the estimated impact of exchange rate appreciation from the firm-level data is much larger.

  • Indicators of capital market development suggest more developed financial systems tend to promote higher investment, largely by easing the financing constraints faced by firms.

Estimated Impact on Corporate Investment 1/

article image

Results are from GMM estimates using an unbalanced panel of 52 countries.

Corporate Savings

  • At the firm-level, higher real interest rates appear to reduce corporate saving but there is no significant effect using aggregate data.

  • Real appreciation tends to lower corporate savings in China; a 10 percent appreciation reduces corporate savings by 1 to 3 percent of GDP (depending on the model used).

  • Capital market development appears to raise corporate savings for the listed firms perhaps because it increases profits due to a more efficient allocation of capital. This effect may, however, mask a negative impact that financial development can have on savings of companies that have little access to financing. For smaller firms, with little access to capital markets, financial development could reduce the need for precautionary savings and cash hoarding to finance investment, ultimately lowering savings.

Net Corporate Savings

  • Overall, the empirical results suggest that financial sector reform, including raising interest rates, appreciating the real effective exchange rate, and developing the domestic capital market, would lower both investment and corporate savings. An exercise looking at the net savings, though, would suggest that higher interest rates and currency appreciation would tend to reduce the imbalance between corporate savings and investment.

Estimated Impact on Corporate Savings 1/

article image

Results are from GMM estimates using an unbalanced panel of 52 countries.

Uses data on gross savings.

Uses data on net savings.

1 See N. Geng and P. N’Diaye, “Financial Development, Corporate Investment and Savings in China,” IMF Working Paper (forthcoming).


45. Rebalancing. If China were to successfully transform its economy, giving greater prominence to private consumption and services, there would undoubtedly be significant positive external spillovers to the rest of the world. Staff analysis suggests that currency appreciation alone would yield only limited benefits. A more comprehensive transformation—as described in the scenario above where appreciation is accompanied by significant systemic reform—would increase output especially for those countries within China’s supply chain (mainly emerging Asia) and commodity exporters. There would be a more limited effect, though still positive, on the large advanced economies.

Growth Impact

(In percent)

article image
Based on input-output model, GVAR, and GIMF

Current Account Impact

(In percent of GDP)

article image
Based on input-output model, and GIMF

46. Continuing the existing model. On the other hand, failing to rebalance China’s economy could lead to excess capacity in many of China’s industries. This would necessitate that China continues to build global market share in a range of products in order to maintain its high growth rates and deploy its growing capacity in heavy industry and manufacturing. Such unprecedented gains in global market share would inflame concerns that China’s comparative advantage unfairly rests on low and distorted cost structures, inviting trade tensions. It may also increase the risks of a disruption in China itself with significant negative spillover effects to the rest of the world. If such a disruption were realized, the resulting sharp slowdown in China would significantly reduce prices for a range of commodities, (especially metals, raw materials, and energy) and have negative consequences for the global economy.

47. Financial spillovers. Despite its closed capital account, China does have an impact on global asset prices and flows. China’s rising foreign exchange holdings—which are expected to continue to increase in both the baseline and rebalancing scenarios—support the prices of reserve currency assets. China’s impact on global financial markets will certainly change as financial reform proceeds, the currency is internationalized, and financial opening gives rise to two-way, non-official capital flows. Even a gradual portfolio shift by China, away from U.S. Treasuries to emerging market assets, would raise long term yields in the U.S. and other advanced countries and sharply reduce emerging market yields.


Impact on Yields of Portfolio Reallocation in China

(Reduced holdings of US assets and increased holdings of EM assets by $100 bn)

Citation: IMF Staff Country Reports 2011, 192; 10.5089/9781462342587.002.A001

Source: Background pa per, “Potential Impact on Global Bond Markets of Reallocating China’s International Reserves”


48. Outlook. As the government stimulus winds down, there is an ongoing hand-off to private sector-led activity. Staff continues to forecast near-term growth in the 9–10 percent range. At the same time, staff expect CPI inflation, on a year-on-year basis, to fall to around 4 percent by end-year, albeit with some upside risk to this forecast.

49. Risks. Aside from the global environment and the potential for domestic supply shocks that reinvigorate food price inflation, China also faces important domestic risks. First, the fundamental drivers of rising house prices remain in place. Second, the expansion in bank lending over the past few years is likely to lead to a decline in credit quality that will need to be handled proactively and carefully. Third, the rise in nonbank intermediation and the increasing sophistication of local capital markets has the potential to undermine China’s levers for macroeconomic control.

50. Property. Vigorous growth, low returns on bank deposits, and an ongoing process of urbanization will all support demand for housing. Administrative measures to slow property price inflation have helped but any durable solution that prevents property price bubbles in China will need to involve a significantly higher cost of capital, the development of financial instruments and markets (to deepen the availability of alternative household savings vehicles), and an increase in the carrying cost for property through higher real estate taxation.

51. Local government financing vehicles. The expansion in lending to local governments represents a tangible near-term risk. The accounting for these liabilities should be quickly brought to a close with comprehensive disclosure and transparency on the scale and nature of such lending. Banks should fully account for the underlying risks of such loans, with appropriate provisioning and risk weighting.

52. Monetary policy. While the central bank’s monetary goals are the right ones, the means by which these targets are being achieved is moving in the wrong direction, relying on an increasingly complicated array of tools and administrative controls that will be difficult to effectively sustain. The dynamically differentiated reserve requirement adds to the complexity of the current monetary framework and moves away from a more market-based system for monetary policy. The central bank should, instead, rely more on higher interest rates and open market operations. This would improve the monetary transmission mechanism, simplify policies, simultaneously influence the cost of both bank and nonbank financing alike, and create fewer incentives for disintermediation. Such a policy shift would lay the groundwork for broader financial market liberalization and reform.

53. Exchange rate. A stronger renminbi is in China’s own interest and an important component in accelerating the transformation of China’s economic growth model toward one that is more reliant on private consumption. An appreciation of the exchange rate will facilitate progress in a number of other areas including financial sector reform, a more independent monetary policy, increasing household disposable income, and developing the service sector.

54. Cross-border renminbi. The expansion in renminbi trade settlement and the growing pace of development of renminbi markets and financial products in Hong Kong SAR are impressive achievements. The trend toward a more international renminbi is a positive one and a natural direction given China’s economic importance. However, the current trajectory remains extremely onesided. As this process evolves, it will be important to ensure that the expansion of cross-border renminbi does not prematurely undermine the capital control regime or create arbitrage opportunities between onshore and offshore markets before China is ready to move to greater capital account convertibility.

55. Imbalances. Despite the commendable efforts to strengthen the social safety net, raise disposable income, and realign some factor costs, the post-crisis decline in the current account surplus has moved into reverse. This is a product of both the recovery in the global economy and a slowing of China’s infrastructure stimulus. Under current policies and assuming a constant real exchange rate, the current account surplus is expected to rise to around 7½ percent of GDP over the medium-term.

56. Economic transformation. The key policy challenge ahead, therefore, will be to accelerate the ongoing transformation of China’s economic model to one of more inclusive growth, more linked to domestic consumption, and less reliant on exports and high levels of investment. The 12th Five-Year Plan recognizes that such a transformation will require efforts in multiple areas and outlines a high-level strategy to achieve those goals. All the essential ingredients for reform are included in this plan and, if successfully and expeditiously implemented, this policy platform has the potential to address the imbalances and tensions in China’s current growth model.

57. Financial reform. Financial reform will be indispensable in this economic transformation. The current system of financial intermediation poses an obstacle to the goals of ensuring a smooth rebalancing of the economic growth model and building a more inclusive economy that is focused on improving people’s livelihoods. The financial system works as an implicit tax on household savings which is then used to subsidize corporate investment and sterilized intervention. A carefully designed approach to financial liberalization and reform would serve to increase household income, lessen both corporate and household savings, and improve the efficiency of investment. In addition, financial reform will help mitigate the risk of asset bubbles and enhance monetary policy transmission.

58. Policies. Financial liberalization and reform will require several elements. The current framework for monetary and exchange rate management will need to be changed, and at an early stage, and the liquidity overhang currently in the financial system will need to be absorbed. This should be accompanied by a strengthening of regulation and supervision, improved financial stability monitoring, and proper development of non-bank channels for financial intermediation. Once such reforms are well advanced, China will be able to fully liberalize deposit and loan rates and move to a system where all interest rates and asset prices are market-determined and achieve capital market clearing. This would facilitate China’s full integration into global capital markets, with the capital account open and the renminbi made fully convertible.

59. Final thoughts. Successfully designing and implementing the broad set of policies discussed in this report—to strengthen the social safety net, raise household income, liberalize the financial system, appreciate the exchange rate, and increase the costs of various inputs to production—will have a sweeping impact on the Chinese economy. This will pave the way to improved living standards and a better distribution of economic gains. Such a reform program is very much in line with China’s own policy goals and will have a positive impact on China’s trading partners, constituting China’s critical contribution toward strong, sustained, and balanced global growth.

60. It is proposed that the next Article IV Consultation with China takes place on the standard 12-month cycle.

Table 1.

China: Selected Economic Indicators

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Sources: CEIC Data Co., Ltd.; and staff estimates and projections.

Contribution to annual growth in percent.

Percentage change of annual average.

Table 2.

China: Balance of Payments

(In billions of U.S. dollars, unless otherwise noted)

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Sources: CEIC Data Co., Ltd.; and IMF staff estimates.

Includes counterpart transaction to valuation changes.

Data provided by the Chinese authorities unless otherwise indicated.

Includes gold.

Table 3.

China: Indicators of External Vulnerability

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Sources: CEIC Data Co.; and IMF staff estimates.

Shanghai Stock Exchange, A-share.

Data provided by the Chinese authorities.

Includes gold.

Metric proposed in “Assessing Reserve Adequacy,” IMF Policy Paper (February 2011); the suggested adequacy range is 100-150 percent.

Debt of banking sector not included.

IMF staff estimates.

Table 4.

China: Monetary Developments

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Sources: CEIC Data Co., Ltd.; and IMF staff calculations.

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 percent of beginning-period stock of monetary liabilities.

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.

Table 5.

China: General Government Budgetary Operations

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Sources: CEIC Data Co., Ltd.; and IMF staff estimates.

Includes net allocations to stabilization fund.

Central government.