People's Republic of China
Staff Report for the 2012 Article IV Consultation

China’s economy has been moderate in 2012, with a GDP growth of about 8 percent. Macroeconomic policies helped to maintain sustainable growth and continued to be adjusted in line with evolving conditions. The 2012 fiscal stance balanced the past stimulus with the growing economy. The authorities have taken necessary steps to accelerate the implementation of approved projects. Directors encouraged the authorities to accelerate the transformation of China’s economy as conceived under the 12th Five-Year Plan.


China’s economy has been moderate in 2012, with a GDP growth of about 8 percent. Macroeconomic policies helped to maintain sustainable growth and continued to be adjusted in line with evolving conditions. The 2012 fiscal stance balanced the past stimulus with the growing economy. The authorities have taken necessary steps to accelerate the implementation of approved projects. Directors encouraged the authorities to accelerate the transformation of China’s economy as conceived under the 12th Five-Year Plan.

Near-Term Macroeconomic Management

A. Near-Term Outlook

1. Growth. Staff project growth to moderate to 8 percent this year—¼ percentage point lower than in the April WEO—the lowest in many years (Figure 1). This projection assumes that global activity is slightly weaker than envisaged in the April 2012 WEO and that the authorities continue to gear policies to achieving this year’s fiscal and monetary targets. Growth is expected to bottom out in the second quarter, and then accelerate in the second half of the year. Growth next year is projected to be 8½ percent.

Figure 1.
Figure 1.

Growth Appears Headed Toward a Soft Landing

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: CEIC; Haver Analytics; WEO; and IMF staff calculations.

2. Inflation. Since peaking at 6½ percent last July, inflation has been on a downward path to 3 percent in May. Price pressures have eased across all major components of the CPI basket, led by declining food inflation that reflects the unwinding of agricultural supply shocks. Policy efforts to rein in the property sector have also helped to lower inflationary impulses from housing, and softer global commodity prices have contributed to lower production costs. Inflation in China remains driven primarily by food prices, and barring further shocks to agricultural supply, inflation should stay in the 3–3½ percent range this year and fall to 2½–3 percent in 2013.

3. Authorities’ views. The authorities have been pursuing policies aimed at slowing the economy to a more sustainable pace. As a result, growth has been steadily moderating over the past five quarters. This managed slowdown, however, has run into stronger-than-anticipated headwinds from the worsening of the euro area crisis. Measures to support growth are now being given more prominence and the authorities are confident that growth will be at least 7½ percent this year. Regarding inflation, they noted that ongoing reforms to increase factor prices could push inflation above staff’s 2013 forecast.

B. Macroeconomic Policies

4. Fiscal policy. The 2012 budget strikes a balance between unwinding the 2009-10 fiscal stimulus and providing support to the slowing economy (Figure 2). The overall deficit is expected to be 1¼ percent of GDP, unchanged from last year in cyclically adjusted terms.1 Although revenues have been subdued this year, the full-year revenue targets remain achievable, as activity is expected to pick up in the second half of this year. To help support activity, implementation of approved 2012 projects is being accelerated and some measures to support energy-efficient consumption have been implemented, all of which fit within the existing budget envelope.

Figure 2.
Figure 2.

Lingering Effects of the Last Stimulus

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: CEIC; Haver Analytics; WEO; and IMF staff calculations.

5. Structural fiscal reforms. Ongoing fiscal reforms aim at facilitating China’s economic transformation to a more consumer-based economy over the medium term, including by boosting household purchasing power and improving living standards. Recent progress includes reforms of the personal income tax to exclude more low-income workers from the tax net, increased social safety net payments, higher natural resource taxation, and a pilot reform to replace the business tax on services with the more efficient VAT. More broadly, staff highlighted that, in light of China’s looming demographic changes (Box 1), it is important to ensure that the strengthening of the social security system is fiscally sustainable. In this context, the publication of well-defined medium-term fiscal plans would help anchor expectations and provide assurance that the planned fiscal reforms, including to social security, are affordable.

6. Monetary policy. The authorities are maintaining their 14 percent target for M2 growth this year. Credit growth has slowed significantly from a peak of 29 percent in early 2010 to 16 percent in May 2012, reflecting the authorities’ policy efforts to slow the economy, with particular emphasis on reining in areas such as real estate development and local government financing vehicles (see section D below). Looking ahead, recent policy adjustments, including lower benchmark interest rates and an acceleration of investment projects already part of the 12th Five-Year Plan, are expected to support a moderate rebound of growth in the second half of the year, with a corresponding firming of credit demand. The reduction in foreign exchange intervention has lessened the need for sterilization, facilitating three cuts in banks’ required reserve ratios since December. Going forward, staff advocated further reductions in reserve requirements and increased reliance on open market operations to manage liquidity.

7. Interest rates. To provide cyclical support to the economy, the authorities have lowered benchmark interest rates twice since early June (by a cumulative 0.56 percentage point on lending and 0.5 percentage point on deposits). At the same time, they permitted banks to have more flexibility in setting interest rates (Box 2) under the administered benchmark interest rate system. By reducing the minimum margin between the deposit and lending rate, the recent reform will make banking more competitive over time with other types of intermediation. On the lending side, the majority of loans are already priced above the benchmark rate and, therefore, the near-term impact on average lending interest rates is unclear. Staff has long advised that price-based tools should play a stronger role in monetary policy, which would allow the central bank to rely less on administrative tools on bank lending to achieve its monetary goals. This goal is becoming more urgent as financial innovation is facilitating intermediation outside of the standard deposit-and-loan business.

Demographics—Has China Reached the Lewis Turning Point?

An abundant supply of low-cost rural labor has been a key feature of China’s economy. But do reports of wage inflation and labor shortages mean that this era is coming to an end? Staff analysis suggests not yet, but structural demographic factors indicate that China will approach the Lewis Turning Point (LTP) by the end of the decade.


China is experiencing a rapid demographic change. In addition to the projected decline in the labor force post-2015, the old-age dependency ratio is expected to increase at an almost unprecedented rate over the coming decades, from about 13½ percent in 2010 to around 20 percent in 2020 and around 28 percent in 2030. The rural old-age dependency ratio will rise to over 34 by 2030 (World Bank China 2030 Report).


A simultaneous equation disequilibrium model of the labor market is used to gauge the current level of excess labor supply.1 The result is used to project the path of excess labor supply based on China’s fundamentals (including demographics, household wealth, labor market characteristics, productivity, and external demand) and to determine the approximate period during which China will cross the LTP. Alternative assumptions are used to assess the impact of possible reforms.


China: Excess Supply of Labor Estimates

(In millions)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001


  • Excess supply of labor is strongly related to demographics (population, labor force, and participation), real wages, total factor productivity, household wealth, and the unemployment rate. The baseline estimates indicate that:

    • China will continue to benefit from excess supply of labor through 2020. Excess labor is estimated in the range of 150 million at the present time, and projected to fall to around 30 million in 2020.

    • China is poised to cross the LTP somewhere between 2020 and 2025.


    Excess Labor: Baseline and Alternative Scenarios

    (In millions)

    Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

  • Higher fertility rates (such as by relaxing the one-child policy) would induce a positive, albeit small, delay in crossing the LTP, as it will translate into a larger labor force but only with a significant passage of time.

  • Raising labor force participation rates (such as by granting migrant workers urban residency permits and easier access to subsidized housing, schooling, and healthcare in their city of residence) would move the LTP to after 2025, assuming a 4 percentage point rise in participation relative the 2010 rate.

  • Financial sector reform could accelerate reaching the LTP. Interest rate liberalization that permanently lifts deposit rates would raise net household wealth and thus induce a reduction in the supply of labor as households find it less attractive to work.

  • An increase in total factor productivity (by raising competition in the service sector and improving the efficiency of investment) would boost output, cause firms to demand more labor, and reduce the effective supply of labor.

1 See Das, M. and P. N’Diaye, “Has China Crossed the Lewis Turning Point?” IMF working paper (forthcoming).

Recent Interest Rate Reform

On June 7 and July 5, 2012, the People’s Bank of China (PBC) announced (i) reductions in benchmark interest rates and (ii) changes to the margins around benchmark renminbi deposit and lending interest rates:

  • Reduction of benchmark rates. The one year benchmark deposit rate was lowered by a cumulative 50 basis points (to 3 percent), and the lending rate by 56 basis points (to 6 percent). These were the first reductions since the second half of 2008. Adjustments were also made to benchmark interest rates on deposits and loans of other maturities, as well as deposit and lending interest rates of the personal housing provident fund.

  • New margin on deposit rate. The maximum deposit interest rate was allowed to be 10 percent above the benchmark rate, whereas previously it could not be set above the benchmark. As a result, the highest possible one-year deposit interest rate was reduced from 3.5 percent to 3.3 percent (10 percent above the new 3.0 percent benchmark).

  • Larger reduction in minimum lending rate. The minimum lending interest rate, previously at 90 percent of the benchmark rate, was lowered to 70 percent. The minimum one-year lending interest rate therefore declined from 5.9 percent to 4.2 percent.

  • Minimum margin considerably smaller. As a result, the margin between the minimum lending interest rate and the maximum deposit interest rate at the one-year tenor has been narrowed by 150 basis points, from 240 basis points to 90 basis points.


Benchmark Lending and Deposit Rate

(In percent pa; 1 year)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: CEIC; and IMF staff calculations.

Nomimal Lending Rates

(In percent)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

8. Authorities’ views. On fiscal policy, the authorities were confident that there was space within the existing budget to continue to adjust policies to support growth. They continued to view their monetary targets as appropriate and noted that the recent cuts in benchmark interest rates would help ensure that these targets were achieved. Moreover, they highlighted that the recent announcements also include important further steps toward interest rate liberalization. They also considered that prices were already playing a key role in financial intermediation.

9. Property. The residential property market has cooled off in recent months, with nearly two-thirds of the 70 major cities tracked in the official index witnessing sustained price declines. In the larger tier 1 cities, price declines have mainly occurred in outlying areas and suburbs. Real estate investment has slowed, but continues to be supported by social housing construction. So far, the slowdown in the property sector appears to be relatively smooth and no major developer has been reported to experience serious financial distress. However, as in the last property cycle, the trough in investment is likely to come after property prices start to rise. Given the importance of the property sector in the Chinese economy and its extensive forward and backward linkages, the authorities are attaching high priority to carefully monitoring price and transactions developments and ensuring that they remain on a stable trajectory.


Residential Property Price and Activity, National

(In percent, yoy)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

C. Global Risks

10. External risks. The main external risk continues to be spillovers to China from a worsening of the euro area crisis. Staff analysis indicates that China would feel the impact primarily through the trade channel. Assuming no policy response in China, growth could decline by as much as 4 percentage points in response to a 1¾ percentage point slowdown in global growth (as in the January WEO downside scenario).

11. Policy response. A record of fiscal discipline gives China ample space to respond to a heightened external shock using fiscal policy as the primary tool. In 2009–10, China’s timely and large stimulus succeeded in supporting domestic growth, shielding China’s population from the worst of the crisis, and helping the global recovery by providing a lift to world demand. However, the side effects of the largely credit-fueled stimulus are still being felt and its heavy reliance on investment has led to an increase in excess capacity, a heightened risk of future NPLs, and concerns about the financial health of local government financing vehicles. This underscores the importance of using on-budget fiscal measures as the principal tool of any future stimulus. Such measures should aim to boost consumption and support the medium-term objectives of transforming China’s growth model. Options, many of which are already being pursued to some extent, include direct subsidies to consumption, incentives to reduce pollution and energy use, fiscal support to small enterprises, and higher social safety net spending. The response should be guided by the principle of accepting growth that is somewhat slower but better balanced.

12. Authorities’ views. The authorities were concerned about the external outlook, especially the risk of a worsening of the euro area crisis and the lack, so far, of a sufficiently strong policy response within Europe. They noted that the euro area crisis was already weighing on exports, investment, and consumer sentiment in China. Weakening activity and potentially pro-cyclical fiscal policy in the United States were also cited as risks. The authorities agreed that, in the event of a worsening of the euro area crisis, they had ample room for a forceful policy response. They would aim to adopt a balanced approach between fiscal and monetary measures, designed to safeguard the official growth target of 7½ percent for 2012 while avoiding the build-up of future imbalances. They highlighted that rising real interest rates and the still-high reserve requirements provided space for a further monetary response. By ensuring healthy domestic consumption and investment growth, China would continue to contribute significantly to global economic stability.

D. Domestic Risks

13. Weaker growth? The authorities’ efforts to slow the economy entail the risk that growth could weaken too much. This is especially true against the backdrop of a worsening external environment. If activity softens further, there is scope to adjust macroeconomic policies. To avoid a repeat of the 2009–10 credit and investment stimulus (which would compromise the medium-term rebalancing agenda), fiscal policy should assume the lead role in this response, with monetary policy geared to achieving the existing targets.

14. Real estate risk. Staff raised the potential risk that measures to cool the real estate market could overshoot and lead to a sharper-than-anticipated decline, especially with a possibility of more severe external headwinds going forward. Staff spillover analysis suggests that a disorderly decline in real estate investment could have significant implications for growth in China and the global economy (Box 3). In the event the market contracts too much, there is space to accelerate the social housing program and selectively loosen some of the restrictions that hold back housing demand, notably those affecting first-time buyers, owner-occupied housing, and low-income groups. Staff emphasized, however, that mitigating China’s inherent tendency for property bubbles would require addressing the underlying structural causes. This would include providing more outlets for household savings through deepening local financial markets and eventually opening the capital account, and increasing the carrying cost of real estate by achieving, over time, structurally higher real interest rates and putting in place a broad-based property tax. This, however, will require a well developed registration and appraisal system.

The Spillover Effects of a Downturn in China’s Real Estate Investment1

Real estate investment accounts for a quarter of total fixed asset investment in China. This box examines the spillover effects of an independent decline in China’s real estate investment on a large set of macroeconomic, labor, financial, and trade indicators in China and its G20 trading partners as well as global commodity prices. The interaction between China and the rest of the G20 is captured by a two-region factor-augmented VAR (FAVAR), based on monthly data during 2000M1-2011M9.

Domestic Impacts. Following a decline in real estate investment, activity would fall in a broad range of sectors, given the real estate industry’s strong backward linkages to other domestic industries (such as consumer durables, construction, light industry, electricity). Weakening domestic demand would depress China’s imports and, in turn, impact trading partners’ production, employment and domestic demand. As a (second-round) result, China’s exports would weaken. The fall in China’s imports reflects robust linkages of real estate activity to domestic industries that require inputs from abroad on top of a significant share of processing trade in total trade (see Fig. 1). Consumption would weaken as income and wealth decline. Total industrial value added and output would fall, with impact starting to dissipate after 4 quarters. The overall slowdown is reflected in the stock market as well as employment conditions. As demand conditions deteriorate, property transaction volume and price would also fall.

Fig 1:
Fig 1:

China, Peak Impact on Macroeconomic Indicators

(In percentage points, saar; 1 s.d. shock)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Global Spillover. Capital goods manufacturers that have sizable direct exposure to China, especially Korea and Japan, and those that are highly integrated with the rest of the G20—therefore sharing adverse feedback (second-round impact) from a negative shock in China with other trading partners, such as Germany and Japan—would experience a larger slowdown in industrial production and GDP (see Fig. 2). All in all, a 1-percent decline in China’s real estate investment would shave about 0.2 percent off China’s real GDP within the first year, with negative spillover impacts to China’s G20 trading partners, which would result in global output loss of 0.06 percent. Trading partners face a direct impact on exports of machinery, equipment, and commodities following a downturn in China’s real estate investment. This initial impact is further amplified through second-round effects on domestic demand.

Fig 2:
Fig 2:

Peak Impact on Real GDP, implied

(In percentage points, saar, 1 s.d. shock)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Global trade activity would weaken, which implies that economies that derive significant benefit from global trade expansion and have indirect links with China via supply chain countries over the past decade, such as Germany and Japan, would be harder hit in the second round.

Table 1.

Impacts one year after a 1-standard-deviation exogenous decline in China’s real estate investment: Selected Commodity Prices

article image
Remark: A one-standard-deviation decline in growth is equivalent to 2-percent decline in real estate investment levels from baseline

Worsened global growth prospects would be reflected in falling asset prices and sovereign bond spreads (except the United States, where the initial flattening of the yield curve is reversed after around two quarters, pointing to better recovery prospects compared to other G20 economies).

Global growth slowdown and a drop in China’s demand for base metal imports would lead to a drop in the international prices of iron ore, aluminum, copper, lead, nickel, and zinc (see Table 1). The impact on overall metal prices could last 4 quarters, with up to 5–6 quarters for lead and zinc, possibly due to weaker supply response.

1 See Ahuja, A. and A. Myrvoda, “The Spillover Effects of a Downturn in China’s Real Estate Investment on G20 Economies and Global Commodity Prices,” IMF Working Paper (forthcoming).

15. Authorities’ views. The authorities regarded the risk from policy over-tightening as low. On the real estate risk, they felt that current measures were sufficient to support the real estate market in the short run, and were also conducive to the long-term development of the housing market and the economy as a whole. They also noted that current policies were already aimed at encouraging first-time buyers’ demand and that nonspeculative transactions should rebound once the property sector had cooled enough.

16. Local government finances. Local governments have direct responsibility for the delivery of social services, and therefore play an important role in distributing the benefits of growth to all parts of society. However, they lack adequate own-revenue sources and are prohibited from on-budget borrowing (except for a limited pilot in a few provinces; instead, many of them make recourse to borrowing by off-budget financing vehicles to fund investment projects). This has consequences for the provision of social services, the property market (given the strong incentive to use land sales as a source of financing), the banking system via lending to local government entities, and public debt dynamics. Addressing the problem of local government finances should be a priority, which will need to include clarifying expenditure assignments, ensuring that revenue sources are adequate to meet these assignments, and putting in place a system to closely monitor and control the risks related to borrowing by local entities, especially local government financing vehicles.

17. Authorities’ views. The authorities agreed that reforming local government finances was a priority, including on the revenue, spending, and financing sides. They indicated that around 20 percent of the debt owed by local government and local government financing vehicles as of end-2010 had already been repaid during 2011, and local government financing vehicles had taken on a minimal amount of new debt during the same period.

E. Financial Sector

18. Bank asset quality. The side effects of the last stimulus are still winding their way through the economy. As a result, there is a clear risk of deterioration in bank asset quality, which would be amplified in a lower-growth scenario. As suggested by the Financial Sector Assessment Program (FSAP) stress tests, and corroborated by new stress tests conducted by the authorities at the end of 2011, the risk to the overall banking system appears manageable under most scenarios. Reported data indicate that bank balance sheets are generally healthy, with provisioning rates against gross loans at 2.5-3 percent (covering reported NPLs close to three times) for the largest banks. Also, the fiscal position is sustainable even under conservative assumptions about the ultimate fiscal costs of dealing with a rise in NPLs. Nevertheless, a substantial rise in NPLs would raise potentially difficult questions about burden sharing between banks and different levels of government. In this context, it is critical to put in place a crisis management framework that allows for the orderly exit of weak or failing financial institutions and clearly defines the roles of the state in providing fiscal support; and to adopt a formal deposit insurance scheme. Moreover, the China Banking Regulatory Commission (CBRC) should continue to ensure that banks fully account for the underlying risks of their loan portfolios with appropriate classification, provisioning, and risk weighting.

Selected Banking Indicators (in percent)

article image
Source: CBRC.

19. Off-balance sheet and nonbank financial intermediation. Financial activity outside of bank balance sheets has continued to grow at a rapid pace. This migration of resources into off-balance sheet activity and nonbank intermediation risks undermining the use of traditional monetary aggregates as policy targets, and potentially adds to vulnerabilities. While such activity reflects public demand for financial services and can benefit financial development in China, there is a risk that it could weaken monetary control and threaten financial stability. Addressing this risk requires the continued upgrading of regulatory and supervisory capacity. This includes further improving data collection on nonbank intermediation and strict oversight of nonbank risk management, especially in areas where short-term customer funds are channeled into longer-term risky investments. More broadly, these developments underscore the importance of strengthening the monitoring of systemic risk and pushing forward financial reform (in line with FSAP recommendations), including making monetary policy more reliant on price-based signals.

20. Financial sector reform. The last Article IV consultation and last year’s FSAP (Box 4) focused on the importance of financial sector reform. International experience shows that while financial liberalization can foster long-term growth, careful sequencing, monitoring, and adjustments along the way as needed by changing circumstances, are important to avoid crises. Box 5 summarizes the progress made since last year’s FSAP, including the widening of the renminbi trading band, the recent increase in interest rate flexibility, a stress testing exercise, and an implementation plan for adopting Basel III. Moreover, the trend toward making the renminbi a more international currency is positive and consistent with China’s economic importance; to be successful, it needs to proceed in tandem with the gradual opening up of the existing capital control regime (Box 6).

From External to Internal Rebalancing: Transforming China’s Growth Model

A. Progress with Rebalancing

21. Current account. China’s external imbalances have been reduced significantly (Figure 3). The current account surplus declined sharply from a peak of 10.1 percent of GDP in 2007 to 2.8 percent of GDP last year, due primarily to a reduction in the trade surplus. The decline reflects a variety of factors including a worsening of the terms of trade, as China is no longer a price taker in many markets; cyclically weak foreign demand knocking down exports; strong domestic investment driving up imports, especially of primary commodities; and the appreciation of the real exchange rate.2 Since some of these factors are likely to continue putting downward pressure on China’s external imbalance, the medium-term forecast has been significantly lowered to a surplus of some 4 to 4½ percent of GDP (well below the 7 to 8 percent of GDP previously expected). However, China’s surplus would still rise as a share of global GDP from 0.2 percent in 2012 to 0.6 percent in 2017. The projection cautiously assumes that the terms of trade will continue to deteriorate steadily (at around ½ percent per year), investment as a share of GDP will stay close to the current level, fiscal consolidation will continue over the medium term, advanced economies recover as envisaged in the April WEO, China will continue to gain global market share at the average pace seen over the past decade, and the standard staff assumption of a constant real effective exchange rate holds.

Figure 3.
Figure 3.

Current Account: Recent Trends and Prospects

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: CEIC; Haver Analytics; WEO; and IMF staff calculations.

FSAP Follow Up: A Preliminary Assessment of Recent Reform Efforts and Pending Priorities

Last year’s Financial System Stability Assessment (FSSA) noted significant progress in moving toward a commercially oriented financial system, but also identified several near-term risks, structural challenges, and policy-induced distortions.

The Chinese authorities welcomed the FSSA, and explained that time was needed to study its recommendations and decide upon implementation. They noted that the FSSA’s reform proposals would be carefully considered as China continues to develop and safeguard its financial system under the 12th Five-Year Plan. However, since the FSAP was completed only last year, the authorities cautioned that it was still too early for a full-fledged assessment of the follow-up.

Significant progress has already been achieved in several areas. Key examples include:

  • The widening of the renminbi intraday trading band in April, which the PBC notes has been underpinned by sharply reduced foreign exchange market intervention. If sustained, such restraint would mark welcome progress toward a more market-based exchange rate system.

  • The PBC’s decision in early June to give banks more flexibility in setting deposit and lending rates, which sharply reduced the minimum interest margin and created scope to enhance monetary control via prices rather than administrative guidance.

  • A stress-testing exercise conducted in late 2011 that built on earlier work undertaken during the FSAP. Establishing a regular stress testing cycle would underpin the authorities’ efforts to ensure proactive, forward-looking oversight of evolving banking sector risks.

  • Improved data collection, including a dedicated statistical system for bank acceptance bills and a credit code system gathering data on beneficial ownership and control for institutional bank account holders. The CBRC is also enhancing its collection of offsite surveillance data on leverage ratios and cross-border exposure.

  • Launch of an inter-agency mechanism to develop the corporate bond market, led by the PBC and incorporating the National Development and Reform Commission and the China Securities Regulatory Commission. It aims to improve rules on issuance, trading, and information disclosure.

  • Creation of a task force to help develop a new risk-based solvency framework for the insurance sector. The China Insurance Regulatory Commission has also set up a risk monitoring system for the insurance industry and clarified the rules governing exit from the market via portfolio transfers.

  • Finalization of an implementation plan for Basel III, which will introduce higher standards for capital adequacy to be phased in from January 1, 2013 onward.

Nonetheless, staff recommended further efforts in other areas, notably to upgrade the prudential framework to keep pace with the ongoing liberalization of the financial system. The FSSA underscored the need to develop a robust crisis management framework, establish a Financial Stability Committee to enhance the monitoring of systemic risk, and to introduce a formal deposit insurance scheme. The authorities noted some preparatory work in these areas and recognized that further efforts are desirable. Concrete progress will become increasingly important to ensure that the benefits of financial liberalization are not undermined by heightened risks to financial stability.

Roadmap for Financial Sector Reform

Objective. Move to a more commercially oriented financial system that fosters stable and inclusive economic growth, facilitates internal rebalancing, and safeguards financial stability. The current system impedes rebalancing as it works as an implicit tax on household savings that is used to subsidize corporate investment and protect bank earnings.

Principles. There is no optimal and predetermined path for financial sector reform, and plans should remain flexible and tuned to changing circumstances. Nonetheless, the complexity and interconnections between different aspects of the reform process—and the consequences of mistakes—underscore the importance of careful sequencing.

Exchange rate. Reaching exchange rate equilibrium with greater exchange rate flexibility will simplify monetary management by reducing the need to sterilize capital inflows and providing scope for a more independent monetary policy.

Monetary framework. Monetary policy should move toward price-based means instead of administrative controls on lending, which will require the absorption of excess liquidity to steer interest rates to an appropriate level. Implementing reserve averaging, targeting a short-term repo rate, and ensuring the PBC standing facilities operate immediately would help strengthen liquidity management and limit the volatility of money market rates. A new monetary policy framework could be put in place that focuses on growth, inflation, and financial stability.

Regulation and supervision. Improvements in supervision and regulation, as well as in systemic risk monitoring and the crisis management framework need to keep pace with increases in the commercial orientation and innovation of the financial system.

Financial market development. Strengthening nonbank financial intermediation will provide competitive discipline on banks, offer companies alternative avenues for finance, and provide households with a broader range of investment opportunities. Progress, however, needs to be calibrated with bank reforms to prevent a destabilizing rush away from bank-based intermediation.

Interest rate liberalization. As a strong system of prudential oversight is put in place, the central bank can move to liberalize the limits on loan and deposit rates and allow them to be market determined. It is critical, however, to ensure that this liberalization does not result in an unintended loosening of monetary conditions.

Capital account liberalization. Full liberalization—especially for short-term flows—should wait until the bulk of the reforms identified above are in place. The existing framework of qualified foreign institutional investor and qualified domestic institutional investor could be used to advance a gradual and controlled opening of the capital account.

Renminbi Internationalization

The authorities are facilitating a gradual increase in the international use of the renminbi. This has involved allowing the settlement of cross-border trade in renminbi and the development of renminbi financial products in offshore markets. This has resulted in a growing share of trade invoiced in renminbi, a build-up in renminbi deposits in Hong Kong SAR, and an increase in issuance of renminbi-denominated “dim sum” bonds. More recently, and as the forward markets in Hong Kong SAR were pricing in depreciation of the renminbi against the U.S. dollar, the use of renminbi in Hong Kong SAR has leveled off as indicated by a flattening in the share of trade settled in renminbi and a modest dip of renminbi deposits. Market development has been helped by a selective relaxation of capital controls to allow offshore renminbi to flow back to the Mainland.

The expansion in the international use of the renminbi has occurred largely in Hong Kong SAR with its open capital account, highly regarded legal system, and strong regulatory oversight provided by the Hong Kong Monetary Authority. A payment infrastructure has been created, with the Bank of China as the clearing bank. Measures relaxing capital controls to support renminbi internationalization have been progressively implemented:


RMB Cross-Border Settlement for Trade

(In RMB bn)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: Bloomberg; CEIC; HKMA; PBoC; and IMF staff estimates.
  • Trade settlement in renminbi has been expanded to all Chinese corporations.

  • Rules to remit offshore renminbi back to the Mainland as FDI have been simplified.

  • A scheme has been put in place (renminbi-qualified foreign institutional investor) to allow offshore renminbi to be invested in Mainland interbank, bond, and stock markets (subject to a RMB 70 billion quota).

  • Mainland banks and corporations have been allowed to issue “dim sum” bonds in Hong Kong SAR and repatriate the funds back to the Mainland.

  • A renminbi swap facility with Hong Kong SAR can be used to provide renminbi liquidity offshore.

International use of the renminbi is also being promoted through bilateral agreements. China has established renminbi currency swap arrangements with 18 central banks totaling $260 billion. The China Development Bank has also arranged renminbi credit lines with other development banks and state enterprises in some emerging markets for renminbi trade settlements.

There are plans to expand the offshore renminbi business to other financial centers. Most recently, sales of renminbi financial products have been conducted in London.


RMB Deposits in Hong Kong SAR

(In RMB bn)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: CEIC; HKMA; and IMF staff calculations.
Table 1:

Estimated Contributions to Decline in China’s Current Account Surplus, 2007-11

(In percent of GDP)

article image
Source: IMF Staff calculations.

Elasticities based on estimated calculations for exports and imports of goods.

Preliminary actual.

22. Authorities’ views on current account forecast. The authorities considered the underlying policy and related medium-term assumptions as too conservative and, consequently, the current account surplus forecast by staff in the medium term as too high. They expected demand from advanced economies to remain subdued for some time, and emphasized that the bulk of the decline in China’s current account surplus was due to structural factors rather than cyclical ones, including reforms that have helped boost imports.

23. External assessment. The exchange rate assessment is based on a variety of inputs, including from the Consultative Group on Exchange Rate Issues (CGER), the new pilot External Balance Assessment (EBA), and other factors assessed by staff (Box 7 and Figure 4). Both CGER and EBA suggest that China’s current account should be in a small surplus assuming output gaps in China and all other major economies were closed and, in the EBA framework, policies were at desired levels. This, together with the sharp decline in the current account surplus and related developments, convey that the undervaluation of the renminbi has been reduced. Overall, the renminbi is assessed to be moderately undervalued against a broad basket of currencies.

Figure 4.
Figure 4.

Exchange Rate

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: PBC; Bloomberg; CEIC; Haver Analytics; OECD; IFS; INS; and IMF staff calculations.

24. Authorities’ views on external assessment. The authorities noted that prevailing foreign exchange market conditions were close to equilibrium. This, combined with the significant reduction in the current account surplus and renminbi appreciation, indicated in their view that the renminbi was now close to equilibrium or, at most, slightly undervalued. They appreciated the staff efforts to develop a new methodology for external assessments. However, they had significant reservations about the new model that was being piloted. They argued that more time was necessary before this approach was applied to China so as to better understand the model and allow for the needed vetting by the wider public. On the model itself, they expressed concerns that it was not evenhanded, as it focused on policy gaps in emerging markets, while missing key policy features of advanced economies that had contributed to the last crisis (such as financial market supervision). They also disagreed strongly with the new focus on a desired current account balance and highlighted that previous China staff reports had never emphasized a current account target or norm.

Analysis of the External Sector

Staff’s assessment is that the renminbi is moderately undervalued against a broad basket of currencies. As in the past, this assessment draws on a range of inputs.

  • Current account. In addition to the multilateral model analysis discussed below, the current account surplus has declined sharply, from 10 percent of GDP in 2007 to less than 3 percent of GDP in 2011. Staffs medium-term forecast has also been revised down significantly.

  • Real exchange rate. In addition to the multilateral model analysis discussed below, the real effective exchange rate has appreciated by some 30 percent since the 2005 exchange rate reform, and by 8 percent over the past year (end-April). The nondeliverable forward and onshore forward markets have been pricing in modest depreciation and spot market pressures are no longer one-sided.

  • International reserves. The pace of international reserve accumulation has slowed considerably over the past 12 months (based on balance of payments data). It was especially low in the second half of 2011 before rebounding to US$75 billion in the first quarter of 2012—still below the post-2005 reform quarterly average of US$100 billion. Nevertheless, reserves are well above all standard metrics and the real effective exchange rate should be allowed to continue appreciating by reducing intervention and making it two-sided over the medium term.

  • Capital account. China maintains a broad range of controls on capital inflows and outflows. Over the medium term, a carefully planned and sequenced loosening of capital controls that supports and reinforces domestic financial liberalization would be appropriate. It is not clear what effect liberalization would have on the direction of capital flows.

  • Net foreign assets. Net foreign assets amount to 30 percent of GDP and have grown rapidly over the past several years. This reflects the persistent current account surpluses that peaked at 10 percent of GDP and years of strong FDI inflows. The composition of assets is dominated by foreign exchange reserves, which are around 50 percent of GDP, while liabilities are largely composed of FDI. International investment position vulnerabilities are low.

New multilateral methodology. A new methodology, External Balance Assessment (EBA), is being piloted. Similar to the CGER,1 it generates results for three different approaches, but aims to improve on CGER by more explicitly looking at the role of policies in contributing to external imbalances. The EBA also takes into account a much broader set of factors that may influence the current account or real effective exchange rate. The analogs to the CGER external sustainability and effective real exchange rate approaches, as well as the CGER macro balance approach, yield a moderate undervaluation. The analog to the CGER macro balance approach is expressed in terms of the current account balance. This approach suggests that China would have a small current account surplus after controlling for the effects of the business cycle (both in China and the rest of the world) and assuming that all countries put in place the desired policies for the social safety net, fiscal balance, capital controls, and foreign exchange intervention.2 To achieve that position, the underlying current account would come down. The results are preliminary and the model estimates are subject to uncertainty.

1 Lee, J.; G.M. Milesi-Ferretti; J. Ostry; A. Prati; L.A. Ricci, 2008, “Exchange Rate Assessments: CGER Methodologies,” IMF Occasional Paper No. 261 (Washington: International Monetary Fund).

2 For more details on the methodology and preliminary results of this analysis, see the Pilot External Sector Report (forthcoming).

25. Factor costs. In addition to the appreciation of China’s nominal exchange rate, other factor costs in China have also been rising (such as labor, natural resources, and energy). Over time, these developments will further erode China’s competitiveness and contribute to narrowing the undervaluation.

26. Energy and other inputs. Progress has been made to bring energy costs more in line with international levels. Oil product prices have been indexed to a weighted basket of international crude prices; natural gas prices have been steadily increased; and preferential power tariffs for energy intensive industries have been removed. Nevertheless, input costs remain significantly below most international comparators, and some users (such as those in the industrial zones) receive preferential pricing.


Water and Gas Prices

(In percent; deviation from sample average)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

27. Labor cost. In the labor market, official data show wages growing at an average 15 percent over the past couple of years. Wages have been rising faster in inland provinces as more companies relocate there from the coast. However, the rise in aggregate wages has been only marginally above that of productivity, and the available data suggest that the household income to GDP ratio is not yet on a firm upward trend. Background work by the staff suggests that China still has untapped labor resources, and so has not yet reached the Lewis Turning Point (Box 1). The share of migrant workers in the labor force has risen from 23½ percent in 2008 to 26 percent in 2011. The recent rise in wages is thus mainly a result of increases in the minimum wage, efforts to improve workers’ rights (including greater scrutiny of compensation and hours worked), and growing skill mismatches. However, demographic changes mean the labor force will gradually start to shrink after 2015, putting greater pressure on labor costs.


China Unit Labor Cost and Industrial Profit Margin

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

* Imputed wage data for 2011Q4.

28. Corporate profits. Rising factor input costs have, so far, not led to a visible erosion of industrial corporate profit margins or signs of broad-based corporate stress. Indeed, corporate profit ratios have been rising on average, and the share of loss-making enterprises has been declining. Geographical relocation, strong productivity, and modest increases in export prices are helping to defray cost pressures that firms may be facing. Recent data suggest that while profit margins may be weakening in some sectors, they continue to remain healthy on aggregate.

29. Rising domestic imbalances. While important progress has been made, the reduction in the current account surplus to date does not yet represent the “rebalancing” in China advocated by staff over the past several years. In particular, there is little evidence, as yet, of a decisive shift toward consumption and lower national savings as the main force behind the lower current account surplus. This raises concerns related to the sustainability of the recent decline in the current account surplus and the risk of growing domestic imbalances.

30. Authorities’ views. The authorities considered that they had already turned the corner on domestic imbalances. Consumption, they noted, had already stopped declining as a share of GDP and would soon start to rise. Indeed, it had contributed significantly more to growth last year than in 2010. The authorities also felt that consumption was likely underestimated, and pointed to ongoing work to improve China’s national accounts. Moreover, as discussed below, they had some reservations about characterizing China’s investment rate as being excessive.

B. High Investment: Risks and Spillovers

31. High investment growth. The Chinese economy continues to face strong incentives to over-invest as the effective cost of capital and other key inputs remains too low. By most standards, including a cross-country comparison and the historical experience of other fast-growing economies, China’s investment is very high. Approaching 50 percent of GDP, investment has been sustaining China’s high growth and is creating large excess capacity in the economy, with the capacity utilization rate declining from just under 80 percent before the crisis to around 60 percent today, according to staff analysis. Consequently, the economy is likely operating below potential, as illustrated by staff estimates based on a structural model (Box 8). Closing this gap will require time and the pursuit of reforms to rebalance the economy.

32. Demographics. Staff analysis suggests that about half of the recent increase in potential GDP has come from capital accumulation. This type of extensive growth can work as long as there is abundant supply of labor, so that firms can readily find low-skilled workers without driving up wages. However, demographic changes mean that in the coming years the labor force will gradually start to shrink. Extensive growth will therefore cease to be an option, and sustaining growth will hinge on investing less, but in better and more productive capital, and consuming more. Achieving this transformation will require a comprehensive package of reforms as described below.

China’s Rapid Investment, Capacity, and Output Gap

Measuring potential output in China is affected by significant uncertainty, given the large structural changes in the economy. Its growth model has relied on very high rates of investment; combined with surplus labor, this has created sizable and persistent excess capacity that will take time to close.

China has had a remarkable record of rapid growth and low inflation, which has helped lift more than 400 million people out of poverty. Since the last burst of inflation in 1996, real GDP growth has averaged 10 percent and nonfood inflation 1 percent. The growth model, however, is heavily dependent on investment, and capital accumulation has explained more than one-half of the increase in potential output (defined as the amount the economy could produce without generating inflation while fully utilizing available capacity and labor). A potential output estimation method that differs from standard filtering techniques explicitly models the use of capital and labor, as well as the relationship between output and inflation.1


China: Potential Output Growth

(In percent)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Using this methodology suggests that, while GDP growth dropped to 9.2 percent at the onset of the global financial crisis, potential output continued to expand at about 10 percent as the government put in place a large stimulus package that further boosted investment. With investment increasing by 5 percent of GDP over the past three years, staff estimates show that capacity utilization has declined from just under 80 percent before the crisis to around 60 percent today. This low rate of capacity utilization, together with continued low core inflation, suggests that there is large excess capacity in the economy.

Unlike output gap estimates based on standard filtering techniques such as the Hodrick-Prescott filter, the structural modeling approach suggests the output gap was around 5 percent below potential at end-2011. However, given China’s large structural changes, it is hard to pin down the output gap precisely, and other methodologies typically give different (smaller) values.


Average Capacity Utilization

(In percent)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Sources: IMF staff calculations.

The estimates also show that China has had excess capacity for most of the past decade. The gap was closing in the run-up to the financial crisis, but did so based on an unsustainable level of external demand. Even in 2007, when growth exceeded 14 percent, nonfood inflation was low and stable, suggesting the economy was still operating below capacity. Then, in 2008, the government put in place a large investment stimulus that propped up growth and built out capacity in a range of areas. Filtering techniques which impose a cycle on the data would point to a negative output gap since 2007 even while price pressures were virtually nonexistent and excess capacity was growing.


Estimates of China’s Output Gap

(in percent of potential output)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Eliminating China’s excess capacity will take time and cannot quickly or persistently be achieved with standard demand management tools without building imbalances. Rather than aim to do this with short-run stimulus measures, a package of structural reforms should be put in place to rebalance the economy away from investment and toward consumption as a driver of demand growth. This would translate into slower but higher-quality growth over the medium term.

1 The methodology is based on a structural model that incorporates information about the level of investment and excess labor supply through a production function framework. It is estimated using a system of four basic structural equations: an aggregate production function, a Phillips curve, an equation to estimate the NAIRU, and an Okun’s law relationship relating the unemployment gap to the output gap.

33. Risks. Maintaining high investment will add to overcapacity and thereby create problems over the medium term. Staff highlighted the risk that persistent overcapacity could lead to deflationary pressure, a rise in bankruptcies, and large financial losses. It could also drive up exports and depress prices to maintain high global market shares in a range of products, which could trigger retaliatory trade action. Eventually, under this scenario, a sharp correction in investment would become inevitable, with significant negative implications for growth and employment.

34. Spillovers. Should domestic rebalancing fail to take place in an orderly fashion, staff analysis suggests that the alternative of a sharp decline of China’s investment would have a significant impact on trading partners’ growth and global commodity prices (Boxes 3 and 9). The combination of China’s reliance on investment for growth and its growing footprint of commodities and capital goods imports leave several economies exposed to a slowdown in China’s fixed-asset investment. The growth impact would be significant for G20 economies such as Japan, Germany, Canada, and Brazil. It would also be considerable for those economies within China’s supply chain of electronics and machinery exports, such as Taiwan Province of China, Malaysia, and Korea, and the primary suppliers of key minerals and natural gas. A sharp slowdown in China’s investment growth would also lead to a decline in financial asset prices abroad, as well as base metal prices (particularly zinc, nickel, copper, lead, aluminum, and iron ore), the prices of agricultural raw materials, and nonfuel primary commodities in general. This would result in a deterioration in the terms of trade for commodity exporters (see Box 3 for more details). A fuller discussion of these spillovers is contained in the 2012 Spillover Report.

35. Authorities’ views on investment. The authorities agreed with the need to rebalance the economy to be based more on consumption. However, they considered that the questions of whether China had been over-investing and whether China’s investment level was too high remained open to further in-depth study. This should take into account, for instance, China’s stage of development, geographic size, regional disparities, demographics, and fast urbanization from a low base. In recent years, capacity utilization rates appeared to have been falling because external demand had been weak, although there could also be overcapacity in some sectors. More fundamentally, they considered that China’s capital stock was still too low and, therefore, there was much room for further productive investment. In the future, the authorities expected investment growth to recede to a lower and stable level as China moved up the value chain and developed its service sector further.

Investment-Led Growth in China: Global Spillovers1

Over the past decade, China’s growth model has become more reliant on investment and its importance to trading partners in its supply chain has grown substantially. The ratio of exports to China relative to trading partner GDP has, on average, quadrupled across the decade. This box quantifies potential global spillovers from an investment slowdown in China.


Exports to China, 2001 and 2011

(in percent of national GDP)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

The effect of the spillover from China on trading partner growth is estimated using a panel of 64 economies exposed to China through the export channel. The sample covers the period of China’s membership in the WTO (2002–11) and includes the full set of OECD economies, emerging markets classified under the MSCI index, and key commodity producers.

Economies within China’s supply chain are increasingly exposed to the risks from a deceleration in investment in China. Aggregating across all economies in the sample (weighted by their PPP shares), the current impact on global growth of a one percentage point slowdown in investment in China is just under one-tenth of a percentage point. The impact is about five times larger than in 2002. The most heavily exposed economies are those that lie within the Asian regional supply chain such as Taiwan Province of China, Korea, and Malaysia. If investment growth declines by 1 percentage point in China, GDP growth in Taiwan Province of China, for example, falls by slightly over nine-tenths of a percentage point. Among the advanced economy exporters of capital goods, Japan suffers a decline of just over one-tenth of a percentage point in response, while growth in Germany declines by a slightly smaller amount. Among commodity exporters, the impact of a slowdown in investment growth in China is likely to be largest on mineral ore exporters with relatively less diversified economic structures and a higher concentration of exports to China. In response to a 1 percentage point slowdown in investment growth in China, the estimated effect on Chile’s growth is a reduction of close to two-fifths of a percentage point. By contrast, the larger commodity exporters such as Australia and Brazil with more diversified economies suffer relatively smaller declines in growth.


China Investment Slowdown (1 percentage point) Impact on Trading Partner Growth

(in percentage points)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001


China Investment Slowdown (1 percentage point) Impact on Commodity Exporter Growth

(in percentage points)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

A complementary approach based on FAVAR shows that the spillover effects from an investment slowdown in China would register strongly across a range of macroeconomic, trade and financial variables among G20 trading partners, as well as world commodity prices. The results are broadly similar to those reported in Box 3, which examines the spillover impacts from China’s real estate investment slowdown.

1 See Nabar, Malhar and Ashvin Ahuja, “Investment-Led Growth in China: Global Spillovers,” IMF Working Paper (forthcoming).

36. Authorities’ views on spillovers. The authorities considered the probability of a sharp decline in investment as remote. Implementation of their structural reform agenda would help ensure a smooth transformation of the economy. They highlighted that investment devoted to updating and improving the efficiency of the capital stock in recent years would not translate into overcapacity. Moreover, successful rebalancing would help ensure that capacity was absorbed domestically. Rather, they indicated that the more likely source of an unanticipated decline in investment was the weak global economy. The authorities also emphasized that steady, albeit somewhat slower, investment growth and continued capital stock upgrading were not only necessary for China’s long-term sustainable development, but also for more balanced and sustained global growth.

C. Toward Higher-Quality Growth

37. Reform package. A package of reforms is needed to achieve the authorities’ goal of quality growth that is less reliant on investment and more on consumption, and that addresses rising inequalities, especially between coastal and inland regions, by promoting inclusive growth. With growing excess capacity and demographic shifts around the corner, time is running out on the current growth model. Implementing the needed policies, however, will take time and it is therefore urgent to accelerate the process to avoid a further build-up of risks and help ensure a smooth and controlled adjustment to a more consumer-based economy. Delay could prove costly, and a disorderly unwinding of China’s domestic imbalances poses an important risk for the domestic and global economy.


Real Average Wages: Dispersion Across Provinces

(In RMB thousand)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

38. Saving, Investment, and Incomes. Internal rebalancing hinges on reducing household saving, increasing household real disposable income, and reducing incentives to over-invest Key reforms to achieve this include:

  • Improve the social safety net. China has made significant progress in this area, which has helped improve the welfare and living standards for both urban and rural households (Box 10). A continuation of reforms to the pension, health, and education systems would also help boost consumption by reducing precautionary savings and over time improving labor productivity.

  • Lower social security contributions. Very high contribution rates—the combined employee and employer share exceeds 40 percent in many cases—are an impediment to internal rebalancing. Reducing contributions would help boost employment and also directly increase household disposable income. Moreover, lower-income households would get the biggest benefit (given the regressive nature of social security contributions), which would help foster more inclusive growth and provide a relatively larger boost to consumption (since low-income households have a higher marginal propensity to consume). However, a reduction in social security revenue needs to be accompanied with other reforms (including coverage, benefits, and financing) to safeguard the financial viability of the system.

  • Expand the service sector. Although the labor share of employment in the primary sector has declined markedly over the past decade to about 35 percent in 2011 from 50 percent in 2002, it remains high when compared to other countries and after taking into account China’s fundamentals. There continues to be scope to absorb more labor into the services sector, which would help boost labor’s share of income. This could be done by opening up domestic sectors to competition and raising productivity in sectors such as utilities, banking, and telecommunications.


Urbanization Rate, Primary Sector Share of Employment and GDP

(In percent)

Citation: IMF Staff Country Reports 2012, 195; 10.5089/9781475505467.002.A001

Social Safety Net

China has made significant progress in developing its social safety net in recent years, which has provided substantial social benefits. It should also help reduce household savings and boost private consumption. To meet the government’s targets, additional resources may be needed in the coming years and several lingering issues will have to be resolved.


Targets. The government is aiming for comprehensive coverage of the pension system by 2020. It has established principles for reforming the urban pension system: “broad coverage, protect at the basic level, multi-layered, and sustainable.” Principles for the rural system are identical.

Recent achievements. Complementing the existing urban workers pension insurance scheme, a rural pension pilot was launched in September 2009 and a pension pilot for urban residents (for informal workers) in 2011. Since 2010, the urban workers scheme, in principle, allows workers changing jobs to transfer both their accumulated individual accounts and social pooling rights to other jurisdictions.

Key remaining priorities

Broadening coverage. Based on World Bank estimates, around 30 percent of China’s labor force contributes to a pension scheme in 2008. Among migrants, participation in the urban system doubled between 2005 and 2010, but remained low at around one-quarter, compared to 80 percent for local workers.

Raising replacement rates. According to the World Bank, for instance, gross replacement rates for the urban old age insurance system are about 45-55 percent, compared to the OECD median of over 70 percent in 2008.

Increasing portability. Despite the significant progress in improving portability, lack of portability of pension rights across urban pension subsystems or between rural and urban systems remains an issue. In addition, practical barriers constrain reliable and timely transfer of pensions even within provinces, including from incompatible information systems.

Reducing fragmentation, both across space and schemes. Across space, funds could be pooled at higher levels to increase efficiency and reduce risks, first at the provincial level and ultimately at the national level. Across programs, international best practice suggests integrating the various urban schemes—including the public sector unit, civil servant, and urban workers’ schemes—and eventually merging the rural and urban residents’ schemes.


Targets. The government intends to provide safe, affordable and effective health care to all citizens by 2020, notably by raising health insurance coverage, formulating a national essential drug program, improving basic medical services for screening and prevention, and reforming the management of public hospitals.

Recent achievements. According to the OECD, 95 percent of the population is now covered by basic health insurance and the private share of health expenditures (including out-of-pocket expenses) has declined to around 35 percent, from 60 percent in 2001. In addition to the urban employee basic medical insurance scheme, two new ones have been recently introduced: urban residents scheme targeting nonworkers and the new rural cooperative scheme.

Key remaining priorities

Curbing out-of-pocket expenses. Benefit levels are still fairly low and cost-sharing requirements high. For instance, the rural scheme pays out $50 per person per year and reimburses 50 percent of the cost of in-patient care.

Increasing coverage of catastrophic diseases. Health benefits are capped and those covered by insurance are not always protected against catastrophic health expenditure, leaving patients uncovered for the worst crises and providing incentives for pre-cautionary saving. Pilots of enhanced coverage for some limited catastrophic diseases have begun, but need to be significantly bolstered.

Reforming public hospitals and pricing. Financing and managing public hospitals are areas where reforms have lagged. In addition, their heavy dependence on revenues from selling medicines fuels inefficient use of hospital services and contributes to inflated pharmaceutical prices.

Reducing fragmentation. Contributions required and benefits provided vary significantly between China’s health insurance schemes. Fragmentation has especially hurt the effective coverage of migrants. Typically enrolled in the rural scheme, they can face higher out-of-pocket expense and must claim in their home county, with much lower reimbursement rates and long lags.

Financing. More resources will likely be needed over the medium term to meet China’s social security targets, ensure the sustainability of the systems, and deal with legacy pension costs. Currently, public expenditure on health, pensions, and other forms of social protection only amounts to 5.7 percent of GDP in China. On average, economies at similar levels of development spend more than twice as much.

  • Boost state-owned enterprise (SOE) dividend payments. Requiring SOEs to increase dividend payments to the budget would reduce self-financed investment and increase budget revenue that, in turn, could be used to finance fiscal and social security reforms. This should include steps to ensure that dividends from profit-making enterprises to a parent company are not used to finance investment in loss-making ones at the expense of budget revenue.

  • Structurally higher real interest rates. This would help improve the allocation of investment by reducing reliance on administrative credit controls (which typically favor large state-owned enterprises, at the expense of smaller, private firms), increase household interest income, and reduce household saving (because the income effect on consumption dominates the substitution effect).3

  • Increase cost of factor inputs. China has made progress in increasing the cost of energy, land, water, and pollution, all of which will help reduce the incentives to over-invest and improve its efficiency. Still, many investments are profitable only because input costs are kept artificially low. This creates a large wedge between the cost of capital and the marginal product of capital.4 Pricing factor inputs at the right cost will make many existing investment plans not profitable and therefore reduce firms’ incentives to invest. This will also ensure a better pricing of externalities. The recent hike in resources taxes are a good example and reforms in this area should continue.

39. Stronger renminbi. Currency appreciation continues to be an important component of the package of reforms needed to transform China’s economy. A stronger renminbi would increase household purchasing power, help expand the service and other nontradable sectors, boost the labor share of income, and facilitate financial sector reform. The recent widening of the intraday trading band is an important step in this regard, as it will allow the market to play a stronger role in determining the exchange rate. Using this increased flexibility would also have the benefit of allowing for a more independent monetary policy. As reserves are well above all standard metrics and the currency is moderately undervalued, the real effective exchange rate should be allowed to continue appreciating by reducing intervention over the medium term.

40. Authorities’ views. The above priorities are shared by the authorities and all feature in the 12th Five-Year Plan. The authorities had several comments on specific aspects of the agenda. Regarding the renminbi, the authorities considered that the market was already basically in equilibrium. As for lowering social security contributions, they were open to exploring this option but underscored that it had to be done in the context of a comprehensive reform of the social security system to ensure its actuarial and financial soundness. Finally, on SOE dividends they noted that these were paid in accordance with existing laws and that consideration could be given to gradually increasing the payments that flow to the budget.

Staff Appraisal

41. Outlook. The authorities’ plan to target slower growth is appropriate. In line with this objective, the economy is slowing and growth is projected to moderate to 8 percent this year. However, intensifying strains in Europe have increased the downside risks to this outlook. Inflation peaked a year ago, is on a downward trajectory, and, barring further shocks to food supply or global commodities, is expected to remain below the authorities’ target of 4 percent.

42. Fiscal policy. The 2012 fiscal stance strikes a balance between unwinding of past stimulus and supporting the slowing economy. The efforts to calibrate fiscal policy to support growth, within the existing budget envelope, are appropriate. Fiscal reforms, meanwhile, should continue to be oriented to facilitating the transformation of the economy to a more consumer-based one, including through ongoing efforts to ensure appropriate costs of resource use, expand the VAT to services to replace the business tax, and improve the livelihood of lower-income households through tax reductions and social safety net improvements. In addition, the publication of well-defined medium-term fiscal plans would help anchor expectations and provide assurance that the reform agenda is fiscally sustainable.

43. Monetary policy. This year’s 14 percent M2 growth target is consistent with projected growth without exacerbating the risks from the credit overhang. Recent cuts in required reserve ratios and benchmark interest rates will help achieve this year’s economic objectives and increase the market orientation of monetary policy. In particular, the recent steps to allow banks more flexibility in setting interest rates will allow prices to play a greater role in clearing the capital market, which is becoming increasingly important as financial innovation leads to more intermediation taking place outside of standard bank deposits and loans. Meanwhile, sustained reduction in foreign exchange purchases by the central bank would lessen the need for sterilization, create welcome space to further lower banks’ reserve requirements, and allow the central bank to increasingly rely on open market operations to absorb liquidity.

44. Domestic risks to growth. The authorities appear to be succeeding in slowing the economy. Assuming the global environment does not deteriorate precipitously, the current stance of policies should support growth at around 8 percent. The deliberate cooling of the real estate market has been a key factor, given the property sector’s important role in the economy through its significant linkages to other sectors. Staff spillover analysis suggests that real estate investment also has a sizeable impact on the global economy, underscoring the importance of ensuring healthy development in this sector. In the event the market cools too much, there is space to further accelerate the social housing program and selectively loosen some of the restrictions that hold back housing demand. However, mitigating the propensity for property bubbles requires a range of reforms to make housing relatively less attractive as a vehicle for financial investment by providing more alternatives and raising the carrying costs.

45. External risk. The chief external risk continues to be spillovers to China from a worsening of the euro area sovereign debt crisis. A history of fiscal prudence has made China well placed to respond forcefully to an adverse external shock using fiscal policy as the primary tool. The authorities’ strong response to the last crisis helped maintain robust growth in China and provided needed support to the global economy. It also relied heavily on a large expansion in bank credit—especially to local government financing vehicles—which is now raising concerns about bank asset quality, the size and efficiency of investment, and the financial health of some local government entities. Given the lingering risks from the last stimulus, future measures should be implemented mainly through the budget, which would help safeguard the banking system, promote more efficient use of the stimulus funds, and allow for a stronger emphasis on reforms that promote the desired transformation of the economic growth model. There is ample fiscal space for the response to be commensurate with the size of the shock, finding the right balance between tolerating somewhat slower growth, emphasizing reforms consistent with medium-term objectives, and protecting people’s livelihoods.

46. Financial sector. The rapid increase in lending during the last stimulus poses a risk to bank asset quality, especially if growth slows considerably. The risk to the overall banking system appears manageable under most scenarios as reported data indicate that bank balance sheets are generally healthy and there is adequate fiscal space to deal with any problems. Nonetheless, a substantial rise in NPLs would raise potentially difficult questions about burden sharing between banks and different levels of government. In this context, it is important to strengthen the crisis management framework, adopt a formal deposit insurance scheme, and ensure that banks fully account for the underlying risks of their loan portfolios. Meanwhile, financial innovation is resulting in more intermediation taking place outside of traditional bank deposit and lending activity. This is a positive step in financial development; but unless it develops in an orderly and supervised way, it could weaken monetary control and threaten financial stability. Addressing this risk requires the continued upgrading of regulatory and supervisory capacity to keep pace with innovation, strengthening the monitoring of systemic risk, and pushing forward financial sector reform, especially to increase the reliance on price-based instruments.

47. Current account. The sharp decline in China’s external imbalances is a welcome development, especially the significant reduction in the current account surplus. The decline reflects both structural and cyclical factors, and staff has accordingly lowered the medium-term current account forecast to a surplus of some 4–4½ percent of GDP.

48. External assessment. The sharp decline in the current account surplus and the recent appreciation in the real effective exchange rate suggest that the undervaluation of the renminbi has been reduced. The renminbi is assessed as moderately undervalued against a broad basket of currencies. Many reforms underway, such as strengthening the social safety net, reducing intervention, and moving toward a more open capital account, will further help achieve the desired external rebalancing.

49. Internal rebalancing. China has relied heavily on investment as a driver of growth. This has pushed up investment to the point where it accounts for nearly half of GDP, which is unusually high by international and historical standards. It is also leading to excess capacity that could result in problems down the road if domestic and global markets are unable to absorb the output, leading potentially to trade frictions, price declines, bankruptcies, and a worsening of bank asset quality. This model, therefore, is not sustainable.

50. Spillovers. China is now the world’s second largest economy and its domestic developments have significant spillovers to the rest of the world. It is clear that China’s success in maintaining robust growth since the onset of the global financial crisis in 2008 has provided a welcome lift to global demand. The rapid growth in investment, moreover, had particularly strong benefits for primary commodity producers and exporters of machinery and equipment. Going forward, it will be important to ensure that investment returns gradually to a more sustainable level. Otherwise, there is a risk of a sharp and disorderly reduction in investment, which would have significant adverse domestic and global repercussions.

51. Reform package. It is well recognized that a broad package of reforms is needed to achieve quality growth that relies less on investment and more on consumption, and is inclusive and environment-friendly. As implementation will take time, the reform process should go faster to avoid a further build-up of risks and ensure smooth adjustment. The key elements of the reform are opening up the service sector, raising factor costs, allowing for a continued gradual appreciation of the renminbi, improving the social security system, and implementing a comprehensive financial sector reform program that is continually calibrated in line with evolving conditions.

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

China: Risk Assessment Matrix

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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.

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.

Anualized contribution to reserve money growth, percent.

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 and other adjustments to expenditure.