People’s Republic of China: Staff Report for the 2013 Article IV Consultation
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International Monetary Fund. Asia and Pacific Dept
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Publication Date:
17 Jul 2013
eISBN:
9781475566925
Language:
English
Keywords:
ISCR; CR; market liquidity; rate; estimate; discussion; June; monetary policy; financial system; current account; property tax; net capital
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This staff report on People’s Republic of China 2013 Article IV Consultation highlights macroeconomic developments and outlook. China has maintained robust growth since the global crisis, but the heavy reliance on credit and investment to sustain activity is raising vulnerabilities. The consequence is a steady build-up of leverage that is eroding the strength of the financial sector, local government, and corporate balance sheets. This is most apparent in the continued rapid expansion in total social financing. The development of nontraditional finance marks a shift to more market-based intermediation, and the migration of activity to less-regulated parts of the system poses risks to financial stability.

Abstract

This staff report on People’s Republic of China 2013 Article IV Consultation highlights macroeconomic developments and outlook. China has maintained robust growth since the global crisis, but the heavy reliance on credit and investment to sustain activity is raising vulnerabilities. The consequence is a steady build-up of leverage that is eroding the strength of the financial sector, local government, and corporate balance sheets. This is most apparent in the continued rapid expansion in total social financing. The development of nontraditional finance marks a shift to more market-based intermediation, and the migration of activity to less-regulated parts of the system poses risks to financial stability.

Setting: Outlook and Risks

1. Context. Three decades of rapid economic growth and much reduced poverty are a testament to China’s success in implementing reforms. For the past few years, the difficult policy challenge has been to sustain activity in the face of adverse global conditions while achieving a smooth transition to a more consumer-based, inclusive, and sustainable growth path. While there has been unequivocal success on the first front—growth in China has been a solid anchor for the world economy in recent years—progress with rebalancing has been limited and is becoming increasingly urgent. Encouragingly, the new government—in office since March 2013—has announced a clear commitment to re-energizing the reform effort toward more balanced and environmentally friendly growth. Details are expected to be fleshed out in the coming months. Swift and steadfast implementation of the reform agenda will be critical to maintaining China’s strong track record of economic development.

A. Macroeconomic Developments and Outlook

2. Growth. Despite weak and uncertain global conditions, the economy is expected to grow by around 7¾ percent this year. Although first-quarter GDP data were sluggish, the pace of the economy should pick up moderately in the second half of the year, as the lagged impact of recent strong growth in total social financing (a broad measure of credit)1 takes hold and in line with a projected mild recovery in the global economy. High-frequency indicators have been mixed recently, with infrastructure spending and retail sales showing more resilience than exports and private nonresidential investment (Figure 1). Overall, the risks to the near-term outlook have moved more to the downside, as the expected rebound in the second half of the year may not materialize if, for example, external demand for China’s exports remains subdued and/or the weaker activity in recent months spills over into investment and consumer demand going forward. On the upside, credit growth has traditionally been a leading indicator of economic activity, which has also typically seen an upswing following a leadership transition as new local officials ramp up investment spending.

Figure 1.
Figure 1.

Message: Growth and inflation are stable

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WEO; and IMF staff calculations.
uA01fig01

China: Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff estimates.

3. Inflation. Inflation is likely to remain moderate this year at around 3 percent. Nonfood prices, a proxy for core inflation, have been fairly stable for many years. Inflation has only been loosely linked to output fluctuations because surplus labor has helped prevent wage-price spirals and agricultural supply shocks have been the dominant driver of price volatility. With little sign of a renewed pick-up in food prices, inflationary pressures are likely to stay subdued. Moreover, persistently high investment has led to excess capacity in many sectors that tends to put downward pressure on prices.

uA01fig02

Inflation

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff calculations.

4. Balance of Payments. Last year, the surplus edged up to 2¼ percent of GDP, and it is expected to remain broadly unchanged this year (Figure 2). After years of net inflows, the capital and financial account posted a small net outflow in 2012, reflecting changed exchange rate expectations and a rise in global risk aversion. However, data through May 2013 indicate a resumption in net capital inflows. Purchase of foreign exchange reserves has also increased and amounted to US$157 billion in the first quarter of this year, compared to US$97 billion during all of 2012.

Figure 2.
Figure 2.

Message: After a reprieve in 2012 balance of payments pressures have resumed

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WEO; and IMF staff calculations.

5. Authorities’ views. The authorities saw the Chinese economy on a broadly stable—albeit lower—growth path, with inflation well contained. They were confident that growth would reach or slightly exceed their 7½ percent target for 2013, and viewed the slowdown since 2011 as appropriate and reflective of on-going structural changes in China as well as globally. They agreed that inflation would remain subdued, as food price inflation was low.

B. Rebalancing

6. Domestic rebalancing. Domestic imbalances remain large. Since 2009, investment—implemented through a mix of fiscal, quasi-fiscal, and state-owned enterprise spending—has been used to support domestic activity and offset the impact of external shocks. While this has had positive spillovers to global demand by increasing China’s imports, it has exacerbated the domestic imbalance between investment and consumption. There are signs that these imbalances are no longer worsening, but a decisive shift toward a more consumer-based economy has yet to occur. In particular, last year investment rose while private consumption remained flat as a share of GDP, and the urban household saving rate increased (Figure 3).

uA01fig03

Consumption and Investment

(In percent)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff estimates.1 Percent of expenditure-based GDP.
Figure 3.
Figure 3.

Message: More progress is needed on domestic rebalancing

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WEO; and IMF staff calculations.

7. External sector. In contrast to domestic rebalancing, substantial progress has been made in external rebalancing, and the current account surplus remains well below the 2007 peak of 10 percent of GDP. In the staff’s baseline scenario, the current account surplus gradually rises to about 4 percent of GDP by 2018. This assumes a gradual recovery in global demand (consistent with the WEO projection), a constant real effective exchange rate (REER), and limited progress on domestic rebalancing in China. By contrast, in a scenario that assumes good progress on rebalancing and continued moderate REER appreciation, China’s current account surplus would decline to around 1 percent of GDP by 2018 (see rebalancing scenario below). This reduction (compared with the increase in the baseline) would reflect mainly lower private savings, while investment would also decline, albeit by less than savings.

uA01fig04

Current Account

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.

8. Authorities’ views. The authorities emphasized the progress in external rebalancing, which they saw largely as the result of the structural (and thus lasting) changes in the Chinese economy and the global environment. They were confident that a sizable rebound in the current account surplus (in percent of GDP) was highly unlikely in the medium term, citing higher input costs, such as for labor and from tighter environmental protections, which would rein in export growth. At the same time, the services deficit would continue to rise as rebalancing shifts the economy toward consumption. They considered the staff’s current account projections in the rebalancing scenario as reasonable, but strongly disagreed with the baseline scenario that showed a 4 percent of GDP surplus in 2018. They argued that the baseline continued to use unrealistic assumptions, including about the REER, and did not give enough weight to ongoing and planned reforms.

9. On domestic rebalancing, the authorities pointed to the inherent challenges in shifting the structure of a large and diverse economy. Nevertheless, supply-side and geographic rebalancing had moved forward: they pointed to the higher contribution to growth from real consumption than from real gross fixed capital formation over the past two years, strong growth of services relative to manufacturing, rapid increases in urban and rural household incomes, and growth in central and western provinces outstripping that in the more affluent coastal provinces. They were confident that continuing reforms would achieve the desired rebalancing to a more consumer-based economy.

C. Risks

10. Domestic risks. China has maintained robust growth since the global crisis, but the heavy reliance on credit and investment to sustain activity is raising vulnerabilities. The consequence is a steady build-up of leverage that is eroding the strength of financial sector, local government, and corporate balance sheets. This is most apparent in the continued rapid expansion in total social financing. After years of remaining broadly constant as a share of GDP, the stock of total social financing has increased sharply since 2009 (rising by 60 percent of GDP in just four years).

uA01fig05

China: Social Financing Stock

(In percent of GDP)1

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff calculations.1 In percent of 4Q rolling sum of quarterly GDP.

  • Financial system. While the development of nontraditional finance marks a shift to more market-based intermediation, the migration of activity to less regulated parts of the system poses risks to financial stability (Figure 4). The rapid growth in some areas, notably the trust company and corporate bond sectors, raises questions about the adequacy of supervision and regulation, quality of underwriting standards, and pricing of risk. Moreover, the proliferation in alternative wealth management products (WMPs), managed by banks and securities companies, raises concerns as the composition of underlying asset pools is often opaque, maturity mismatches create liquidity risk, and investors perceive that most WMPs are implicitly guaranteed. Recent regulatory tightening, if strictly implemented, will reduce some of these risks, but does not fully address concerns about weak disclosure and moral hazard. Thus, WMPs and Trust products could over time evolve into a systemic threat to financial stability, especially if a sudden loss of confidence were to trigger a run. A related risk is that the boom in nontraditional sources of credit will entail a worsening of asset quality that could eventually lead to a severe credit crunch and heavy fiscal burden. Banks would not be immune in this scenario, as they remain closely linked to the development of nontraditional finance. Based on reported data, bank balance sheets appear healthy and loan books show only a modest deterioration in asset quality. However, banks remain vulnerable to a sharper worsening of corporate sector financial performance.

  • Local government finances. There is considerable off-budget and quasi-fiscal activity in China, primarily at the local government level, which has been ratcheted up as a means of supporting the economy during the global crisis. Faced with revenue sources that do not match expenditure mandates and a general prohibition on borrowing, local governments have made recourse to off-budget activity, including land sales, to help finance social and infrastructure spending. In particular, borrowing by local government finance vehicles (LGFVs) has increased significantly since 2009. Expanding the definition of government to include LGFVs and off-budget funds, staff estimates that in 2012 “augmented” government debt was 45 percent of GDP and the “augmented” fiscal deficit was around 10 percent of GDP (Box 1). Based on these augmented government estimates, fiscal space is considerably more limited than headline data suggest. The large augmented fiscal deficits also raise questions about local governments’ ability to continue financing the current level of spending and service their debts, which has implications for financial system asset quality and the potential need for central government support. While the size of augmented government debt and overall government resources suggests that such problems would still be manageable, further rapid growth of debts would raise the risk of a disorderly adjustment in local government spending. This would drag down growth, with adverse global spillovers, and potentially lead to disruptions in the provision of social spending since most of education, health, and welfare spending is implemented by local governments.

  • Real estate. The real estate market remains an important source of growth and employment (Figure 5). However, existing distortions make the market susceptible to large cyclical swings. On the supply side, local governments’ reliance on land sales for financing and real estate development for growth can lead to excess supply. On the demand side, the market is prone to bubbles since housing represents a uniquely appealing investment opportunity given real deposit interest rates that are close to zero, significant capital account restrictions, a history of robust capital gains, and favorable tax treatment. The measures put in place to limit real estate credit and speculative demand have helped, although price growth has picked-up again recently. An expansion in social housing, meanwhile, has helped sustain investment and address the need for low-cost housing. Over the medium term, however, real estate development will need to slow to a more sustainable pace as the market matures, which will act as a drag to economic growth. The challenge is to avoid excess supply or policy missteps that could trigger an abrupt investment decline and/or a sharp price correction.

Figure 4.
Figure 4.

Financial Sector Risks

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WEO; WDI; and IMF staff calculations.
Figure 5.
Figure 5.

Message: Real estate has rebounded

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WIND Info; and IMF World Economic Outlook and staff calculations.

Selected Banking Indicators

(In percent)

article image
Sources: CEIC; CBRC.

11. Diminishing space. As of now, the authorities still have sufficient tools and fiscal space to address potential shocks, which reduces the likelihood of significant macroeconomic instability in the near term. However, maintaining rapid and unbalanced growth would further strain financial sector, government, and corporate balance sheets. Failure to change course and accelerate reforms—as assumed in the staff’s baseline scenario—would thus increase the risk of an accident or shock that could trigger an adverse feedback loop. For example, financial distress would lead to a contraction in credit, a fall in domestic demand, and lower growth, which would make it more difficult for highly-leveraged borrowers to grow out of their debt. The timing and coincidence of events that would trigger such an adverse feedback loop are difficult to predict, and the staff’s baseline scenario assumes that it would occur sometime after the initial five-year projection period.

Debt and Deficits with a Broader Definition of Government

A significant amount of activity that is fiscal in nature, such as a majority of local government infrastructure spending, is not included in China’s general government data. Since the financial crisis, such off-budget infrastructure spending has become an important countercyclical tool. To better assess the contribution of fiscal policy to stabilizing output and the concomitant rise in indebtedness, staff constructed augmented fiscal data by expanding the perimeter of government to include off-budget infrastructure spending. The main findings are that the augmented fiscal debt has risen to above 45 percent of GDP as the augmented fiscal deficit has been both much higher and more countercyclical than the headline government deficit. Because of data gaps the augmented fiscal data estimates rely partly on assumptions, and thus need to be read with caution and can only serve as a complement, not a substitute, to the standard fiscal definitions used in China (see Appendix III).

Augmented fiscal debt. The augmented fiscal debt rises to above 45 percent of GDP in 2012. The staff estimate is within in the range—though on the low-side—of estimates published by many academics and researchers. For example, staff of the Development Research Center (DRC), the research wing and advisory body of the China’s State Council, recently published a similar estimate.1

Augmented borrowing is general government net lending/borrowing plus the market financing of local government infrastructure (such as LGFV borrowing through banks, bonds, and trusts) and net withdrawal of government cash deposits, data on which are incomplete and filled in using staff estimates. This measure captures transactions in financial liabilities—that is, debt creating flows and thus closely corresponds to the change in augmented fiscal debt.

Augmented fiscal deficit is augmented net borrowing plus financing from land sales (net of costs such as land development and compensation for relocation). Land sales are treated as a financing item akin to privatization, but do not contribute to debt accumulation. This is an analytical concept well-suited to capturing the overall impact of fiscal policy on aggregate demand. The augmented fiscal deficit increased sharply in 2009 and more modestly in 2012, underscoring how off-budget spending has contributed to stabilizing output.

Further considerations. Estimating the augmented fiscal data involves numerous assumptions and the uncertainty around the estimates suggests some caution in interpreting the results. Nonetheless, it is clear that China has considerably less fiscal space than indicated by conventional general government data. Moreover, the augmented fiscal data only capture some aspects of fiscal risk and vulnerability. Additional sources of vulnerability include possible contingent liabilities related to the financial sector, SOEs, and actuarial shortfalls in the pension system. However, a comprehensive assessment would also include the government’s holding of financial and nonfinancial assets, such as the China Investment Corporation, National Pension Fund, and the equity stake in SOEs.

uA01fig06

Augmented Public Debt Level

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC, Chinabond, EUROSTAT, China Citic Press, China Trustee Association, NAO, and the Ministry of Finance; and IMF staff estimates.
uA01fig07

Augmented Deficits and Net Borrowings

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC, Chinabond, EUROSTAT, China Citic Press, China Trustee Association, NAO, and the Ministry of Finance, Zhang and Barnett (2013).
1 Yu and Wei (2012), A Study on China’s Fiscal and Financial Risks, DRC Research Series. Their estimate was 59 percent of GDP, but refers to the end of 2010 and includes items not in the staff definition (asset management companies, pension funds, and ministry of railway.

12. Authorities’ views. The authorities recognized the importance of containing risks and continuing reforms to change the course of economic growth, but were confident that vulnerabilities were well under control with the countervailing measures already put in place. On the financial side, they considered the rapid growth in trust, WMP, and corporate bond activity as important shifts toward more market-based intermediation. They acknowledged that this process involved risks, but viewed these as manageable, especially as they were actively committed to improving supervisory oversight. While reported NPLs had been rising in some industries, they remained low and Chinese banks had some of the highest capital and provisioning ratios in the world. The authorities continued to closely monitor the real estate market, and would fine-tune policies, as necessary, to ensure the stable development of the market, including for low-income housing. At the same time, they acknowledged that rapid growth had helped mask some of the problems in the past, but with growth slowing, they were being especially vigilant, particularly with respect to risks in the fiscal and financial sectors.

13. The authorities noted staff’s focus on the augmented fiscal data. They emphasized that the staff’s estimates involved several simplifying assumptions, and, the actual augmented position could be stronger. Moreover, they emphasized that some LGFVs generated operational revenue and would be able to service part of their own debt and a significant portion of LGFV spending was for the acquisition of fixed assets. Regarding land sales, they considered this to be a viable source of financing for many years to come and questioned why it was included as a financing item in the augmented fiscal deficit, rather than focusing on debt-creating net borrowing requirements. Nonetheless, they acknowledged that local government debt had become a pressing issue in some jurisdictions, and they were thus considering further strengthening of local debt management, including the creation of a monitoring system to contain risks. Overall, they emphasized that banks appeared comfortable with their exposures and the underlying health of projects they had financed. The authorities noted, however, that those projects without cash flows would be transferred to the government budget.

14. External risks. The main external risks to China are renewed financial distress in the euro area, a protracted period of slower euro area growth, and the risks associated with unwinding of unconventional monetary policy in major advanced economies (see Risk Assessment Matrix). Should any of these risks materialize, the spillovers to China would be significant given its dependence on demand from the euro area and the United States, which together account for around 30 percent of China’s exports. In addition, a prolonged slowdown in advanced economies or a reappraisal of U.S. or Japanese sovereign risk could have a strong negative impact on China. At the same time, continued reforms to the Chinese financial and services sectors, as well as further exchange rate liberalization, would be part of a global package that could lead to higher and more stable growth worldwide. A fuller discussion of these spillovers is contained in the 2013 Spillover Report.

15. Authorities’ views. The authorities remained concerned about the impact of continued slow growth in major advanced economies (AE), which was depressing export growth in China and other emerging market and developing economies. They also noted that unconventional monetary policy (UMP) in several advanced economies created adverse spillovers and policy challenges elsewhere. Besides the well-know channels of trade, capital flows, and exchange rates, these policies in their view created significant uncertainties for investors and consumers worldwide. They also were concerned that UMP risked allowing AE governments to continue postponing the necessary structural reforms critical to long-term growth.

Policies

A. The Challenge

16. The challenge for China now is to accelerate its transition to a more balanced and sustainable growth path, while maintaining adequate domestic growth and stability in a global environment that is likely to remain difficult for some time. Successful transition will require a decisive new round of reforms that will combine to unleash new sources of growth, address the growing risks in various parts of the economy, and make growth more inclusive and environmentally sustainable (Box 2; Figure 6; Box3). At a strategic level, the reform agenda will need to (1) give a greater role to market forces through continued liberalization and reduced government involvement; (2) embed strong governance in lower-level state or state-related economic institutions, especially banks, state-owned enterprises, and local governments; and (3) boost household incomes and consumption. In terms of economic policies, the agenda includes a broad set of fiscal, financial sector, exchange rate, and other structural measures. Many of these reform directions and policy objectives have been outlined in the authorities’ recent announcements; timely and focused implementation will be crucial for success. The necessary focus on managing risks and structural change will likely entail somewhat slower growth in the short run, but this is not a reason to delay as vulnerabilities are rising and, even in the best of cases, the necessary restructuring of supply and demand will take time to implement. Moreover, looming demographic changes (Box 4) add urgency to reforms that make growth less dependent on factor accumulation, and more on productivity gains (Box 5).

Figure 6.
Figure 6.

Inclusive Growth

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF Asia and Pacific Regional Economic Outlook (October 2011).

17. Authorities’ views. The authorities recognized the challenges, and pointed out that the new government had already announced a set of reforms for 2013 to address them. They emphasized their intention to embark on a comprehensive reform agenda at all levels of government and to give market forces the primary role in resource allocation, while strengthening the framework of regulation, oversight, and incentives to ensure the proper functioning of markets. They also noted their commitment to address the environmental challenges and to ensure that the benefits of growth would be shared more equitably among all parts of society.

B. Demand Management

18. Policy stance. Near-term policies should focus on containing the build-up of risks and advancing the structural reform agenda, while providing support to activity if needed to prevent an unduly sharp slowdown of growth. The rapid growth in total social financing needs to be reined in through a coordinated effort that includes tighter supervision, prudential measures, and market discipline, which would lead to higher interest rates for many borrowers. These policies are likely to dampen activity in the near term, but will do so in a way that supports the transition to a more sustainable growth path. If growth were to slow too sharply below this year’s target, then on-budget fiscal stimulus could be used. Such stimulus, however, should focus on measures that support domestic rebalancing, such as reductions in social contributions, subsidies to consumption, or targeted social safety net spending. Using on-budget stimulus would improve transparency, prevent a further build-up of risks in the financial sector, allow spending to be allocated more in line with social and economic priorities, and lower financing costs by replacing more expensive commercial financing with government debt.

The Nexus between Inclusive Growth and Rebalancing1

Since its reform and opening up period, China has made remarkable strides in lifting people’s incomes and reducing poverty (Figure 6). In 1981, nearly 85 percent of its population lived on less than $1.25 a day, the fifth largest poverty incidence in the world. By 2008, this proportion had fallen to 13 percent, well below the developing country average.

However, inequality has increased sharply. According to the World Bank, China’s Gini index increased from 0.29 in 1981 to over 0.42 in 2005, higher than in the United States. Notwithstanding a downtick since 2009, official estimates report a Gini of over 0.47 in 2012. Many unofficial estimates are even higher.2 These data suggest that China’s growth has been less inclusive than in most other developing regions, including Latin America and a number of its Asian peers.

In many ways, inequality has been an inevitable by-product of China’s investment and export-led growth model. The capital stock was largely utilized to support the growth of the manufacturing sector, increasingly to meet export demand; wages were low in large part due to the large labor dividend; and the East coast developed first for geographical reasons, benefitting from trade and FDI.

The unbalanced nature of growth has propagated income gaps based on skills, sectors, and geography. Between Chinese households, the most important factors explaining income inequality are education, access to health insurance, and labor market variables, including sector of employment and enterprise size. Across China’s provinces, divergences in per capita incomes are driven by the relative level of urbanization, financial access, reforms, and capital-intensity. Importantly, the public sector can play a role in dampening geographic disparities, as it has done since the “Go-West” Policy of 2000. In addition, excess liquidity has exacerbated inequality in the last decade, with the wealth gap from asset price inflation further differentiating the income of the rich from the poor. This includes rising property prices, which also raise issues of affordability.

Based on these findings and international experiences, a number of policies could help broaden the benefits of growth in China. These include prudent monetary policy, a fairer fiscal tax and expenditure system, higher public spending on health and education, deregulation and reforms to increase competition, measures to raise labor incomes and assist vulnerable workers, and better access to finance for both households and SMEs, including in rural areas. These policies are also in line with recent recommendations by the World Bank and Asian Development Bank.3

In fact, many of these measures are already being put in place by the authorities in an effort to rebalance the economy. Indeed, the change in China’s growth model envisaged in the 12th Five Year Plan would go a long way toward facilitating the needed reduction in inequality. The income distribution plan recently approved by the State Council further identifies many supportive reforms, including minimum wage increases, improving the tax system, and strengthening social security.

1 Based on Lee, Syed, and Xin (forthcoming), IMF Working Paper: “Two Sides of the Same Coin: Rebalancing and Inclusive Growth in China.” 2 For instance, a recent study by the Southwestern University of Finance and Economics estimated a Gini of 0.61 in 2010. 3 See Development Research Center and World Bank (2013), “China 2030 Report: Building a Modern, Harmonious, and Creative Society;” and Asian Development 2012 Outlook Report.

China: The Environment and Planned Reforms

While China’s rapid economic development has been remarkable, it has also resulted in a notable deterioration in the environment. The World Bank estimates China is home to 16 of the world’s most polluted cities. Air pollution, water quality and supply, and resources are pressing issues that have health, social, economic, and even global implications. This note describes some of these challenges and the policy response.

Air quality. The Chinese Academy of Environmental Planning estimated that environmental damage in 2010 cost the equivalent of 3½ percent of GDP. China 2030 (2013) puts the cost higher and well above other countries. In Beijing, the Air Quality Index (AQI) and small particulates concentrations (PM2.5) often far exceed international standards—and though Beijing attracts the most media attention, it ranks ninth in the list of most polluted cities in China. Since 2005, China has been the largest emitter of greenhouse gases and emissions of sulfur dioxide exceed that of the United States and European Union combined. The burning of coal is the main source of air pollution, accounting for 19 percent, while vehicle emissions contribute 6 percent.

uA01fig08

Environmental and Natural Resource Degradation and Depletion

(In percent of GNI)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: World Bank and DRC China 2030 report.

Water. China faces the twin challenges of water shortage and pollution. One-third of major river systems, 85 percent of lakes, and 57 percent of underground water in monitoring sites are polluted. Nearly 300 million rural residents lack access to clean drinking water and some major rivers have become too polluted to supply drinking water.

Natural resources. Nearly 70 percent of China’s energy consumption comes from coal, which is the biggest source of manmade carbon dioxide emissions and poses the greatest threat to the climate. According to the OECD (2007).1 China’s energy consumption per unit of GDP is about 20 percent higher than the OECD average. Desertification is also a problem, due in large part to overgrazing, and leads to the loss of about 5,800 square miles of grasslands every year. In addition, 31 percent of national land area experiences soil erosion and 85 percent of the total grassland area is degraded.

Policy response. The authorities have made improving the environment a priority. They have introduced measures to reduce car emissions in some cities (by restricting use to alternate days) and planted trees to combat desertification. To improve monitoring, the authorities have established a nationwide air and water quality monitoring network, which was recently strengthened; set a new standard for air quality monitoring in 74 cities, and will extend it to 190 cities by the end of the year; and report weekly water quality data from 131 monitor sites on the nation’s major river systems. Regulations aimed at raising environmental standards have been passed and enforcement efforts stepped up. However, the OECD (2012) highlights that enforcement remains a key challenge because it is mainly delegated to local governments that lack sufficient capacity; fines are too small to act as an effective deterrent; and criminal charges, while possible, are difficult in practice and rarely used.2

Plans. The 12th Five-Year Plan for Environmental Protection (2011–15) sets out a blueprint with seven major targets to achieve by 2015, with a special emphasis on improving water and air quality and protecting ecosystems. Progress reports, including to the public, are due this year and 2015. The 12th Five Year Economic Plan also promotes environmentally-friendly growth, as three out of seven priority industries are aimed at cleaner and more sustainable growth. It also calls for advancement of environmental protection tax reform and improvement in waste disposal fees. Resource tax reforms have been piloted in some regions since 2010 and, in 2011; taxes on crude oil and natural gas were raised (and converted to an ad-valorem basis). A comprehensive environmental protection tax plan has been submitted to the State Council this year, which covers water, solid waste, emissions, and noise. Price signals could be better used to promote the efficient allocation of resources and, more broadly, achieving the desired domestic rebalancing would help reduce the strain on the environment by shifting activity away from manufacturing to the less resource intensive and less polluting service sector.

1 OECD (2007), “OECD Environmental Performance Reviews: China 2007.” 2 OECD (2012), “China in Focus: Lessons and Challenges,” http://www.oecd.org/china, htttp://www.oecdchina.org.

China’s Looming Demographic Changes

China is at the dawn of a demographic shift as the economy will soon start to be weighed down by a shrinking workforce and aging population. The working-age (15–64) population will start to fall in less than a decade due to declining fertility, reflecting the one-child policy. The cohort of 25–39 year olds—the core industrial workers—will shrink even faster, with implications for the pattern of growth reliant on building new factories and finding a ready supply of workers. The dependency ratio (population younger than 15 and older than 64 as a share of the working-age population), which declined for decades, is projected to increase from 13½ percent in 2010 to around 30 percent by 2030.

uA01fig09

Growth of Working-Age Population

(In percent)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.

These demographic changes imply that China will meet the Lewis Turning Point—when the supply of plentiful low-cost labor is exhausted—toward the end of the decade.1 As the surplus labor dwindles, labor cost will rise, which would affect prices, incomes, and corporate profits in China and would have implications for trade, employment, and price developments in key trading partners. For China, this transformation makes it even more important to switch from an extensive to an intensive growth model.

uA01fig10

Demographic Pressures

(In millions)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: UN Population Database; and IMF staff estimates.
1 See Das and N’Diaye (2013), “Chronicles of a Decline Foretold: Has China Reached the Lewis Turning Point,” IMF Working Paper 13/26.

Toward Intensive Growth

Time is running out on the current model which has relied on extensive growth—factor accumulation and relocation of labor from the countryside to factories. Without accelerating reform, vulnerabilities will increase as will the probability that China’s convergence process stalls. Moving to high-income status will require transitioning to a growth model that is more reliant on total factor productivity (“intensive” growth).

Context. Growth has moderated, even as investment has risen and reliance on credit has increased, pointing to diminishing returns to the current model (which has depended heavily on factor accumulation). High investment has resulted in excess capacity and the return on investment has continued to decline to around 16 percent, down from 25 percent in the early 1990s.

uA01fig11

Adverse Feedback Loop During Crises

(In percentage points)1

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: WEO, WDI, IMF staff calculations; and Laeven (2012), IMF working paper.1 Change in three-year average of real GDP growth, credit banking sector growth, and unemployment rates before and after crises.

An extension of the baseline scenario beyond 2018 illustrates the consequences of continuing the current growth model. The scenario assumes a further build-up of excess capacity and misallocation of resources. With demographic trends implying a decline in the labor force after 2015 and exhaustion of surplus labor around 2020, the returns on investment would be progressively lower than envisaged, which would cause bankruptcies and financial losses. China’s own and cross-country experience suggests that the outcomes could be costly not just in terms of direct fiscal cost of clean-up, but also because the financial losses and deleveraging would in turn generate an adverse feedback loop that hampers employment and growth. The convergence process would stall, with the economy slowing to around 4 percent, and GDP per capita would remain about a quarter of that of the United States through 2030.

Moving to high-income status requires changing the growth model to be more reliant on total factor productivity (TFP) and less on factor accumulation. Factor accumulation has helped develop lower- and middle-income provinces, which have made modest gains catching up to the richest province in terms of average income. However, they have fallen further behind in TFP. This illustrates both the past reliance on capital accumulation, as well as the scope for the less developed provinces to improve TFP going forward, which would help drive China’s growth and convergence to high-income status.

uA01fig12

Convergence Process of Per Capita GDP: China, Japan, Korea

(PPP, relative to United States)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.
uA01fig13

Real Output per Worker Relative to Shanghai

(2000 and 2010)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.
uA01fig14

Physical Capital Input Relative to Shanghai

(2000 and 2010)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.
uA01fig15

TFP Relative to Shanghai

(2000 and 2010)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.

The transition from middle-to high-income status will be accompanied with slower growth. Average TFP growth is likely to fall below its pre-crisis level, consistent with the typical slowdown in TFP growth most countries go through during their transition from middle to high income. This, together with a declining labor force and more moderate pace of investment, means average GDP growth could fall to around 6 percent during 2013–30 (down from a pre-crisis average GDP growth rate of 10 percent). At such a pace China’s per capita GDP would be about 40 percent of that of the United States by 2030.

uA01fig16

China: Contribution to Growth by Input

(In percentage points)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.
uA01fig17

TFP and PPP GDP per Capita

(Five-year averages)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff calculations.
uA01fig18

China Reform Payoffs: Potential Increase in Average TFP Growth1

(In percentage points)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.1 Reforms envisage moving the national average of service sector employment share, contestability, and nonagricultural hukou share of population to the level of Shanghai in 2010.

Accelerating the pace of structural and financial reforms would help China limit the typical TFP growth slowdown that occurs during the transition to high-income status. Regression analysis using provincial data suggest that greater contestability of markets could increase productivity. Service sector reform (deregulation and increasing the share of labor employed in services) would also lift productivity growth. Hukou reform would support the urbanization process and boost productivity by enabling knowledge spillovers and specialization.

1 Nabar and N’Diaye (forthcoming), IMF Working Paper: “China’s Medium-Term Growth Prospects: The Path to a High-Income Economy.”

19. Authorities’ views. The authorities considered the current mix of prudent monetary and proactive fiscal policy to be appropriate. They noted that growth, employment, and inflation were progressing broadly as expected, and hence saw little need to alter the macroeconomic policy stance at this point. If necessary, they agreed with the relative benefits of on-budget fiscal stimulus. While growth in monetary aggregates this year had so far exceeded forecasts, the central bank would take measures to ensure appropriate growth for money and credit. Policy fine-tuning would continue to draw on a variety of measures, including open-market operations, macroprudential measures, and window guidance.

Financial Sector

20. Priorities. Accelerating financial sector reform is key for preventing a further build-up of risks and tapping new sources of growth. The priorities are to:

  • liberalize interest rates, to allow market-pricing of deposits and lending by the banks and reduce regulatory arbitrage;

  • strengthen regulation and supervisory oversight, especially in areas exhibiting rapid growth such as trusts and wealth management products;

  • improve the institutional setting by introducing explicit deposit insurance, improving the resolution framework for financial institutions, and removing the moral hazard stemming from the perception that all interest-bearing assets are implicitly guaranteed; and

  • move to using interest rates as the primary tool of monetary policy (Box 6).

Addressing the moral hazard problem is especially critical. With China’s financial markets developing rapidly, effective pricing of risk requires tolerance for occasional losses or haircuts on interest-bearing financial instruments, such as corporate bonds or wealth management products without a formal principal guarantee. Routinely shielding investors from such losses, by contrast, perpetuates the perception of implicit guarantees and artificially depresses risk premia, and contributes to excessive growth in credit and investment.

Priorities for Financial Sector Reform

Further steps toward a more commercially oriented financial system and market-based monetary policy framework will improve the allocation of resources, facilitate internal rebalancing, and safeguard financial stability. The priorities are:

  • Interest rate liberalization. Notable progress has already been made with interest rate liberalization, including the greater flexibility introduced in mid-2012. As the next step, the maximum deposit rate should be raised further, for example, by increasing the upward float to 30 percent to match the downward flexibility in lending rates. This will reduce regulatory arbitrage that currently favors wealth management products over bank deposits.

  • Supervision and regulation. As financial reform progresses and interest rates are liberalized, close monitoring and effective supervision of banks, particularly smaller institutions, are critical to guard against the risk of destabilizing competition. At the same time, a continued upgrading in the regulation and supervision of non-bank and off-balance sheet intermediation is needed to ensure that risks are properly disclosed, institutions hold adequate buffers against potential losses, markets operate transparently, and the pace of credit creation does not result in systemic risks. In this regard, the recent steps to tighten the rules for banks’ wealth management products are welcome.

  • Institutional setting. Introducing deposit insurance and improving the resolution framework as soon as possible is key to allow for an orderly exit of weak or failing financial institutions. Similarly, investors must be allowed to suffer principal losses on nonguaranteed products, including corporate bonds and trust products, to promote risk-awareness and prevent the perception that all financial investments are implicitly guaranteed.

  • Use interest rates as primary instrument of monetary policy. Given the increasing complexity of the financial system, administrative controls on bank credit are losing effectiveness and should be progressively replaced by money market interest rates as the primary tool of monetary policy.1

  • Specifically, the central bank should begin by establishing a stable short-term interest rate (seven-day or overnight interbank repo) as a precursor toward instituting a policy rate. The recent introduction of the standing liquidity operations will over time facilitate this effort by reducing interest rate volatility.

Progress also needs to continue in improving the commercial orientation of banks, with particular emphasis on prudent credit allocation and timely recognition of problem loans. Strong risk management and vigilant oversight by the authorities are indispensable for the success of financial reform, and indeed for opening up the capital account without the risk of major domestic financial instability or adverse spillovers.

1 See Liao and Tapsoba (forthcoming), IMF Working Paper: “Financial Liberalization, Innovation, and Money Demand Function Instability: Implications for China.”

21. Reform and Stability. In many countries, financial liberalization was followed by an unintended loosening of financial conditions that ultimately led to systemic financial distress.2 As the move to a more market-based system accelerates, implementation needs to safeguard financial stability, including through appropriately tight overall liquidity conditions and steps to reduce moral hazard to ensure that banks do not engage in potentially destabilizing competition. Even so, there will likely be some financial stress in individual firms and banks, which is normal (and necessary) in market-based systems. Weaknesses will need to be monitored carefully and resolved transparently. It will also be important to ensure adequate provisioning and transparent recognition of asset quality problems in the broader financial system. At any rate, the risks of delay are prohibitive, as accelerated arbitrage from traditional into new forms of intermediation, lack of proper pricing of risk, and continued ‘dual-track’ financial development would escalate the imbalances and associated risks. The authorities have taken measures to help contain risks, including in recent months, asking banks to monitor lending to certain sectors, control lending to LGFVs and property developers, and tighten rules on WMPs. In addition, continued progress in implementing the recommendations from the 2011 Financial Sector Stability Assessment would facilitate the move to a more liberalized financial system (Appendix II).

22. Authorities’ views. The authorities’ agreed with the thrust of the staff advice and are committed to accelerating financial sector reform. A priority for this year is to make further progress on interest rate liberalization and, as recently announced by the central bank, conditions are broadly in place to introduce deposit insurance. The central bank intends to continue to gradually move toward greater reliance on market-based methods for the implementation of monetary policy. Meanwhile, the various regulatory agencies expressed their commitment to continue improving prudential oversight, with particular focus on the rapidly growing nonbank finance.

Fiscal Policy

23. Medium-term adjustment. The augmented fiscal deficit estimates indicate that fiscal policy—especially local government off-budget and LGFV activity—has played a significant role in supporting demand since the global crisis. As a result, the augmented fiscal position has deteriorated significantly. Though the augmented debt is still at a manageable level (see Debt Sustainability Analysis: Tables 7–8), the augmented government deficit should be gradually reduced to a more comfortable level. Staff’s baseline assumes a gradual unwinding of stimulus through a decline in the budget deficit and reduction in local government infrastructure spending (consistent with the retrenchment in 2010–11). Development of a medium-term fiscal plan that outlines the path for government revenues, spending, deficits and debts over a rolling (annually updated) multiyear horizon would facilitate adjustment. This should also include all local government operations and thus help curb projects with low economic or social returns.

Table 1.

China: Selected Economic Indicators

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Sources: CEIC Data Co., Ltd.; IMF, Information Notice System; and IMF 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.; IMF, Information Notice System; 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.; Bloomberg; IMF, Information Notice System; 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 estimates.

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.

Annualized 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.

Augmented fiscal data expand the perimeter of government to include local government financing vehicles and other off-budget activity.

Augmented net lending / borrowing adjusted to treat net proceeds from land sales as a financing item, akin to privatization.

Table 6.

China: Illustrative Medium-Term Scenario 1/

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Sources: CEIC Data Co., Ltd.; IMF, Information Notice System; and IMF staff estimates and projections.

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

Contribution to annual growth in percent.

Percentage change of annual average.

Table 7.

China: Public Sector Debt Sustainability Framework

(In percent of GDP, unless otherwise indicated)

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Coverage of public sector refers to gross debt of the budgetary general government.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

The augmented government debt is based on staff estimate, which includes off-budget borrowing by local governments.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table 8.

China: Public Sector Debt Sustainability Framework with Augmented Debt and Deficit

(In percent of GDP, unless otherwise indicated)

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Coverage of public sector refers to gross debt of the budgetary general government.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g + p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

The scenario assumes r-g converges to -4.3 percent by 2018, in line with the pace of convergence identified in April 2013 Fiscal Monitor.

24. Local government finances. To ensure China’s fiscal soundness, a top priority is to strengthen the management, transparency, and overall governance framework of local government finances. One element is ensuring that local governments have adequate resources to deliver the necessary social and infrastructure spending, by aligning revenue responsibilities with expenditure mandates. Options to achieve this include giving local governments more control over revenue items, adjusting revenue sharing arrangements, and reducing expenditure mandates. Another challenge is to mitigate risk by strengthening fiscal management. This can be achieved by: (i) establishing and enforcing an institutional framework that limits government debt, contingent liabilities, and off-budget borrowing (such as a fiscal responsibility law); (ii) integrating government and LGFV investment spending into an overall public investment strategy; and (iii) improving data and transparency on off-budget fiscal operations, fiscal risks, and contingent liabilities.

25. Social security contributions. High social security contribution rates are a headwind to domestic rebalancing. Combined employee and employer contributions are around 40 percent for an urban worker earning the average wage, which is high by international standards. The contribution system reduces household disposable income, raises the cost of labor, encourages informality and evasion, and exacerbates inequality (as it is highly regressive). It also raises substantially more revenue—about 5 percent of GDP—than the personal income tax (1 percent of GDP). Social contributions are mandatory for most urban workers, though only around 85 percent contribute, whereas just 3 percent of workers pay income tax on labor income. Shifting the tax burden away from regressive social contributions would help boost consumption, reduce inequality, and facilitate rebalancing. Staff recommends that an initial step toward lowering social contributions could be made now, while continuing with the needed comprehensive social security reform to further improve coverage and ensure actuarial soundness. The budget should compensate the social security funds for the lost revenue, while ensuring deficit neutrality by taking offsetting fiscal measures that are more efficient, progressive, and supportive of rebalancing. Moreover, a strong case could be made for shifting the legacy costs of pension reform as well as the welfare components of the pension system to the budget. With offsetting budget measures to ensure fiscal sustainability, this would make room for a significant reduction in social contributions, which would cover only the insurance aspects of the system.

uA01fig19

Average Tax Wedge

(In percent; 2012)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: OECD, World Bank.1 Social contributions taken as difference between average tax wedge and income tax rates.

26. Other tax reforms. Other tax reforms that support rebalancing and promote efficiency should continue to be implemented. These include replacing the specific business taxes with the VAT, which will help broaden the tax base, minimize cascading, and reduce evasion. At the same time, expanding the property tax pilot will help contain speculation in the real estate sector and boost local government revenues (the pilot covers Chongqing and Shanghai and has a narrow base—for example, in Shanghai existing homeowners were grandfathered and in a sample of new purchases about 20 percent were subject to the property tax).

27. Authorities’ views. The authorities were committed to ensuring medium-term fiscal sustainability, and they agreed on the importance of strengthening the fiscal framework to better manage local government finances. They favored allowing limited, transparent, and well-regulated local government borrowing, and considered development of a municipal bond market as part of the solution to the challenges facing local governments. They agreed with the benefits of lowering social contributions, but were concerned about the cost and financial implications for the social security system. They would consider the possibility as part of a comprehensive social security reform. They were committed to continuing tax reforms, especially replacing the specific business tax with the VAT. They were also considering other taxes that could be well-suited to collection and control by local governments, including broadening the pilot property tax program.

External Sector

28. Exchange rate system. Continuing to move to a more market-based exchange rate system is a key part of the rebalancing package. This means reducing intervention and allowing the exchange rate to move more in line with market forces. Staff suggested that the next steps should be to further widen the daily band and make the central parity better reflect market conditions, with larger day-to-day fluctuations in the central parity. A more flexible exchange rate will strengthen liquidity management by reducing the need to sterilize reserve purchases, facilitate further gradual capital account opening, and help ensure that investment decisions pay due regard to exchange rate risk. A number of quantitative models and indicators are used to assess the external position (Box 7). Overall, staff considers that the renminbi remains moderately undervalued against a broad basket of currencies. Given the assessment of the renminbi as moderately undervalued, greater flexibility is likely to result in some further real appreciation of the renminbi over time, which will help with domestic rebalancing by making investment in nontradables more attractive and boosting household purchasing power.

uA01fig20

Spot Exchange Rate

(In USD/RMB)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: Haver Analytics; Bloomberg; and IMF staff calculations.

29. Capital account. Staff supports the authorities’ intention to further open the capital account (Box 8). A gradual liberalization will reinforce financial sector reform, improve the efficiency of investment, and ease overheating pressures in the domestic property market by providing opportunities for portfolio diversification. However, capital account opening must be carefully timed and sequenced with other reforms, especially as regards the financial sector—which needs to be able to effectively intermediate large and potentially volatile cross-border flows—and the exchange rate regime—which needs to be flexible to serve as a shock absorber.

30. Outward spillovers. Staff research suggests that capital account opening in China would prompt sizable portfolio stock adjustments resulting in large gross flows in both directions. On balance, this stock adjustment could initially result in net capital outflows as China’s large pool of savings is diversified internationally (Box 9). Over the longer term, the direction and size of net capital flows with an open capital account will depend on fundamental drivers such as real interest rates, saving, and growth prospects, which generally point to net capital flows toward fast-growing developing and emerging market economies like China.

External Sector Assessment

Staff’s assessment is that the external position appears moderately stronger and the currency moderately undervalued compared with the level consistent with medium-term fundamentals and desirable policy settings.

Recent balance of payments developments. The current account surplus is projected to rise slightly this year and further over the medium term to about 4 percent of GDP. While capital flows turned negative in the second half of last year, on the back of changed exchange rate expectations (from one-way appreciation to more balanced expectations), this has been reversed in recent months with renewed inflows and appreciation pressures. Overall, these developments suggest that the external position has remained broadly unchanged over the past year.

uA01fig21

Real Effective Exchange Rate

(2000=100)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: IMF, Information Notice System; and IMF staff calculations.

International reserves and NFA. Reserve accumulation in the second half of 2012 was around zero, a significant change from a decade of large increases. In recent months, however, the pace of reserve accumulation has picked up again, and China’s reserves continue to be considerably above all standard metrics. With large net foreign assets (around 30 percent of GDP) China’s international investment position vulnerabilities are low.

External Balance Assessment (EBA)

  • In this year’s EBA, the methodology has been refined, some data revised, and the assessment period shifted to 2012 from 2011. The current account balance approach estimates that China’s 2012 current account surplus, adjusted for cyclical factors, is 1.8 percent of GDP above the level consistent with fundamentals and desirable policies (compared with 2.6 percent of GDP in last year’s EBA). Consistent with the approach in last year’s ESR (which applied some rounding and a range of +/- 1 percent to the current account point estimate reflecting uncertainty about the output gap), this implies a current account gap of about 1–3 percent of GDP—equivalent to RMB undervaluation of about 4–12 percent.

  • The 2013 EBA’s REER approach indicates that the renminbi is 17 percent weaker than consistent with fundamentals and desirable policies. However, the EBA estimate for China’s REER is surrounded by large uncertainty, with the unexplained residual accounting for 8 percentage points of the estimated undervaluation.

  • Estimates using CGER methodology indicate an undervaluation of 15 percent for the current account approach, and an overvaluation of 7 percent for the REER approach. The external sustainability approach indicates the renminbi is 9 percent below the level consistent with unchanged NFA.

On balance, recent developments and available quantitative estimates suggest that the renminbi remains moderately undervalued by 5-10 percent relative to a level consistent with fundamentals and desired policies.

Current Status of Capital Account Liberalization

China has gradually widened the scope for capital flows, but the non-FDI capital account remains subject to considerable restrictions. Specifically:

  • Portfolio investment is controlled by quotas. Inward investment is channeled through 207 Qualified Foreign Institutional Investors (QFII) and subject to at least a 3-month lock-in period for most shares and an overall ceiling of USD 80 billion. In 2011, an R-QFII scheme was introduced that allows qualified firms to invest offshore renminbi back into China, subject to an overall ceiling that was raised to RMB 270 billion by end-2012. Before March 2013, only Hong Kong subsidiaries of eligible fund management and securities companies were allowed to participate in the R-QIII scheme. Outward portfolio investment—for foreign securities purchased by residents—is channeled through Qualified Domestic Institutional Investors (QDII), subject to a ceiling of USD 90 billion by end-2012. Cross-border issuance of securities requires approval.

  • Other investment. Foreign borrowing is subject to a ceiling (for short-term borrowing) or approval requirements (for long-term borrowing), but lending abroad by banks and affiliated companies is largely unrestricted. The holding of cross-border accounts requires SAFE approval.

uA01fig22

Qualified Foreign & Domestic Institutional Investor

(Approved Investment Fund)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff calculations.

Despite pervasive capital controls, capital flows have been considerable. While portfolio flows remain well below those of other emerging markets, other investment flows—both assets and liabilities—are on par with economies that have more open capital accounts. In particular, inflows and outflows of short-term borrowing have each been on the order of 10 percent of GDP (though largely offsetting).

Nonetheless, the capital controls appear to be binding. One indication of this is the presence of arbitrage opportunities between on- and off-shore markets for spot and forward renminbi as well as between forward rates and interest differentials. Despite rapid growth since 2009, the offshore market remains small with RMB-denominated offshore deposits accounting for 0.7 percent of one-shore deposits and RMB-denominated offshore (”Dim Sum”) outstanding debt for about 1 percent of on-shore outstanding debt.

Capital Flows, Average 2005–101

(Percent of GDP)

article image
Sources: Haver Analytics; IMF IFS; and IMF staff estimates.

Colors reflect the quartile of absolute values in each row, with red the lowest quartile and yellow the highest quartile. Data for Australia, Russia, and Malaysia are based on BPM6. For all others, based on BPM5.

Potential Spillovers from Capital Account Liberalization in China

Approaches. Two complementary approaches are used to provide some indications for possible capital flows resulting from capital account liberalization in China: (i) the experience during episodes of capital account liberalization in advanced or emerging economies since the 1970s, and (ii) a cross-country regression analysis of bilateral portfolio exposures.

Historical precedents. Past episodes of capital account liberalization were followed by sharp increases in gross international assets but ambiguous changes in net capital flows. Kaminsky and Schmukler (2003) date capital account liberalization episodes in about 20 advanced and emerging markets since the 1970s.1 In the five years following capital account liberalization, gross foreign assets on average increased by 19 percent of GDP. The increase in net capital flows depended on many factors: the global and domestic business cycle, growth prospects, and—importantly for the comparison with China—the interaction with financial sector liberalization. When capital account opening took place soon after financial sector liberalization, then the net inflows in portfolio and other investment were smaller and often negative. Net capital inflows in portfolio and other investment did not respond significantly to capital account liberalization in the two countries in the sample (U.S. and Japan) in which financial sector liberalization was only undertaken later.

uA01fig23

Increase in Gross International Assets During Five Years Following Capital Account Liberalization1

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: IMF IFS; and IMF staff calculations.1 Data for the United Kingdom available only for year after capital account liberalization.
uA01fig24

Change in Net Portfolio Investment Inflows

(Percent of GDP, between one year before and after full capital account liberalization)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.1 Trend line excludes outliers United States, Japan, and Spain.

Cross-country regression. A panel regression for all global bilateral portfolio exposures is estimated based on the model in Forbes (2010),2 focusing on portfolio equity and debt assets (the most restricted capital flows into and out of China). The results suggest that capital controls in the source country of international assets significantly restrict the buildup of international portfolio assets. In the extreme, and assuming no offsetting changes in the macrofinancial environment, the regression coefficients suggest that full capital account liberalization in China could prompt a one-off adjustment—although likely phased over several years—in the stock of Chinese resident assets held abroad of up to 25 percent of GDP and in the stock of nonresident assets in China of just under 10 percent of GDP. This would imply an increase in China’s net international portfolio assets around 15 percent of GDP. (This is in contrast with India, where the model would predict net inflows.) The estimated direction of capital flows is broadly in line with other estimates, even if the magnitude is larger, and with the historical experience of liberalization in countries with a short history of financial sector liberalization. Based on data from the April 2013 Global Financial Stability Report, gross flows in the estimated magnitude would be equivalent to 1 percent of global debt markets and 2–3 percent of global stock market capitalization.

Predicted Change in Porfolio Investment

(Percent of GDP)

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Sources: Bayoumi and Ohnsorge (forthcoming), “Capital Account Liberalization in China” IMF Working Paper; He, Cheung, and Zhang, and Wu (2012), “How Would Capital Account Liberalization Affect China’s Capital Flows and the Renminbi Real Exchange Rate?” HKIMR Working Paper No. 09/2012; Sedik and Sun (2012), “Effects of Capital Flow Liberalization—What is the Evidence from Recent Experiences of Emerging Market Economies?” IMF Working Paper No. 12/275.

Estimate applies to the aggregate of FDI, portfolio, and other investment flows.

1 Kaminsky and Schmukler (2003), “Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization.” 2 Forbes (2010), “Why Do Foreigners Invest in the United States?”

31. Authorities’ views. Regarding the external sector assessment, the authorities continued to express strong reservations about the quantitative models. They considered that the exchange rate was close to its equilibrium value. The authorities remain committed to moving to a more market-based exchange rate, including a further widening of the exchange rate band. They noted that with trend reserve accumulation having declined, recent intervention is an anomaly triggered in part by unconventional monetary policies in advanced economies. Regarding capital account liberalization, they emphasized that liberalization would continue at a measured pace consistent with fostering domestic stability and avoiding disruptions to external markets.

Other Structural Reforms

32. A wide range of additional reforms will support the transformation to more balanced, inclusive, and sustainable growth. These include:

  • Opening markets. Many markets are considered strategic and still largely reserved for big SOEs. These include many service sector and upstream industries, which has an impact throughout the supply chain. Allowing more domestic and foreign competition in these sectors will help generate the total factor productivity gains needed to sustain growth.3 Moreover, these sectors are often labor-intensive, and making them more competitive will help boost household income.

  • Resource pricing. The progress already made in raising resource prices is welcome, but more needs to be done. Raising factor input costs (such as energy, land, and water), including through taxation, will help rationalize investment, especially in energy-intensive sectors, and help protect the environment.4 Moreover, stronger enforcement of environmental regulations—and higher fines as existing ones often provide little deterrent—will promote more environmentally friendly development.

  • SOE dividends. The SOE sector in China is highly profitable (mainly due to large profits in industries where entry and competition is limited), yet only a fraction of profits are transferred to the budget. In 2011, central government SOEs earned profits of RMB 913 billion, but paid only RMB 77 billion in dividends, of which just RMB 4 billion went to the budget (0.4 percent of profits). Instead, most of the profits are used to finance investment, as the opportunity cost of these funds is extremely low; transferred among subsidiaries of state holding companies (dividends are paid on the basis of holding company net profits); or held as retained earnings. Increasing the dividends SOEs pay to the budget will rationalize investment, improve financial discipline, and provide welcome additional fiscal revenue.

33. Data. Staff welcomes the progress that has been made in recent years in improving statistics. China, however, remains one of only two G-20 members that do not subscribe to the Special Data Dissemination Standards (SDDS) and participate in the Coordinated Portfolio Investment Survey (CPIS). Staff encourages the authorities to graduate from the General Data Dissemination Standards (GDDS) to the SDDS and participate in the CPIS as soon as possible.

34. Authorities’ views. The authorities noted that they plan to improve further the pricing of natural resources. Over the near term, the pricing of electricity, oil and other raw materials will be moved toward a more market-determined basis. On SOE dividends, the authorities noted that collections were already high, especially for banks, but allowed that there was room for improvement in the area of holding companies and subsidiaries. On data provision, the authorities will continue to explore ways to collaborate with the Fund.

The Dividends of Reform, at Home and Globally

35. Sustainable Growth. The current growth model is showing diminishing returns and needs to adapt (Box 6). Reforms are urgent and intended by the authorities. This is critical to avoid a sharp correction later on, and to lift China onto a new growth path. The package of reforms described above will likely entail slower growth than projected in the staff baseline scenario as the economy adjusts to the new path (see rebalancing scenario in Table 6). However, this is a tradeoff worth making, because it comes with the benefit of more durable and sustainable long-term growth and higher consumption. The result will be an economy that distributes prosperity more broadly, better protects the environment, and delivers substantially higher living standards.

36. Spillovers. Ensuring better-quality and sustainable growth in China will undoubtedly benefit the rest of the world. The benefits are likely to materialize over the medium to long term as payoffs from reforms materialize. In particular, stronger demand from China will generally support trading partners’ exports. At the same time, ensuring stable and sustainable growth in China will reduce tail risks and provide further support to global growth. In the short to medium term, the spillovers to the global economy from slower growth in China can be mitigated if the rest of world, especially the most systemic economies, implements the fiscal, financial, and structural policies needed in their own economies. Implementing reforms in a global and coordinated manner will reduce the likelihood of downside risks and lift global output significantly over the long term.

37. Authorities’ views. The authorities agreed with the thrust of the staff analysis on the impact of rebalancing. It was important, they added, that the global community understand that reform in China would entail somewhat slower growth than in the past, but with the benefit of sustained income gains over the medium to long run—an outcome that would provide lasting benefits to the global economy.

Staff Appraisal

38. Overview. A history of bold economic reforms has helped China generate three decades of rapid growth and lift more than 500 million citizens out of poverty. Since the global crisis, the resilience of China’s economy has also provided a welcome boost to global demand, and substantial progress has been made with external rebalancing as the current account surplus has been sharply reduced. However, China’s pattern of growth has become too reliant on investment and an unsustainable surge in credit, resulting in rising domestic vulnerabilities. Thus, the transformation of the economy is not complete, and continued success now requires a decisive new round of reforms. The Chinese authorities have announced the broad direction of economic reforms as well as policy priorities for 2013 that are intended to rebalance growth and reduce risks. Turning these plans into specific policies and actions that are successfully implemented will achieve the goal of transitioning to a more balanced and sustainable growth path that relies more on consumption, is more inclusive, and better safeguards the environment.

39. Outlook and risks. This year, China’s economy is projected to maintain growth around 7¾ percent, with downside risks; inflation is expected to remain subdued. From the external side, the risk of slower global growth or renewed stress in world financial markets continues to weigh on the outlook. On the domestic front, vulnerabilities have increased in the financial, government, and real estate sector sectors. Rapid financial innovation is compounding the risks, as more lightly regulated entities account for a growing share of new lending, while implicit guarantees on all interest-bearing assets undercut market discipline. While China has the resources and capacity to maintain stability even in the face of an adverse shock, the margins of safety are narrowing. Continuing down this path leaves China vulnerable to the risk of a sharp downturn in growth, with significant adverse spillovers to the rest of the world.

40. Balancing reforms and near-term growth. The near-term challenge is to contain the build-up of risks and advance structural reforms. Activity has become too reliant on an unsustainable growth in total social financing and investment, especially local government infrastructure spending. It is necessary, therefore, to rein in broad credit growth, as the threat to financial stability dominates the short-term benefit of shoring-up growth. If growth were to slow too much below the authorities’ 7½ percent target, then on-budget fiscal stimulus should be used to support activity, with an emphasis on measures that support rebalancing and protect vulnerable households.

41. Monetary and financial policies. A more commercially-oriented and liberalized financial system is critical to prevent a further build-up of risks, foster a more efficient allocation of investment, and boost household capital income. The priorities are to liberalize interest rates; strengthen regulation and supervisory oversight; establish a robust and transparent framework for resolving bad debts and troubled financial institutions; and move to using interest rates as the primary tool of monetary policy. Ensuring the effective pricing of risk is essential, and requires resolving the moral hazard problem rooted in the perception of widespread implicit guarantees. Interest rates will need to play an increasingly stronger role in managing monetary conditions, especially with more intermediation taking place outside traditional bank lending. In transitioning to a more market-based financial system, care should be taken to safeguard financial stability.

42. Fiscal policy. Off-budget and quasi-fiscal activity, especially at the local government level, has played a significant role in supporting demand since the global financial crisis. This support should be gradually unwound over the medium term. Containing the risks from rising local government debts while protecting priority social and infrastructure spending requires strengthening the management, transparency, and overall governance framework of local government finances. Shifting the tax burden away from regressive social contributions to more progressive and efficient forms of taxation would help boost consumption, reduce inequality, and promote rebalancing.

43. External sector. As in the past, the staff’s assessment of China’s external position and exchange rate uses a broad range of inputs, including recent developments in the external accounts, medium-term balance of payments projections, and quantitative models of the current account and the real effective exchange rate. Overall, staff assess the external position as moderately stronger and the currency moderately undervalued compared with the level consistent with medium-term fundamentals and desirable policy settings. A more market-based exchange rate system, with reduced intervention, would support rebalancing by allowing the renminbi to appreciate over time.

44. Structural reforms. A range of additional reforms will help strengthening governance, liberalizing the economy, and rebalancing domestic demand. A gradual opening of the capital account, appropriately sequenced with financial sector and exchange rate reforms, will support other aspects of the reform agenda. Other priorities include opening markets to more domestic and foreign competition, especially service sectors and upstream industries currently reserved for SOEs; raising resource prices and taxes, which will help rationalize investment and protect the environment; and increasing the dividends SOEs pay to the budget.

45. Reform dividends. Accelerating the reform process is critical to lift China onto a new growth path and avoid a sharp correction later on. The package of reforms described above will likely entail a moderate slowdown in growth as the economy adjusts to the new path. However, this is a tradeoff worth making, because it comes with the benefit of more durable and sustainable long-term growth. The result will be an economy that distributes prosperity broadly, better protects the environment, and delivers substantially higher living standards. Moreover, the benefits would spread beyond China and help foster robust and sustainable global growth.

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

Appendix I. China: Risk Assessment Matrix

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Appendix II. China: Progress on Key Recommendations in Table 1 of the FSAP, 2011, CR 11/321

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Notes: NT (Near Term) means implementation completed within three years; MT (Medium Term) means implementation completed in three to five years. Paragraph numbers in parentheses attached to recommendations refer to CR 11/321—People’s Republic of China: Financial System Stability Analysis.

Appendix III. Staff Estimates of Augmented Fiscal Data5

This note lays out the data and assumptions used in calculating this staff’s estimates of augmented fiscal balances and debt. Section I explains staff’s estimate of the general government data. Section II presents the assumptions used to estimate the augmented fiscal deficit and net borrowing; Section III does the same for the augmented debt. Section IV presents additional considerations on the potential perimeter of public sector liabilities.

A. General Government Deficit: IMF and Authorities’ Definitions

The accounting treatment of the stabilization fund is the main difference between official and staff estimates of general government data. The authorities do not include the stabilization fund as part of the general government, but instead treat transfers to the fund as expenditure and transfers from the fund as revenue (see table). However, the stabilization fund works analogously to a government bank account, in which the government makes yearly deposits and withdrawals. For this reason, staff, in line with Government Finance Statistics practices, considers the stabilization fund part of the general government, recording cash transactions with the stabilization fund “below the line,” as transactions with other government accounts would be treated.

uA01fig25

Official vs Staff Estimates of General Government Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: CEIC; and IMF staff estimates.

Staff also add external and some local government (”on-budget”) debt to the general government balance sheet. The external debt stock is calculated from the flows of external financing, with an adjustment for estimated amortization. The local government is based on the NAO (2011) estimate for the stock at end-2010, and the NAO (2013) report and assumptions about amortization are used to estimate 2011–12 data. Bonds issued by the central government on behalf of local governments are already included in the official general government debt stock. General government expenditure (and thus, the deficit) is adjusted by the amount of this additional financing.

B. Construction of “Augmented Fiscal Deficit” and “Net Borrowing”

The “augmented fiscal deficit” and “net borrowing” add to the general government data the quasi-fiscal activities which are currently classified as off-budget, chiefly infrastructure spending. Augmented fiscal deficit is equal to augmented net borrowing plus the net proceeds from land sales. The estimates are constructed based on financing (below-the-line) data, and an above-the-line approach is used as a cross-check. The calculation requires numerous assumptions to fill in data gaps, highlighting the uncertainty surrounding the estimates.

Augmented Fiscal Deficit

The “augmented fiscal deficit” adds net proceeds from land sales and local government market financing to the staff definition of the general government. The augmented fiscal deficit calculation only includes the net proceeds from land sales—that is, the portion that is actually used to finance current and infrastructure spending.6 The net proceeds from these asset sales are treated as financing, not revenue, since they are analogous to privatization proceeds. Market financing is the borrowing by local government entities from the commercial banks, trust companies, and corporate bond market. The “augmented net borrowing” excludes net land sales, but is otherwise the same as the augmented fiscal deficit.

uA01fig26

Augmented Net Borrowing and Fiscal Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.
Market financing

Beginning in 2009–10, local governments expanded market borrowing through the use of Local Government Financing Vehicles (LGFVs). Local governments are in general forbidden to borrow directly unless approved by the State Council. This was relaxed somewhat in response to the global financial crisis, as the central government was allowed to issue bonds on behalf of local governments. However, the amounts were fairly limited and too small to allow local governments to make the expected contribution to the 2009–10 stimulus package. Hence local governments largely channeled their borrowings through LGFVs and other government-related entities that typically borrow from policy banks, commercial banks, and more recently from trust companies and the corporate bond market.

uA01fig27

Local Government Market Financing

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.

LGFVs are legally distinct entities, often receiving public credit enhancement, that engage in long-term infrastructure projects. Despite legal prohibitions, some LGFV debts were informally guaranteed by local governments, and there is a general perception that the local governments would stand behind their LGFVs if needed. LGFVs borrowing could also be collateralized by land or other assets, either owned by the LGFV itself, pledged by the local government, or provided by another entity. Such guarantees or collateral are important for infrastructure LGFVs, which, especially in the short term, may not generate sufficient cash flow to service their debt. Some LGFVs may operate on a primarily commercial basis, while some local-government owned SOEs may carry out quasi-fiscal activities. However, since the former are exceptions, rather than the rule, the assumption here is that all LGFV debt warrants inclusion in the augmented deficit, while local-government owned SOE debt does not.

If approved by the State Council, local governments and government related entities can issue debt on a discretionary basis. This amounted to around 7 percent of end-2010 local government debt according to the NAO (2011). Staff estimates annual issuance by equally distributing accumulated debt among earlier years. This assumes that central government bonds issued on behalf of local governments were already included in the total stock.

uA01fig28

Gross Issuance and Amortization of Corporate Bond by LGFVs1

(In RMB bn)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

1 LGFVs are urban construction investment companies, which were set up by local governments to finance their infrastructure and public entities projects. Source: IMF staff estimates.

The other major components of market financing are bank loans, corporate bonds, and trust loans:

  • Bank loans accounted for 79 percent of total local government debt by 2010, equivalent to CNY 12.7 trillion, of which CNY 10.7 trillion was borrowed by provincial, city, and county governments (NAO, 2011), CNY 0.8 trillion by township governments (DRC), and CNY 1.2 trillion for roads and highways that are not captured by the NAO (2011). Using the growth rate of local government debt provided by the NAO (2011), staff estimate the net local government debt issuance and the proportion financed through bank loans for earlier years. Information gaps prevent decomposition of net bank loan issuance by the gross amount, repayment through land sales proceeds, and debt rollover. The NAO (2013) report is used to estimate the debt stock at the end of 2012 based on the survey result that debt has risen by 13 percent since 2010.

  • Corporate bonds are derived from the WIND database, which provides data on gross amount and maturity dates of corporate bond issuance by LGFVs.

  • Trust loans to infrastructure projects amounted to CNY 1.39 trillion by Sept 2012, based on data from the China Trustee Association. This fell to just below CNY 0.9 trillion by the first quarter of 2010. There is no data before 2010, so the growth rate of bank loans is used to estimate flows for earlier years.

uA01fig29

Central Government in the Monetary Authorities

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff estimates.

Changes in cash deposits of the government are included as financing. Deposits totaled around 4 percent of GDP at end-2012; these had been growing steadily, but started falling as a share of GDP after the peak of the crisis. Deposits of LGFVs, however, are not included due to lack of data.

Land sales

Data on net land sales are not published for every year and are estimated using some simplifying assumptions. Gross land sales data in recent years are from CEIC. Most land sales are channeled through Government Managed Funds (GMFs), with the gross proceeds recorded as revenue in off-budget accounts. For example, in 2011 gross land sales explained CNY 3.3 trillion (7 percent of GDP) of the CNY 3.8 trillion in GMFs’ revenue. Net land sales for 2010 and 2011 are derived from Ministry of Finance data that show how the gross proceeds were used. Net proceeds subtract the cost of acquisition, compensation to farmers, and land development. In 2010, the net proceeds were 50 percent of the gross, whereas they were only 33 percent in 2011. Except for 2010–11, data are not available to calculate net proceeds, so staff assume the net proceeds each year are 42 percent (the average of 2010 and 2011). Land sales data for 2005-9 appear incomplete and for 2005 and earlier are discontinuous, so a series is extrapolated using data on land sales growth from Soufun (a Chinese real estate services firm) and official data for 2010–12.

uA01fig30

Official and Staff Estimates of Land Sales Revenue

(In trillon)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; the Ministry of Finance; Soufun; and IMF staff estimates.
uA01fig31

Decomposition of Gross Land Sales Proceeds: Costs and Uses

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

* In percent of total gross land sales proceeds.Sources: Ministry of Finance; and IMF staff calculations.
Cross-check with Above-the-Line Data

Budgeted revenue is adjusted for GMF income net of land sales. Once land proceeds are excluded, this item is small. In 2011, officially reported GMF revenue was CNY 4.1 trillion, but, after subtracting land sales (which only accrue to local governments), this falls to CNY 0.8 trillion. Of this, CNY 0.3 trillion is from the central government and CNY 0.5 million from local governments (CNY 3.8 trillion less CNY 3.3 million in land sales). Data on central government GMFs come from the Ministry of Finance and CEIC. For local governments, staff assumes that GMF revenue is a constant share of land sales.

uA01fig32

Infrastructure Investment and Financing Sources

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Source: IMF staff estimates.

Expenditure is adjusted for spending by GMFs and LGFVs. Data on LGFV spending are not available, so staff includes all infrastructure investment, calculated from data on fixed asset investment, in augmented spending.7 This is added to total spending by the budget and GMFs, which is then adjusted to avoid double-counting of on-budget and GMF-financed infrastructure spending. Specifically, based on 2011 data, staff assumes that infrastructure spending accounts for 21 percent of local government budget spending, 14 percent of central government budget spending, 36 percent of local GMF spending, and 47 percent of central GMF spending. The residual is the estimate of LGFV infrastructure spending, and broadly corresponds to the financing data.

The above-the-line approach yields an augmented fiscal deficit that is somewhat larger than the financing approach in recent years. This is not surprising, as the above-the-line data include all infrastructure spending even though some is executed by entities outside the augmented government—such as SOEs. Moreover, it could also be inflated to the extent that some LGFV infrastructure spending is financed by own-revenue instead of market borrowing.

uA01fig33

Augmented Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; the Ministry of Finance; Soufun; and IMF staff estimates.
uA01fig34

Augmented Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; the Ministry of Finance; Soufun; and IMF staff estimates.
Construction of Augmented Debt Ratio

Debt data are based on public sources or cumulated financing flows. Central government debt data are readily available from public sources. For augmented local government, NAO (2011) provides the starting point, an estimate of CNY 12.7 trillion for 2010. Data for previous and subsequent years are then calculated based on the financing assumptions described above.

uA01fig35

Augmented Fiscal Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; Chinabond; EUROSTAT; China Citic Press; China Trustee Association; NAO; and the Ministry of Finance; and IMF staff estimates.

Differences with other public estimates are minor, and often stem from different methodologies or base years. For example, the DRC and NAO (2011) estimates refer to the end of 2010. While the National Audit Office conducted a nation-wide survey, most investment banks and research institutions, which lack the authority and resources to access microlevel data, took approximations based on publically available information on bank credit.

uA01fig36

Debt Estimates

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

In most cases, higher estimates are due to different coverage. DRC’s local government debt estimate, which captures townships in addition to provinces, cities, and counties, is CNY 2 trillion higher than the NAO estimate, which only captures three levels of government. In addition to local government explicit liabilities, many estimates also include central government debt and contingent liabilities at the general government level, such as NPLs held by asset management companies, borrowing by policy banks, and pension fund liabilities.

C. Other Considerations

The augmented fiscal data are intended to provide a better picture of the fiscal policy stance and gross government liabilities. They do not provide a comprehensive picture of government net worth in a balance sheet framework.

Railways Ministry debt is excluded from the augmented data. The Ministry was corporatized this year and debt moved to a new SOE, which should be classified going forward as part of the public sector but not the augmented government. It is consistent, therefore, to exclude it from the estimates of augmented fiscal debt and deficit as defined in this exercise (including it would increase somewhat the estimated augmented deficit and debt).

uA01fig37

Ministry of Railway Debt and Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Note: Net issuance were calculated as the difference of debt stock provided by ChinaBond Audit Reports. Debt stock by the end of 2012 were extrapolated from Sept 2012 debt stock and the net issuance in 2012 is the difference between the estimated 2012 debt stock and 2012 debt stock.

Contingent liabilities are also excluded. Quasi-fiscal debts are explicit liabilities, but the government is also exposed to contingent liabilities, including debt of nonfinancial state-owned enterprises excluding LGFVs, policy banks’ outstanding debt, nonperforming loans (NPLs) in the banking sector, old NPLs assumed by asset management companies, and pension fund liabilities. The Chinese Academy of Social Science (CASS) estimated total 2010 contingent liabilities at just above 100 percent of GDP.

Social security funds are excluded from the data. China does not consolidate social security into general government accounts. Inclusion would increase augmented revenue and spending, but somewhat reduce the deficit. The social security funds have also built up financial assets: the National Pension Fund held assets of 4.3 percent of GDP at end-2012. However, the pension system faces significant challenges going forward. World Bank (2013) notes that legacy costs in the pension system were 80–132 percent of GDP in 2008 and that the system had a potentially large actuarial deficit (estimates, albeit dated, suggest the actuarial deficit was around 95 percent of 2001 GDP).

uA01fig38

Social Security Fund

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 211; 10.5089/9781475566925.002.A001

Sources: CEIC; and IMF staff calculations.

On the other hand, state assets, including public sector financial assets, are also excluded from the gross augmented debt estimates. The government’s significant ownership stake in SOEs is also excluded. China does not publish a public sector balance sheet, and estimation of the government’s equity stake is difficult, though the value is probably large. According to CASS, the government owns CNY 60 trillion (147 percent of GDP) worth of equity of state owned for-profit nonfinancial enterprises, CNY 8 trillion (20 percent of GDP) worth of equity in state-owned for-profit financial enterprises, and almost CNY 8 trillion of worth of equity in state-owned nonprofit enterprises.

Appendix Table III.1.

China: General Government Fiscal Data, Staff and Authorities’ Estimates

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Sources: CEIC Data Company Ltd.; MOF; and IMF staff estimates.

Figures do not include local government financing vehicles and other off-budget activities.
1

In addition to “traditional” bank credit, total social financing includes a range of other forms of credit, such as trust products, corporate bonds, and equity financing.

2

See IMF Country Report No. 11/192, Box 8.

3

See Ahuja (2012) “De-monopolization Toward Long-Term Prosperity in China,” Working Paper No. 12/75.

4

See IMF Country Report No. 11/192, Box 3; and Geng and N’Diaye (2012) “Determinants of Corporate Investment in China: Evidence from Cross-Country Firm Level Data,” Working Paper No. 12/80

5

See Zhang (forthcoming), IMF Working Paper: “Fiscal Vulnerabilities and Risks from Local Government Finance in China.”

6

Net proceeds from land sales are calculated by subtracting the cost of acquisition, compensation to farmers, and land development from the gross land sales proceeds.

7

Infrastructure investment is calculated as the sum of fixed asset investment in primary industry; electricity and heating; gas; water; highway transport; waterway transport; air transport; water conservancy and environment management. Since the breakdown is only available since 2004, staff assume that infrastructure investment and total fixed asset investment grew at the same rate in previous years.

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Cover IMF Staff Country Reports
People's Republic of China: 2013 Article IV Consultation
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2013: Issue 211
Publisher:
International Monetary Fund
ISBN:
9781475566925
ISSN:
1934-7685
Pages:
93
DOI:
https://doi.org/10.5089/9781475566925.002
Figure 1.

Message: Growth and inflation are stable

China: Real GDP Growth

(In percent)

Inflation

(In percent, year-on-year)
Figure 2.

Message: After a reprieve in 2012 balance of payments pressures have resumed

Consumption and Investment

(In percent)
Figure 3.

Message: More progress is needed on domestic rebalancing

Current Account

(In percent of GDP)

China: Social Financing Stock

(In percent of GDP)1
Figure 4.

Financial Sector Risks
Figure 5.

Message: Real estate has rebounded

Augmented Public Debt Level

(In percent of GDP)

Augmented Deficits and Net Borrowings

(In percent of GDP)
Figure 6.

Inclusive Growth

Environmental and Natural Resource Degradation and Depletion

(In percent of GNI)

Growth of Working-Age Population

(In percent)

Demographic Pressures

(In millions)

Adverse Feedback Loop During Crises

(In percentage points)1

Convergence Process of Per Capita GDP: China, Japan, Korea

(PPP, relative to United States)

Real Output per Worker Relative to Shanghai

(2000 and 2010)

Physical Capital Input Relative to Shanghai

(2000 and 2010)

TFP Relative to Shanghai

(2000 and 2010)

China: Contribution to Growth by Input

(In percentage points)

TFP and PPP GDP per Capita

(Five-year averages)

China Reform Payoffs: Potential Increase in Average TFP Growth1

(In percentage points)

Average Tax Wedge

(In percent; 2012)

Spot Exchange Rate

(In USD/RMB)

Real Effective Exchange Rate

(2000=100)

Qualified Foreign & Domestic Institutional Investor

(Approved Investment Fund)

Increase in Gross International Assets During Five Years Following Capital Account Liberalization1

(In percent of GDP)

Change in Net Portfolio Investment Inflows

(Percent of GDP, between one year before and after full capital account liberalization)

Official vs Staff Estimates of General Government Balance

(In percent of GDP)

Augmented Net Borrowing and Fiscal Deficit

(In percent of GDP)

Local Government Market Financing

(In percent of GDP)

Gross Issuance and Amortization of Corporate Bond by LGFVs1

(In RMB bn)

Central Government in the Monetary Authorities

(In percent of GDP)

Official and Staff Estimates of Land Sales Revenue

(In trillon)

Decomposition of Gross Land Sales Proceeds: Costs and Uses

(In percent of GDP)

Infrastructure Investment and Financing Sources

(In percent of GDP)

Augmented Revenue

(In percent of GDP)

Augmented Expenditure

(In percent of GDP)

Augmented Fiscal Deficit

(In percent of GDP)

Debt Estimates

(In percent of GDP)

Ministry of Railway Debt and Deficit

(In percent of GDP)

Social Security Fund

(In percent of GDP)