People’s Republic of China: Staff Report for the 2013 Article IV Consultation

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 78), 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.