People’s Republic of China: Staff Report for the 2014 Article IV Consultation

KEY ISSUESContext. After three decades of remarkable growth, the economy has been slowing. Much of theslowdown has been structural, reflecting the natural convergence process and waning dividends from past reforms; weak global growth has also contributed. Moreover, since the global financial crisis, growth has relied too much on investment and credit, which is not sustainable and has created rising vulnerabilities. Growth was 7.7 percent in 2013, and is expected to slow to around 7½ percent this year and decline further over the medium term.Focus. The pattern of growth since the global financial crisis is not sustainable and has resulted in rising vulnerabilities. The discussions focused on assessing the risks posed by the continuedbuild-up of vulnerabilities; reforms to unleash new, sustainable engines of growth and reduce vulnerabilities; and how to best manage aggregate demand in this context, as growth is slowing yet risks are still rising. A key takeaway is that to secure a safer development path, accommodative policies need to be carefully unwound, accompanied by decisive implementation of the announced reform agenda to promote rebalancing. The result will be somewhat slower but safer growth in the near term, with the significant long-run benefit of securing more inclusive, environment-friendly, and sustainable growth.Risks. Credit and ‘shadow banking,’ local government finances, and the corporate sector— particularly real estate—are the key, and interlinked, areas of rising vulnerability. In the near term, the risk of a hard landing is still considered low as the government has the capacity to combat potential shocks. However, without a change in the pattern of growth, the hard-landing risk continues to rise and is assessed to be medium-likely over the medium term.Reform agenda. The authorities have announced a comprehensive and ambitious blueprint of reforms. Successful implementation should achieve the desired transformation of the economy, but will also be challenging.Demand management. Reining in credit growth, local government borrowing, and investment will address the risks, but also slow growth. Macro support should be calibrated to allow needed adjustments to take place, while preventing growth from slowing too much.Scenarios and spillovers. With faster adjustment and reform implementation, growth will be somewhat lower in the near term, with moderate spillovers for trading partners. However, in the medium term, income and consumption will both be higher—a result that is good for China and good for the global economy.

Abstract

KEY ISSUESContext. After three decades of remarkable growth, the economy has been slowing. Much of theslowdown has been structural, reflecting the natural convergence process and waning dividends from past reforms; weak global growth has also contributed. Moreover, since the global financial crisis, growth has relied too much on investment and credit, which is not sustainable and has created rising vulnerabilities. Growth was 7.7 percent in 2013, and is expected to slow to around 7½ percent this year and decline further over the medium term.Focus. The pattern of growth since the global financial crisis is not sustainable and has resulted in rising vulnerabilities. The discussions focused on assessing the risks posed by the continuedbuild-up of vulnerabilities; reforms to unleash new, sustainable engines of growth and reduce vulnerabilities; and how to best manage aggregate demand in this context, as growth is slowing yet risks are still rising. A key takeaway is that to secure a safer development path, accommodative policies need to be carefully unwound, accompanied by decisive implementation of the announced reform agenda to promote rebalancing. The result will be somewhat slower but safer growth in the near term, with the significant long-run benefit of securing more inclusive, environment-friendly, and sustainable growth.Risks. Credit and ‘shadow banking,’ local government finances, and the corporate sector— particularly real estate—are the key, and interlinked, areas of rising vulnerability. In the near term, the risk of a hard landing is still considered low as the government has the capacity to combat potential shocks. However, without a change in the pattern of growth, the hard-landing risk continues to rise and is assessed to be medium-likely over the medium term.Reform agenda. The authorities have announced a comprehensive and ambitious blueprint of reforms. Successful implementation should achieve the desired transformation of the economy, but will also be challenging.Demand management. Reining in credit growth, local government borrowing, and investment will address the risks, but also slow growth. Macro support should be calibrated to allow needed adjustments to take place, while preventing growth from slowing too much.Scenarios and spillovers. With faster adjustment and reform implementation, growth will be somewhat lower in the near term, with moderate spillovers for trading partners. However, in the medium term, income and consumption will both be higher—a result that is good for China and good for the global economy.

Setting

A. Background

1. Decades of rapid growth are a testament to China’s success in implementing reforms. Since the start of economic liberalization in the early 1980s, China has grown at a rate of almost 10 percent per year, translating into higher living standards and raising over 600 million people out of poverty. This success was built on waves of major reforms, and frequent adjustment of policies in line with evolving conditions. With economic, social and environmental challenges rising, the need for another round of reforms has become ever more urgent. The new government leadership, which came to power early last year, has stated a strong commitment to reinvigorate the effort to transform the economy with a broad and ambitious reform agenda.

2. The announced reform agenda is broadly consistent with past Fund advice. The key message from the last few Article IV consultations was that a comprehensive package of reforms was needed to secure more balanced and sustainable growth. The reform blueprint announced after last autumn’s closely-watched Third Plenum is a comprehensive package that includes the type of financial, fiscal, external, and social security reforms that were recommended in previous consultations (Appendix I). As would be expected from such an over-arching document, in many areas the blueprint is fairly general. However, this has not been followed up with details on the specific reforms or timetables other than the broad goal to implement the agenda by 2020. Recent measures that are in line with past advice include a widening of the exchange rate band, progress on interest rate liberalization, strengthened financial sector regulation and supervision, and efforts to rein in local government borrowing. Appendix II updates progress with regards to the key recommendations from the 2011 FSAP.

3. Discussions this year focused on advancing reforms and addressing vulnerabilities, while ensuring that growth does not slow too sharply. The global financial crisis hit China just as the dividends from the last major wave of reforms (late 1990s and early 2000s) were waning, especially the shift of resources from agriculture to manufacturing, and potential growth was slowing. Since then, growth has relied too heavily on investment and credit, a pattern that is not sustainable and resulting in rising vulnerabilities. The challenge is thus to implement reforms to unleash new sources of growth and address the growing risks, with demand management geared toward preventing growth from slowing too much without undermining adjustment and reforms.

A01ufig1

Fixed Asset Investment and Total Social Financing

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.1 Difference between use of gross capital formation and saving of nonfinancial enterprises (flow of funds data).

B. Developments and Outlook

4. Growth in 2014 is expected to be around 7½ percent, in line with the authorities’ target. Last year, after a weak start, growth picked up in third quarter and the annual target of 7½ percent was exceeded. A similar pattern is emerging this year, as activity was again weak in the first quarter, while more recent data point to some firming, in response to policy action and stronger exports (Figure 1). Domestic demand moderated reflecting a welcome reduction in the growth of total social financing (a broad measure of credit), slower investment growth, and a correction in real estate activity. Despite this, consumption and the labor market have held up well. The authorities have taken a number of measures in the past few months to support activity, including targeted cuts in Required Reserve Ratios (RRRs), tax relief for SMEs, moral suasion on home mortgages, and accelerated fiscal and infrastructure spending. Looking ahead, the near-term growth outlook for China remains to an important extent a function of the government’s targets. For 2015, the staff’s baseline scenario projects growth to moderate to around 7 percent, assuming continued efforts to rein in vulnerabilities and steady, if slow, implementation of reforms. In particular, a further slowing of investment, especially in real estate, would be only partly offset by stronger external demand from the continuing global recovery.

Figure 1.
Figure 1.

China: Growth and Inflation

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff calculations.
A01ufig2

China: Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

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

5. Inflation has been stable. Nonfood price inflation, a proxy for core, has remained around 2 percent. Although headline CPI inflation has been somewhat more bouncy, this reflects volatility in food prices largely related to agricultural supply shocks. Producer prices, however, have been declining for over two years reflecting excess capacity and weak external demand. Inflation is projected to be around 2 percent this year, assuming no significant shocks to food prices.

6. Although credit growth is still rapid, it has decelerated considerably. Total social financing (TSF)—a broad measure of credit covering bank lending, funding from shadow banking, and equity—rose from 130 percent of GDP in 2008 to 207 percent of GDP in early 2014. However, growth in TSF decelerated from 22 percent in May 2013 to 16 percent in May 2014 (Figure 2). This coincided with a series of steps to strengthen regulation and supervision, especially of shadow banking, and a rise in interbank interest rates in the second half of last year. Additional steps were taken in April and May of this year, mainly targeted at reining in interbank activity as a channel for funding shadow banking. While it is too early to gauge the full impact of these measures, trust financing has slowed considerably and activity appears to be shifting back to conventional bank loans as well as corporate bonds. Much of last year’s rise in interbank interest rates was unwound earlier this year, though rates remain modestly higher than April 2013.

Figure 2.
Figure 2.

China: Financial Sector Development

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; and IMF staff calculations.
A01ufig3

Inflation

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.
A01ufig4

China: Social Financing Stock

(In percent of GDP1)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

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

7. Fiscal policy has supported growth significantly in recent years, mainly through off-budget spending. Official budget data do not suggest much stimulus, but exclude a substantial amount of off-budget and quasi-fiscal activity, largely at the local-government level. To capture such activity, staff updated its estimates of augmented fiscal data, which expand the perimeter of government to include off-budget local government financing vehicles (LGFVs) (Appendix III). The augmented deficit—which is the broadest measure and indicates the impact of fiscal policy on aggregate demand—rose in 2013, indicative of a supportive fiscal stance. Augmented net borrowing—which treats land sale proceeds “above-the-line” and better measures debt creating flows—paints a similar picture and rose to 7.4 percent of GDP in 2013. This pushed augmented debt to 54 percent of GDP in 2013, up from 50 percent of GDP in 2012. A comprehensive audit conducted by the National Audit Office (NAO) found that government debt was close to 40 percent of GDP in 2012, which is lower than augmented debt mainly because the NAO excluded LGFV liabilities that under GFSM 2001 do not count as government debt, such as debts that LGFVs would likely be able to service themselves. The authorities, however, have not published a time series of government debt or data on deficits that are consistent with the NAO definition of government. In the absence of such data, the augmented debt (except for those years that NAO debt data are available) and balance data provide a useful complement to general government data. The actual deficit, consistent with the NAO definition of debt, is probably somewhere between the augmented and general government estimates, varying year-to-year depending on how much of LGFV activity is commercial.

A01ufig5

China: General Government Balance

(In percent of GDP; including state-administered SOE funds and social security)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff estimates.

8. Progress on rebalancing has been mixed (Figure 3). External imbalances have fallen considerably, with the current account surplus declining to 1.9 percent of GDP last year. The sharp decline of around 8 percent of GDP since 2007 reflects appreciation of the REER (30 percent since 2007), weak growth in advanced economies, terms of trade worsening, and rapid growth in domestic investment. On domestic rebalancing, the economy is still heavily dependent on investment, which was the largest contributor to growth in 2013. While consumption growth has been robust, household savings still continued to rise. On the positive side, urban household income has been growing faster than GDP and the share of the service sector, both in output and employment, has been rising.

Figure 3.
Figure 3.

China: Rebalancing

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; WEO; and IMF staff calculations.
A01ufig6

Contribution to Growth

(In percentage points)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.

9. Non-FDI capital flows have continued to be volatile. Earlier this year, non-FDI capital was flowing into China fueled by loose monetary conditions in major advanced economies and carry-trade, with interest rate differentials compounded by expectations of continuing renminbi appreciation. Combined with FDI inflows and the trade surplus, these inflows led to a BOP surplus. Indeed, BOP data indicate that intervention (change in reserve assets) was over US$ 100 billion in the first quarter—on top of US$ 430 billion for last year (Figure 4). In late February, the renminbi started to depreciate against the U.S. dollar in what was widely considered to be a deliberate move by the PBC to make the carry-trade less attractive and break perceptions that renminbi appreciation was a one way-bet. Subsequently, market dynamics changed as non-FDI flows reversed direction and intervention appears to have fallen sharply. Moreover, in contrast to the usual pattern over the last several years, the renminbi has been closing mostly on the weaker side of the daily trading band.

Figure 4.
Figure 4.

China: Balance of Payments

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; WEO; and IMF staff calculations.
A01ufig7

Trade, FDI, and Foreign Exchange Intervention

(In USD billion)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.

10. Authorities’ view. The authorities were confident that this year’s target of around 7½ percent growth would be achieved. They broadly agreed with staff’s inflation forecasts. The authorities emphasized that the fiscal position remained strong, as reflected in the official figures and confirmed by the NAO audit, and prompt actions have been taken to address potential risks. Staff’s estimates following the Fund’s widely adopted methodology of the Government Finance Statistics could provide complementary analysis of the fiscal developments in China. The use of augmented fiscal estimates, the coverage of which differs from that of the general government position as defined in the Government Finance Statistics, could easily cause confusion and misreading. Thus the augmented fiscal data should not be used, especially as the staff estimates were imprecise (due to key simplifying assumptions) and included items that should be excluded from the fiscal accounts (such as commercial activity by LGFVs). In particular, considering land sales as a financing item has led to significant exaggeration of fiscal deficit.

11. On domestic rebalancing, the authorities pointed to strong growth of services relative to manufacturing and rapid increases in urban and rural household incomes. The authorities also pointed to the slowdown of investment growth and lower contribution of investment to GDP over the last few years, compared to 2009/10 when the priority was to boost domestic demand in response to the Global Financial Crisis. They were confident that the reforms in the Third-Plenum blueprint would support the desired rebalancing to a more consumer-based economy. Regarding intervention, they noted that the change in reserve assets (the staff intervention measure) also includes the income on China’s international reserves.

Risks and Buffers

12. Although efforts have begun to address them, vulnerabilities are still rising, reflecting years of reliance on credit and investment to fuel growth. Real estate, in particular, is posing a growing challenge as it has become a major engine of growth yet is also in need of adjustment. The authorities still have sufficient buffers to prevent a sharp growth slowdown in the near term, essentially by using public resources and state influence. However, repeated reliance on these buffers without addressing the underlying sources of risk and changing the growth model would further exacerbate vulnerabilities and reduce future growth prospects. In particular, continued efforts to sustain growth through additional credit and investment would vitiate the recent steps taken to rein in vulnerabilities (particularly in the area of shadow banking activities and local government finances). As a result, the risk of disorderly adjustment would continue to rise, especially as the size and complexity of the financial system are rising fast.

A. Domestic Vulnerabilities

13. A web of vulnerabilities exists across key sectors of the economy. To finance rapid investment, firms and LGFVs have borrowed from both banks and shadow banks. This has resulted in rising corporate and local government indebtedness, which is the flip side of the large increase in TSF since 2008. Many strands of the web, moreover, run through the real estate sector. Banks and shadow banks are exposed to real estate directly through credit to developers and household mortgages, and indirectly through the use of real estate as collateral for other loans. Local government spending is also linked to the real estate sector, directly through land sales revenue and indirectly through the tax revenue generated by real estate related activity. Given these interconnections, a major shock to any part of the web would reverberate throughout the whole, creating a negative feedback loop that could considerably amplify the original shock. For example, a real estate shock would reduce growth directly (mainly through lower investment) and indirectly through the knock-on effect to related sectors and the impact on local government finances. The ensuing slowdown would hurt the ability of firms to repay loans, resulting in rising NPLs that would constrain banks’ ability to lend and, in turn, lead to another round of less investment, lower growth, and worsening asset quality.

  • Real estate (Box 1). Real estate has been a significant engine of the economy, but it has shown growing signs of imbalances and activity has softened in 2014. The challenge is to allow for the necessary correction while preventing an excessively sharp slowdown. The contribution of real estate and construction to growth has been rising; last year, it accounted directly for 12.8 percent of value added, and about 33 percent if upstream and downstream sectors are included. Residential real estate is marked by substantial regional differentiation. Large cities have enjoyed favorable demand conditions—reflecting both underlying and speculative demand—and prices show signs of overvaluation relative to fundamentals, despite measures aimed at restricting speculative demand. In contrast, many smaller cities have experienced oversupply as local governments promoted large-scale development to boost growth and used land sales to finance local government spending. Supply seems to have outpaced demand in many areas as evidenced by muted price increases and rising inventories. The commercial real estate market appears to be in oversupply in both smaller and bigger cities.

  • Corporate sector (Box 2). Consistent with strong growth in TSF and investment, corporate debt has risen significantly, particularly in sectors which contributed most to post-crisis growth (mainly real estate and related industries). Data on the entire universe of the corporate sector are not available, but total debt of listed firms has increased by 10 percentage points of GDP since 2007 (to 35 percent of GDP), with about half of the increase coming from real estate and construction sectors. Reflecting regional differences in the property market, the financial situation of real estate companies varies, with big developers in large cities performing better than smaller companies in lower-tier cities. In aggregate, listed real estate and construction firms account for about 25 percent of total listed-firm liabilities, and most of this is held by a relatively small number of highly-leveraged firms (about 80 percent of total liabilities in listed real estate and construction firms are held by about 60 firms with liabilities more than three times of equity). There has also been a substantial increase in leverage among SOEs (including those operating in sectors with overcapacity), who enjoy privileged access to financing on the back of implicit state guarantees.

  • Local governments (Box 3). Compared to other countries, China’s fiscal debt—regardless of how measured—does not appear particularly large. The deficit, however, stands out somewhat more, especially the augmented net borrowing measure. Moreover, some local governments likely face more significant challenges with a combination of large off-budget borrowing and a limited revenue base. China has benefited from a very favorable interest-growth differential, which has allowed the economy to out-grow part of the increase in public debt. However, as shown in the Debt Sustainability Analysis (Appendix V), the increase in debt has made the fiscal position more vulnerable to shocks.

  • Banks (Figure 5). China’s banking system is both an anchor of stability and a potential source of vulnerability. The financial system, especially banks, is still predominantly state-owned—benefitting from implicit backing of the government—and official data show that bank balance sheets are healthy. However, gross NPL formation is now picking up and the rapid post-crisis credit expansion raises risks of further asset quality deterioration (particularly in smaller banks heavily involved in funding the stimulus at the local government level, including local real estate developers). Banks are also involved in the expansion of shadow banking activity (see below), and liquidity risks have increased as some banks are persistent borrowers in interbank markets and liquidity demand and money market rates have been volatile. Bank stocks often trade at a discount to international peers, indicative of market concerns about bank balance sheets and the outlook for the sector.

  • Shadow banking (Box 4). The authorities have taken important steps to contain shadow banking activity, but it remains a source of risk. Shadow banking emerged as an important source of funding for sectors involved in the post-crisis stimulus (real estate, local government infrastructure projects, and SOEs). It became the fastest-growing segment of the financial sector, reflecting in large part regulatory arbitrage as on-balance sheet bank lending has been constrained by financial safeguards (such as capital requirements and loan-to-deposit ratios) and the ceiling on deposit interest rates. Given weaker regulations and the lack of transparency, shadow banking could represent the weak tail of credit distribution. A significant portion of credit appears to be going to SOEs and LGFVs, limiting perceived risks to the extent that such assets are likely to benefit from government support. Moreover, shadow banking investment products have been offered or distributed by banks, strengthening the perception of implicit guarantees (in particular on deposit-like products for retail investors). Together with returns well above the statutory ceiling on deposit rates, this has attracted significant funding to the sector, often without due regard for the quality of underlying assets.

Figure 5.
Figure 5.

China: Banking Sector 1/

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; and Banks’ reports; and IMF staff calculations.1/ Based on the results of the eight largest banks listed in Hong Kong SAR, which account for 55 percent of both domestic deposits and loans.
A01ufig8

Public Debt and Fiscal Deficit

(In percent of GDP, 2013)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; IMF, World Economic Outlook; NAO; and IMF staff estimates and calculations.1 NAO audit indicates general government debt of 39.4 percent of GDP as of end-2012. The NAO audit does not provide a government deficit figure. Staff estimate that the corresponding deficit would be within the range shown.

Selected Banking Indicators

(In percent)

article image
Sources: CEIC; CBRC.

B. Domestic Risk Assessment

14. Notwithstanding the rise in vulnerabilities, an abrupt adjustment in the near term is unlikely, given China’s policy buffers. Cross-country evidence suggests that credit booms of a similar size often led to sharp corrections (Box 5). However, in China the government still has the capacity to absorb shocks and prevent the kind of loss of confidence or sudden stop that have triggered major problems in other countries—such as a deposit run, freezing-up of the interbank market, collapse of the real estate market, or capital flight. Total public debt is relatively low; public sector assets are large (including foreign exchange reserves); domestic savings are high and foreign debt exposures low; capital controls limit the risk of capital flight; and the government retains substantial levers to control economic and financial activity. For these reasons, the probability of a hard-landing in the near term is low. At the same time, repeated use of this policy space—in particular, through credit-financed investment stimulus—risks compounding the underlying vulnerabilities.

15. Thus, without a change in the pattern of growth, the likelihood of a shock triggering financial disruption and/or a sharp slowdown will continue to rise. Overreliance on credit and capital accumulation to support growth would further weaken balance sheets and reduce investment efficiency. This would ultimately lead to a slowdown in growth, and put further pressure on corporate profits and the financial system. The more vulnerabilities accumulate, the more likely it is that a shock could trigger a negative feedback loop. Thus, although the near-term risk of a hard landing is low, it increases to medium over a medium-term perspective.

16. Authorities’ views. There was consensus that the current pattern of growth was unsustainable, and that structural reforms were critical to unleash new engines of growth. The authorities recognized the importance of containing risks and were confident that vulnerabilities were well under control with the countervailing measures put in place, but would remain vigilant. 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 after recent steps to improve 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 monitor closely 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. Local government debt had become a pressing issue in some jurisdictions, but was being addressed by further strengthening of local debt management, including the creation of a monitoring system to contain risks. Overall, the authorities emphasized that banks and other financial institutions appeared comfortable with their exposures and the underlying health of projects they had financed.

C. External Risks

17. External shocks would impact China mainly through the trade channel. Spillovers from potential financial market volatility in the course of exit from UMP in advanced economies (AEs), or from a protracted period of slower growth in advanced and emerging economies, would have the strongest repercussions for China’s economy. In both cases the main impact would be through lower export demand, with some knock-on effects for corporate profits, employment, and domestic demand. If this or other external shocks were to slow near-term growth too sharply, on-budget fiscal stimulus should be used in a manner that supports rebalancing and helps protect vulnerable groups. The Risk Assessment Matrix (Appendix IV) summarizes the main external and domestic risks.

18. Authorities’ views. The authorities remained concerned about the impact of continued slow growth in major AEs, which was having adverse spillovers for growth in China and the rest of the world. They also regard a slowdown in emerging markets as an important risk, given the contribution to China’s export growth from this source. They considered turbulence related to monetary policy normalization in advanced economies as less of a direct risk for China. However, it could indirectly impact China through the effect on other economies, especially emerging markets.

Sustaining Growth and Managing Risks

A. Transition to a New Growth Model

19. Implementation of the reform blueprint will move the economy to a more inclusive, environment-friendly, and sustainable growth path. The aim is to use resources more efficiently and unleash new sources of productivity growth, in a way that better protects the environment and ensures that growing prosperity is widely shared. Key principles include giving the market a more decisive role, eliminating distortions, and strengthening governance and institutions. While the blueprint is comprehensive, it has not been followed up with details on the timing and specifics of the reforms. The discussions focused on the issues that staff considered to be the priorities. Staff urged the authorities to implement the priority reforms quickly and as a package, noting interdependencies, in particular, among the financial sector, SOE, exchange rate, and local government reforms.

Financial sector, SOE, and monetary policies

20. Financial sector reforms will help safeguard financial stability and improve the allocation of credit. Widespread implicit guarantees—of savers, intermediaries, and borrowers—and the cap on deposit rates distort the pricing of risk and borrowing costs, contributing to the misallocation of credit and inefficient investment. Introducing deposit insurance is important to define the perimeter of state guarantees for investors (and thus clarifying what lies outside this perimeter). Removing implicit guarantees also requires greater tolerance of corporate defaults and bankruptcies, including of SOEs. With lending rates now liberalized and more savings vehicles in the market, conditions are ripe for the next step in deposit rate liberalization. Options include increasing upward flexibility or allowing higher rates for some types of deposits.

21. SOE reforms are important in their own right, and a key complement to financial sector reforms. The aim is to ‘level the playing field’ and generally allow markets rather than the state to allocate resources. Needed reforms include opening up to full and fair competition activities currently reserved to SOEs, properly pricing finance and other factor inputs, requiring adequate dividend payments to the budget, and imposing hard budget constraints. The latter means that those SOEs that cannot compete successfully on a level playing field should exit. This is critical for the government’s strategy for SOE reforms—as long as SOEs are perceived to benefit from an implicit backing of the state, they will have preferential access to financing that will continue to tilt the playing field, distort competition, and misallocate resources. Opening up the service sector—in areas such as education, health, finance, telecom, and logistics—to more competition will also be key for generating the productivity gains needed to fuel growth and for boosting household income, as services tend to be more labor intensive than industry.

22. As part of the move to a more market-based economy, the transition to a new monetary policy framework should continue. Regardless of the ultimate framework that China adopts, it is becoming increasingly important to use interest rates as the primary instrument of monetary policy given the growth of shadow banking and planned deposit rate liberalization. This will require establishing a policy interest rate, such as the overnight or seven-day interbank repo rate. As an interim step, the volatility of these short-dated interbank rates should be reduced by introducing reserve averaging, improving communication with the market, and creating an interest rate corridor. Improving the functioning of standing liquidity facilities, to ensure that all qualified banks can directly and automatically access them at a predetermined price, will provide a ceiling for the corridor and also help strengthen liquidity management.

23. Authorities’ views. The authorities agreed that financial sector reforms were critical, and highlighted the progress already made in this area. They planned to introduce deposit insurance in the near future and advance deposit rate liberalization as circumstances allowed. They also agreed that removing implicit guarantees, pervasive throughout the financial and corporate landscape, was key. This saw moral hazard as distorting the allocation of credit and investment, posing a risk to the success of financial liberalization which rested critically on hard budget constraints. Linked to this, the authorities explained that their strategy for SOE reforms included leveling the playing field and opening up to more competition, with the exception of some strategic sectors. Regarding the monetary policy framework, they agreed on the importance of relying more on interest rates over time. They welcomed the joint IMF-PBC conference that was held on this topic in March (see: http://www.imf.org/external/np/seminars/eng/2014/pbc/).

Fiscal and other reforms

24. Improving fiscal management, especially of local government finances, will help contain risks and better allocate resources. The blueprint highlights improving local government finances as a priority. This includes better aligning local revenue with expenditure responsibilities as well as strengthening oversight and management of local government borrowing. The plan to put in place a new framework to limit local borrowing, improve reporting, and establish an early warning system should be implemented as soon as possible. In this context, the authorities envisage selectively ‘opening the front door’ while ‘closing the back door’ to municipal borrowing, with a recent pilot allowing some local governments to borrow directly from the market, under strengthened rules for creditworthiness, accounting, and transparency. Improving the fiscal framework is a priority for the medium term, especially strengthening budget processes and adopting a medium-term fiscal plan.

25. Tax reforms will promote more efficient and inclusive growth. The ongoing extension of VAT to services as a replacement for the existing business operation (turnover) tax is welcome. It is more efficient and easier to collect, and will encourage investment in services and reduce distortions caused by the cascading of a turnover tax. The planned introduction of a recurrent property tax, beyond the limited pilots in Chongqing and Shanghai, will help reduce speculative real estate activity, efficiently raise revenue, and improve progressivity. China’s revenue from real estate taxation is within the range of other countries; however, it comes almost entirely from transaction-related taxes and fees. Thus, there may be scope to offset some of the impact of introducing a property tax by reducing these transaction taxes and fees. The combined income tax and social contribution system is fairly regressive. Currently, social contributions raise nearly five times more revenue than the personal income tax, suggesting scope to rebalance toward PIT and make the combined system more progressive.

A01ufig9

Average Tax Wedge, by Income Level

(In percent of gross income)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: IBFD, CEIC and IMF staff calculations.

26. Social security reform has the potential to boost consumption and address inequality. On the expenditure side, further strengthening the pension and health insurance systems—including by improving and expanding coverage—would have macrobenefits such as reducing precautionary household savings. Social contribution rates, which are high and very regressive, should also be reduced as they distort the labor market, make growth less inclusive, and favor informal over formal employment. These reforms should be done in a way that ensures the sustainability of the social security system, including through parametric changes to the pension system and transferring the welfare and legacy components to the budget. The resulting costs to the consolidated general government will need to be offset by revenue gains from the improvements in the tax system (described above) and cuts in lower-priority spending. Staff analysis shows that such reforms are consistent with securing sustainable public finances (Box 6). Together with household registration (hukou) and rural land reforms, strengthening the social security system will make a significant contribution to elevating living standards, improving the labor market, and boosting labor income.

27. Rationalizing the use of natural resources will promote more environment-friendly growth. Options include adjusting prices, including through better calibration of excise and other taxes (such as a carbon tax on coal, fuel, and gas) to capture the cost of externalities, strengthening emission taxes, and strict enforcement of environmental regulations and incentives to use greener technologies. China already has a broad set of environmental laws and regulations, whose strict enforcement would be major progress in protecting the environment (Box 7).

28. Gradual further opening up the capital account is part of the reform agenda. Capital account liberalization is listed as one of the key reforms in the Third-Plenum blueprint and RMB internationalization is advancing (Box 8). The approach could include further expanding the list of domestic and international investors qualified to engage in capital account transactions under existing quotas, and gradually increasing these quotas. More immediately, the Shanghai Pilot Free Trade Zone established in 2013 liberalized certain restrictions for residents and financial institutions in the Zone: allowing them to set up accounts with higher capital account convertibility, easing controls on outward investments including in securities and derivatives and restricting inward FDI only by an announced ‘negative list.’ The pilot is designed to ‘test-drive’ liberalization and administrative simplification in a more narrow setting, and to apply the lessons learned as liberalization is broadened progressively. Staff welcomed the goal of capital account liberalization as a key objective of the Third-Plenum blueprint, noting that it had to be carefully sequenced with other reforms, in particular, in the financial, SOE and fiscal sectors and exchange rate flexibility.

29. Further improvements in data will help economic analysis and policymaking. Staff encouraged the authorities to graduate from the General Data Dissemination Standard (GDDS) to the Special Data Dissemination Standard (SDDS) and participate in the Coordinated Portfolio Investment Survey (CPIS). In the macroeconomic area, priorities include improving fiscal data, both timeliness and coverage; quarterly and annual national accounts especially expenditure data and labor market statistics. Data issues are discussed in more depth in the Informational Annex.

30. Authorities’ views. Fiscal reforms are central to the authorities’ reform plans. The welcomed the ongoing technical cooperation with FAD on improving the fiscal framework. They agreed that improving management of local government finances was a priority and were confident that their announced strategy would achieve this. Regarding the property tax, the authorities were studying the experience in the pilot areas, which helped in preparing legislation. They agreed that there was room to better calibrate the PIT and SSC to address inequality, but noted the current PIT schedule was already progressive. They added that SSC would be reduced at an appropriate time and pace, while stressing that any reforms to benefits and contributions had to take into account the importance of securing the long-term sustainability of the system. They agreed that an environment tax would help address externalities from pollution. They considered that appropriate targets and measures were in place to reduce air, water, and soil pollution, following the State Council’s approval of the amendments to the Environment Protection Law in April. Regarding data, the authorities were actively considering subscription to SDDS and have been working with STA to conduct technical preparations.

External assessment, exchange rate policy, and rebalancing

31. The external position is moderately stronger compared with the level consistent with medium-term fundamentals and desirable policy settings (Box 9). On that basis, the renminbi is assessed as being moderately undervalued. In terms of the External Balance Assessment (EBA) model, China’s policy gaps (policies different from desired ones, contributing to a moderately stronger external position) stem mainly from intervention, capital controls, and health spending. The pace of reserve accumulation slowed significantly in 2012, but picked up again in 2013 against the backdrop of large capital inflows induced by interest rate differentials, the relatively high real return of capital, and expectations of continued RMB appreciation. Reserves are above the range suggested by the Fund’s metric, rendering further accumulation unnecessary from a reserve adequacy perspective.

32. A flexible, market-determined exchange rate is an important part of the reform agenda. A market-determined exchange rate—in which there is no sustained, large, and asymmetric intervention—is key for sustained rebalancing and as a shock absorber as the capital account is progressively liberalized. Moreover, given the rapid growth in offshore renminbi markets and growing opportunities for financial arbitrage, it is also becoming increasingly important for maintaining an independent monetary policy. The recent doubling of the daily trading band is a welcome step forward. Looking ahead, the goal should be to allow greater flexibility and reduce intervention, which could be achieved by further widening the band and ensuring the central parity better reflects market conditions.

33. Sustained rebalancing will depend on successful implementation of the reform agenda. Implementation of the blueprint would help close the policy gaps identified in the EBA model by moving to a more flexible, market-determined exchange rate (reducing intervention); opening the capital account; and strengthening the social security system. Therefore, as reforms are implemented, the external position should reach equilibrium. As regards domestic rebalancing, the package of reforms will increase the share of consumption in GDP, with a corresponding decline in investment. Consumption will rise, for example, as social security reforms decrease household saving; the opening-up of the service sector spawns more labor intensive growth that boosts household incomes; and fiscal reforms and currency appreciation support higher household spending.

34. Authorities’ views. The authorities disagreed with the assessment that the real exchange rate was moderately undervalued and considered that it was close to equilibrium. They reiterated their previous concerns and strong reservations on EBA, and emphasized the importance of evenhandedness. In particular, they considered that the assessment failed to account for the impact of advanced economy monetary policies on global financial flows and emerging market economies, the continued narrowing of China’s current account surplus, two-way fluctuations of the exchange rate, substantial appreciation of REER, and the movements of other currencies (such as the U.S. dollar). On the current account, they expected a flat or declining surplus over time as they considered that the services deficit would likely continue to rise while the goods surplus would not increase significantly. On the exchange rate, they remained committed to moving toward greater flexibility and avoiding regular intervention. They reiterated that unconventional monetary policy in advanced economies was slowing progress in this regard. They agreed that external and domestic rebalancing would derive from successful implementation of the gamut of economic reforms in the Third-Plenum blueprint, and added that ongoing urbanization (with a target urbanization rate of 60 percent by 2020) would contribute to elevating living standards, improving the labor market, and boosting labor income.

B. Addressing Vulnerabilities and Managing Demand

35. The challenge for demand management is to allow the necessary adjustments in the economy to proceed, while at the same time preventing too sharp a slowdown in growth. Structural reforms will boost growth and help address vulnerabilities, but additional measures are also required. In particular, a reduction in off-budget spending, further reining in credit growth, and slower investment growth are required to contain risks. The drag on activity from these policies is bound to be felt right away, while the growth payoff from structural reforms will be down the road. Finding the right mix of reducing vulnerabilities and maintaining growth will be an ongoing challenge. For this year, the staff argued that the authorities’ should accept somewhat slower growth and deploy a stimulus only if growth were set to slow significantly below their target. At this point, such a stimulus does not appear to be warranted.

36. Quantifying the right speed for the economy is especially challenging at this juncture. There is considerable uncertainty regarding the rate of potential growth and the degree of resource misallocation in the economy (Box 10). Against this background, and consistent with focusing on the right policies to achieve the highest sustainable growth rate, consideration should be given to targeting a range instead of a particular point for GDP growth. For 2015, the staff suggested a target range of 6½–7 percent as consistent with the goal of transitioning to a safer and more sustainable growth path. In setting the range, consideration should be given to the following:

  • Reforms are needed to sustain even the lower potential growth rate. China’s potential growth has been falling in line with the pattern observed in other fast-growing Asian economies. Achieving this growth path over the medium term, however, will depend on the success in implementing structural reforms to unleash new sources of productivity growth.

  • Containing vulnerabilities likely implies somewhat lower near-term growth. Reducing unsustainable investment demand will affect key sectors, such as real estate (where adjustment has already started) and others with overcapacity. This will have a direct effect on economic activity, but also indirect effects as lower aggregate demand spills over to rest of the economy.

  • Policies will need to allow for correction in inefficient and overcapacity sectors. Macro support—if needed to prevent a sharp drop in demand and buy time for labor and capital to move to more efficient sectors—should be consistent with the reform agenda.

A01ufig10

China: Actual vs. Predicted Growth

(In percent, GDP per capita)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: IMF staff estimates and calculations.

37. Fiscal adjustment should ensure that government debt is on a sustainable path. This could largely be achieved by reining in local-government off-budget borrowing, which is a near-term priority and is consistent with other planned fiscal reforms (see Box 6). Consolidation in the augmented balance of about 1 percent of GDP a year on average over the next five years would put augmented debt on a declining path. The exact pace of adjustment each year should be calibrated to avoid an excessive slowdown—taking into account the growth impact of structural reforms and efforts to reduce vulnerabilities. If needed, fiscal support should preferably be deployed on-budget with measures aimed at protecting the vulnerable and advancing reform. Options include reducing social contributions, strengthening the social safety net, central government support for hukou reform, and priority infrastructure projects.

38. Ensuring financial stability will require continued reduction in overall credit growth and improving its allocation. TSF growth has slowed considerably since early-2013. The recent steps to strengthen supervision and regulation should help rein in shadow banking and shift activity to better-regulated formal banks (especially by prohibiting reliance of shadow banking on interbank market transactions). The measures are in the right direction, though continued vigilance is needed to ensure their effectiveness and to guard against the market finding new ways to circumvent the regulations. Further strengthening regulation and supervision remains a priority, particularly by ensuring a swift implementation of the already adopted measures. Ongoing financial sector reforms, such as liberalizing deposit rates and removing implicit guarantees, will also reduce credit growth and improve its allocation. In particular, average lending rate will likely increase and borrowing costs will rise for many SOEs benefitting from implicit guarantees, shifting lending to dynamic private firms that are currently rationed out of the formal credit market (yet able to afford higher interest rates given the value of their underlying projects).

39. Monetary policy should be calibrated to support the ongoing reduction in TSF growth while continuing to ensure low inflation. To help further slow and improve the allocation of TSF, monetary policy tools should complement the ongoing strengthening of regulations and supervision, financial sector reforms, and use of macroprudential tools. Consistent with the move to more price-based tools, liquidity management should increasingly target movements in interbank interest rates. Higher interbank rates in the second half of last year likely contributed to the slowing of TSF growth, although the extent is hard to assess in light of ongoing structural reforms and uncertainties about the evolving transmission mechanism. If TSF growth does not continue to slow, liquidity conditions should be tightened by gradually pushing interbank interest rates back up. However, this alone will not be sufficient to manage credit growth in the present environment, especially as many SOE borrowers may not be interest rate-sensitive. Therefore, macroprudential tools should also continue to be deployed.

A01ufig11

Interbank Repo Rate and Interest Rate Swap

(In percent, p.a.)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.

40. In the real estate sector, the challenge is to prevent a further build-up of risks, while avoiding a disorderly correction in the market. An adjustment in the market is needed and in line with the recommended slowing of credit growth. At the same time, preventing a sharp correction is important. Policies will have to vary by locality, but could include selective unwinding of demand control measures and building social housing. Care must be taken, however, to find the right mix of allowing adjustment to take place and supporting the market if necessary. Over time, the underlying pressure on real estate to expand should abate as (i) financial market reforms and capital account liberalization provide more investment alternatives; and (ii) reform of local government finances reduces incentives for real estate development as a source of revenues.

41. Authorities’ views. While the authorities agreed that a major stimulus was not needed at this juncture, they emphasized that they were committed to achieving this year’s growth target. On fiscal adjustment, they stressed the importance of controlling risks from local government borrowing and highlighted that this was flagged as a priority for 2014 in last December’s Annual Economic Work Conference. The authorities emphasized progress in improving financial sector regulation and supervision, especially the recent steps to improve the functioning of the interbank market which should help contain risks from off-balance sheet and nonbank intermediation. On real estate, they viewed the long-run dynamics of the market to be healthy, and considered a near-term correction manageable.

Scenarios and Spillovers

42. Fast implementation of reforms would have substantial benefits in terms of boosting living standards and reducing risks. Staff prepared three scenarios (Box 11) to illustrate the costs and benefits of pursuing reforms at various speed and intensity.

  • Fast reform. In a scenario with fast implementation of reforms growth would be somewhat slower in the near term. However, compared to alternative scenarios with slower or no reforms, income and consumption per capita would be higher by 2019. Debt is falling and credit growth is likely to be slower, leading to a faster reduction of vulnerabilities and eliminating the risk of a sharper slowdown.

  • Baseline (medium scenario). The staff baseline, which is an intermediate scenario, assumes that the Third-Plenum reforms are implemented, but largely in the latter part of this decade. As a result, the economy would remain on a more risky trajectory in the near term. Growth remains dependent on investment, and fiscal adjustment is more gradual and back-loaded, with debt stabilizing around current levels.

  • No reform. This scenario combines little or no implementation of reforms with continued reliance on investment to support growth. The unsustainable gains in growth in the short-term come at a steep cost of foregone growth over the medium term. Activity would have to rely increasingly on public and quasi-public investment; the augmented fiscal balance would increase further, putting the augmented debt ratio on an increasing trajectory; and rapid credit growth would continue, further increasing leverage. Ultimately growth would drop, initially because of the declining efficiency of investment and lower TFP growth compared to the reform scenario. Over time, the probability of vulnerabilities coming to the surface—leading to a sharp slowdown in growth—would increase, as reflected in the widening projection range.

43. The fast-reform scenario balances the goal of securing long-term growth, supporting activity in the near term, and reducing vulnerabilities. The growth payoff from reforms is projected to be relatively fast, while the impact of the initial slowdown on the labor market is cushioned by reforms supporting labor-intensive activities in the services sector (the flexibility of China’s labor market will facilitate the reallocation process). Regarding debt dynamics, staff analysis shows that the risk of unsustainable dynamics is high in the ‘no-reform’ scenario and, even with China’s substantial cushion, debt is not robust to shocks in the intermediate (baseline) scenario, pointing to persistent vulnerabilities (see Appendix V).

44. Fast reforms are good for China and good for the world. In the near term, the spillovers to the global economy would be slightly negative in aggregate, with some variation across countries depending on the extent of trade linkages. However, over time, the benefits of stronger growth in China dominate. By 2019, global income is higher than in the baseline and most countries are better off, although the impact is differentiated by the nature of current trade exposures to China. In particular, while the growth of commodity consumption is unlikely to slow down sharply, its composition will change as the economy transits towards a more balanced growth (April 2014 World Economic Outlook, Chapter 1). Similarly, benefits from future China growth will accrue increasingly to countries with comparative advantage in the production of goods sought by increasingly sophisticated Chinese consumers (such as durable goods producers in advanced economies.1

A01ufig12

Simulated Global Spillovers from China’s Reform Blueprint

(In percentage points)1

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: Preliminary staff simulation results based on FSGM-G20 model.1 Adjusted for a one percentage change in China’s GDP growth.

45. Authorities’ Views. The authorities agreed that deepening reforms will be critical for transitioning the economy to a more sustainable growth level. While implementation could be challenging, they remained committed to the reform blueprint, noting that China had a strong track record with reforms over the last three decades. They added that implementation would not necessarily slow growth, since reforms would unleash productivity gains that would boost growth.

Staff Appraisal

46. Last year’s Third-Plenum reform blueprint marked the start of a new chapter in China’s development. Successful implementation of reforms will ensure that China can achieve the fastest sustainable growth going forward and continue to converge toward high-income status. The policy support deployed since 2008/09 in response to the GFC boosted domestic demand, which successfully sustained growth, provided a welcome lift to the global economy, and helped reduce external imbalances. However, five years of strong growth in capital spending and credit has resulted in declining investment efficiency and a significant buildup of debt. As recognized in the authorities’ blueprint, the challenge now is to shift gears, reduce the vulnerabilities accumulated since the GFC and transition to a sustainable growth model, while at the same time avoiding too steep of a slowdown in activity.

47. Growth in 2014 is expected to be in line with the authorities’ target. Domestic demand growth has been moderating, reflecting slower investment growth and a correction in real estate activity, partly in response to measures taken by the authorities to rein in credit growth and address financial market vulnerabilities. As activity slowed, the authorities have taken several measures to support growth, targeted at priority areas. As a result, staff projects annual growth this year around the authorities’ target of around 7½ percent. Consumption and the labor market are holding up well, and the global recovery is expected to support external demand going forward. Inflation is expected to remain well below the authorities’ target of 3 percent.

48. Vulnerabilities, however, continue rising. The post-GFC period has been marked by a large expansion in credit and investment. However, investment efficiency has been declining, casting doubt about the quality of assets underlying the build-up of debt. In particular, there are signs that important parts of the real estate market, a key driver of growth, are over supplied even though prices have yet to adjust significantly. Moreover, the vulnerabilities in the financial, fiscal, corporate, and real estate sectors are interconnected, so a shock in any one sector could be amplified through a negative feedback loop. However, if a shock were to occur that threatens to trigger a disorderly adjustment, the authorities have policy buffers to prevent a sharp slowdown in growth. Therefore, the probability of a hard landing in the near term is low. However, repeated reliance on these buffers without addressing the underlying vulnerabilities and changing the growth model compounds the risk of an eventual sharp slowdown and financial disruption, especially as the size and complexity of the financial system are rising fast.

49. Implementation of the authorities’ reform blueprint will secure higher-quality, sustainable growth. Giving the market a more decisive role, eliminating distortions, and strengthening institutions will result in a more efficient use of resources, faster productivity growth, and rising living standards across the income spectrum. Priorities include:

  • Financial sector reforms to support the real economy by better allocating savings and investment. This includes strengthened regulation and supervision, deposit rate liberalization, increasing reliance on interest rates as an instrument of monetary policy, and elimination of the widespread implicit guarantees across the financial and corporate landscape.

  • Fiscal and social security reforms to strengthen public finances, boost consumption, and foster more inclusive and green growth. This includes reordering local government finances by better aligning local revenue with expenditure responsibilities, with strengthened oversight and management of local government borrowing; reducing social security contributions, which are high and regressive; and improving pension and health benefits. To ensure sustainability of public finances, this should be combined with parametric reforms to the social security system, shifting the welfare and legacy parts of the pensions to the budget, improvements in the tax system, and cuts in lower-priority spending.

  • Further progress toward a more flexible, market determined exchange rate with no sustained, large, and asymmetric intervention. This will support domestic and external rebalancing, and is becoming increasingly important for China to have an independent monetary policy.

  • SOE reforms to level the playing field between private and public sectors, by opening up more sectors, especially services, to competition; rationalize resource and financing costs; increase dividend payments to the budget; and harden budget constraints.

50. Reforms will support sustained external and domestic rebalancing. While external imbalances have been reduced considerably since the global financial crisis, the external position is still moderately stronger compared with the level consistent with medium-term fundamentals and desirable policy settings. On the domestic side, continued rapid investment growth underscores the priority of rebalancing toward more consumption. Successful implementation of the reform blueprint—including a more flexible exchange rate regime—will support the desired shift away from investment toward consumption, and further reduction in the current account surplus as aggregate savings fall by more than investment.

51. Demand management needs to focus on reducing vulnerabilities while preventing growth from slowing too much. In particular, a reduction in off-budget spending, further slowdown of credit growth, and less investment growth are required to contain risks. The drag on activity from these policies is likely to be felt immediately, while the full growth payoff from structural reforms will take more time. Finding the right mix of reducing vulnerabilities and maintaining adequate growth will be an ongoing challenge. Vulnerabilities, however, have risen to the point that containing them is a priority and, therefore, stimulus should only be deployed if growth risks slowing significantly below this year’s target. Although stimulus does not appear warranted at present, if it were to become necessary, then fiscal policy should be the first line of defense, preferably deployed on-budget with measures aimed at protecting the vulnerable and advancing reform.

52. Staff commends the authorities for initiating bold economic reforms to secure a more sustainable, inclusive, and environmentally-friendly growth in China. The challenge is to implement the reforms, carefully yet with determination, and not to return to over-reliance on policy buffers as soon as the unavoidable cost of reforms begins to show. Macropolicies will need to be calibrated to avoid too sharp a slowdown, but not at the cost of adding to vulnerabilities and the risk of falling into a low-growth pattern. Growth expectations should be guided by the principle of achieving the highest sustainable growth: this means a focus on the needed reform policies, and accepting growth outcomes within a range that is likely to be somewhat below the current pace. The benefits will include much higher income in the future as the reforms unleash new sources of sustainable growth. A result that would be good for China and good for the global economy.

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

Real Estate: Impact of a Market Correction

The real estate market appears to be undergoing a correction. While a slowing of investment and construction would have a significant impact on growth, an orderly adjustment is factored into the staff’s baseline scenario.

Real estate has been a key engine of growth in China.

Together with construction, it directly accounted for 15 percent of 2012 GDP, a quarter of fixed-asset investment, 14 percent of total urban employment, and round 20 percent of bank loans. In addition, the sector has close links to several upstream and downstream industries. Local governments rely on land sales—closely linked to activity in the sector—as an important source of funding (see Box 3), and real estate is extensively used as collateral for corporate sector borrowing. As a result, a decline in real estate investment could significantly disrupt financial and real activity in China. Ahuja and Myrvoda (2012) estimate that a reduction in real estate investment by 10 percent could reduce GDP growth by about 1 percentage point.

A01ufig13

Real Estate Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calculations.

Recent data suggest that several regions are in oversupply. Residential real estate inventories have increased sharply in Tier III and IV cities, as well as in the industrial Northeast (including Shenyang and Changchun) and parts of the Coast (including Hangzhou, Dalian, Fuzhou and Wenzhou). Commercial real estate, meanwhile, appears to be in oversupply across most regions. In terms of residential price dynamics, Tier II and Tier III/IV cities have performed the weakest, with prices in the latter group falling on month-on-month basis recently. The hardest-hit geographical areas include the industrial Northeast and the Coast. However, developers seem reluctant to cut prices because it may lead new buyers to stay on the sidelines and cause problems with those that bought earlier at higher prices.

Distortions weigh heavily on the property market. On the supply-side, the market is distorted by local governments’ reliance on land sales to finance spending. This helps explain the over-supply in many Tier III/IV cities. On the demand side, the market is prone to speculation since housing is an attractive investment given low deposit rates, a lack of alternative financial assets, capital account restrictions, and a history of robust capital gains. This helps explains why, especially in top-tier cities, prices appear to be overvalued and price-to-income ratios remain high—even though, thanks to rapid income growth, affordability indicators have generally been improving.

Real estate appears to have entered a downturn. As of May, average residential price growth started to turn slightly negative, and there were declines in transactions (10 percent) and new starts (12 percent). Real growth in investment has fallen from almost 20 percent in 2012 and 2013 to around 10 percent by May. While the previous downturns, such as 2008 and 2012, were driven by policies to cool the market, the current one has come without a direct tightening of real estate policies and appears driven by overcapacity and concerns about future capital gains.

An orderly correction in real estate should be manageable. The staff baseline assumes that real estate investment slows to around 5 percent in 2014, stalls in 2015, and gradually recovers thereafter. It takes into consideration low leverage of homeowners, underlying housing demand fundamentals, and government ability to support developers if needed and take other measures (such as removing purchase and lending restrictions, and accelerate infrastructure and social housing construction). On the other hand, risk of large drop in final (investor) demand has increased even if underlying, medium-term home ownership demand is sound. If the market were to undergo a sharper correction—with new starts declining by, say, 30 percent for the year (compared to 20 percent year-to-date), which implies a -3½ percent year-on-year growth in residential investment—then GDP growth would likely be around ¾ percentage point lower than in the baseline (in the absence of offsetting measures).

Box 1 Figures:
Box 1 Figures:

Real Estate: Impact of a Market Correction

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Housing Administration Bureau; and IMF staff calculations.

Corporate Leverage in China

Staff analyzes listed-firm level data, which appear broadly to mirror China’s overall corporate sector. While the level of corporate debt has increased, most firms have healthy leverage and interest rate coverage ratios. The build-up of debt is concentrated in a “fat tail” of highly leveraged large firms mostly in real estate and construction. Overall risk remains manageable given its concentration, which highlights the importance of the real estate sector.

Debt accumulation. Overall corporate debt has increased from 92 percent of GDP (average 2003–07) to about 110 percent of GDP in 2013. The level is among the highest in the region. Among listed companies (which hold about 30 percent of GDP in debt), a significant part of the increase in corporate debt after the global financial crisis concentrated in a few large firms in real estate and construction.

Leverage ratio. While private companies, with the exception of real estate and construction companies, have been deleveraging since 2007, SOEs’ leverage ratios has edged up. Real estate and construction companies, especially the SOEs, however, have increased their leverage ratios significantly.

Fat tail of highly leveraged companies. The buildup of leverage is concentrated in a ‘fat tail’ of firms. The top 50 firms of some 2000 firms accounted for nearly half of the total liabilities of listed firms, a rise of over 20 percentage points of total corporate liabilities over the last decade. Most of the increase was in the real estate and construction sector where about 80 percent of total liabilities of the sector belong to about 60 firms with leverage ratios higher than 300 percent. Highly leveraged local SOEs in mining and utilities also increased their borrowing significantly.

Profitability. Private firms’ profitability in listed firms peaked in 2007 and has fallen since, in line with the slowing economy. Profitability of SOEs, however, has remained stagnant over the last decade. The profitability of low-leveraged firms exceeded that of high-leveraged firms by a margin of 2–2½ percentage points, but the margin narrowed significantly in the past year.

Effective interest rates. Effective interest rates do not seem to reflect the underlying risk profile of listed firms as real estate and construction firms, with higher leverage, enjoyed much lower interest rate levels after the global financial crisis.

A01ufig15

Effective Interest Cost1

(In percent)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: WIND; and IMF staff estimates.1 Including interest expenses on short-term and long-term loans, bonds, and debt.
A01ufig16

Percentage of Firms that Faced Negative Earnings, by Industry

(In percent)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: WIND; and IMF staff estimates.

Sensitivity to shocks. Private firms’ interest coverage ratios are less sensitive than SOEs’ to a change in interest rates. Real estate and construction firms, however, are more sensitive to a rise in interest rate given the high level of debt. Firms with strong links to the real estate sector are most sensitive to a real estate sector downturn, including those oversupply sectors such as construction materials.

Overall assessment. While total debt level has increased, the corporate sector on average has deleveraged over the years, and risk appears manageable given its concentration. The level and concentration of risk highlights the importance of the real estate sector, and the need for focused efforts to deal with excess leverage areas and companies, including well-managed exits where appropriate.

Box 2 Figures:
Box 2 Figures:

Corporate Leverage in China

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; WIND database; and IMF staff calculations.

Local Government Finances

Local governments were at the front lines of the post-GFC stimulus, supporting activity through a considerable rise in investment. Such investment, which has generally been financed off-budget through LGFVs, has remained large and, unless rationalized going forward, would put increasing strains on local government finances and pose risks to financial stability and growth.

During the post-GFC period, local government investement provided significant support the economy. Data for 2009 to 2013 suggest that growth in provincial LGFV liabilities was significantly correlated with provincial investment growth, especially in the central and western regions.1 This underscores the role of LGFVs in supporting activity on the one hand, but also in exacerbating the reliance on credit and investment as an engine of growth. Such investment spending was usually financed off-budget, either through LGFVs (in order to circumvent borrowing restrictions) or land sales.

Local governments have continued to borrow at an unsustainable pace. Augmented net borrowing, which includes off-budget borrowing by LGFVs (but treats land sales “above-the-line”), has remained high and rose to 7½ percent of GDP in 2013. Based on provincial audit results, in 2013 outstanding provincial debt was equivalent on average to nearly 70 percent of consolidated fiscal revenue or around 23 percent of provincial GDP. Adding government guaranteed and contingent liabilities would push the average to about 33 percent of provincial GDP, and over 60 percent of GDP in some provinces—a high level given the small revenue base. The debt burden is often higher for those provinces that rely more on off-budget LGFV activity to support growth, heightening risks to debt dynamics.

Local government finances are exposed to a correction in the real estate market. Many local governments rely on net revenue from land sales to finance large public infrastructure investment. Though provincial-level land sales are not available, aggregate gross land sale revenue was sizeable at about 7 percent of GDP in 2013 (net land sale revenue was 2½–3 percent of GDP after accounting for expenses related to city construction, land development, and compensation for relocation). Land sales could slow considerably if real estate development cools. In addition, tax revenues could also shrink in face of a real estate slowdown. Excluding land sales, tax revenue from real estate and related sectors was about one-fifth of tax revenue in some provinces.

At the moment, risks appear manageable, although the system of local borrowing is nontransparent, making the assessment difficult. The snapshot of local government debt and contingent liabilities in last year’s NAO report suggests that China’s public sector still retains significant fiscal space. However, despite good social and commercial returns on some of the investments, many provinces and localities rely excessively on LGFVs to support growth. The overall trend in local government finances is unsustainable and needs to change, also because linkages to financial system and real estate sector are increasingly complex and potentially difficult to manage. Regular data updates and more information about forward spending commitments (for example, through PPP type arrangements) are needed to assess evolving risks.

Box 3 Figures:
Box 3 Figures:

Local Government Finances

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

1 The weaker relationship between growth in fixed asset investment and LGFV activity in coastal regions possibly reflects the fact that a larger share of coastal LGFVs operate on a commercial basis, engaging in noninvestment activities.

Rapid Growth in Shadow Banking and Internet Finance

“Shadow banking” has increased rapidly, contributing to the strong growth in credit (TSF) and posing new types of risks to the financial system. On the positive side, it marks a move toward more market-based instruments and represents, de facto, a liberalization of pricing and allocation of credit in the economy. However, it also reflects regulatory arbitrage, allowing intermediation to side-step prudential safeguards.

Shadow banking. Market analysts often define shadow banking in China as TSF less bank loans (and a small amount of equity-like items). It is comprised of trust loans, bankers acceptances, entrusted loans (corporate-to-corporate lending administered by a bank), and interbank corporate bonds (see Figure 2). As such, it includes direct credit extension by banks off-balance sheet and by nonbank financial institutions, especially trust companies and securities firms. After bank lending conditions were tightened following the 2009–10 credit boom, the shadow banking system took off. By March 2014, the stock of shadow banking had risen to nearly 53 percent of GDP, with annual growth rates averaging around 30 percent during 2012-13. China’s shadow banking activities typically involve direct lending to the real sector and are often closely tied to commercial banks. For example, trusts rely on banks for funding, banks are also allowed to hold controlling shares in trust companies, and entrusted loans also are administered by banks.

Internet financing. Since mid-2013, internet-based money market funds have experienced exponential growth, albeit from a low base (as of Q1:2014, they were the equivalent of about 0.5 percent of total bank deposits). The growth reflects low transaction costs, access to a large network of potential customers, and the ability of small investors to acquire new financial products. However, it also benefitted from interest rate and regulatory arbitrage. Currently, close to 100 percent of the funds are reinvested in the banking sector either in the form of nonstandardized certificates of deposit (so-called agreement deposits) or via the interbank market (bonds and repos), limiting systemic risk, but as competition in the sector increases, money market funds are likely to invest in riskier assets, including in commercial paper.

Risks. Wealth management products (WMPs)—deposit-like instruments used to fund parts of shadow banking—have grown rapidly and risen to over 10 percent of GDP. Notwithstanding safeguards such as minimum investment thresholds and risk disclosures, investors may believe that WMPs are implicitly guaranteed. As such, even though in principle the risk is transfered to the investor, in practice many investors are unlikely to undertake adequate due diligence on the underlying assets in the WMP. Moreover, losses on fixed-income WMPs are almost unheard of, exacerbating this risk. Shadow banking assets, including those funded by WMPs, may be of lower quality (such as claims on highly leveraged LGFVs or real estate firms). Shadow banking also involves maturity transformation, using lengthened intermediation chains that run through the interbank market. This reliance on short maturities to fund lending for long-term projects could contribute to spikes in liquidity demand and volatility in the interbank market. On the positive side, although China’s shadow banking system is neither simple in structure nor transparent, it is not dominated by complex derivatives and massive leverage.

Regulation. The authorities have strengthened regulation of shadow banks, including tightening regulation of nonstandard credit products, forbidding trusts from funding cash payouts on maturing products with the proceeds from new WMP sales, and restricting ways to fund off-balance sheet credit through the interbank market. Although parts of internet financing is regulated by various agencies, the rapid growth warrants more comprehensive and coordinated regulation.

Finding the right balance. Financial innovation is benefiting both savers and investors, but the rapid growth also poses challenges for (i) investors to assess the risk of the products they are buying, especially given the rarity of defaults; (ii) regulators and supervisors to keep up with the pace of innovation; and (iii) policymakers, as traditional measures of monetary and credit aggregates become less reliable. The authorities’ intention to liberalize interest rates, strengthen regulation and supervision (including of shadow banking), and use more market-based instruments to control credit will reduce the incentive for shadow banking activities.

Box 4 Figures:
Box 4 Figures:

Rapid Growth in Shadow Banking and Internet Finance

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: WIND information; and IMF staff estimates and calculations.

International Perspective on China’s Credit Boom

China’s recent credit boom is not unprecedented from an international perspective. However, the precedents also illustrate the risk, as most of them led to a recession, banking crisis, or both.

Credit measurement. Three measures of credit are used in the analysis. While the closely monitored TSF is a more comprehensive measure of credit to the economy, it has some shortcomings for international comparison. Specifically, it includes nonbank components of lending and some equity-like instruments. Bank credit to the nonfinancial sector is a more conventional and internationally comparable measure, defined as depository corporation’s claims on nonfinancial institutions. Compared to TSF, it excludes items such as trust financing, corporate bonds not purchased by depository corporations, and entrusted loans. A third measure is ‘adjusted TSF’ which, aside from some components of nonbank credit, also subtracts credit to the public sector (mainly LGFVs) that is included in the augmented fiscal debt. This avoids double-counting LGFV debt as both private and public sector, and provides a clearer picture of credit flowing to the private sector.

A01ufig20

Adjusted Total Social Financing, by Components

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff estimates.

Credit boom: deviation from gap. Dell’Ariccia, Igan, and Laeven (2012) find the deviation in percentage points of credit-to-GDP from trend (“credit gap”) to be a good predictor of a financial crisis.1 They used deviation from cubic trend, which applied to China shows signs of credit boom only during 2008–09. Using instead the deviation from real-time HP trend suggest a large boom in 2008–09 and a smaller one 2012–13. These general results hold across different measurement of credit. However, because trend credit growth in China is so fast, these “credit gap” techniques may understate China’s credit boom.

A01ufig21

Credit Booms and Change in GDP Growth Rates

(In percentage points)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: IMF staff estimates and calculations.

Size and pace of credit accumulation. Previous studies suggest that a credit boom that starts from a higher level of credit-to-GDP ratio and lasts for longer period is more likely to precede a systemic banking crisis. In the past five years, China’s TSF stock increased by 73 percent of GDP,2 while adjusted TSF and bank credit to nonfinancial sector increased by around 30 percent of GDP. Looking at a sample covering 43 countries over 50 years, staff identified only four episodes that experienced a similar scale of credit growth as China’s recent TSF growth. Within three years following the boom period, all four countries had a banking crisis. With a lower threshold of a 30-percent-of-GDP increase in credit over five years, there are 48 episodes of credit boom, half of which were followed by banking crises.

1 G. Dell’Ariccia, D. Igan, and L. Laeven, “Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market,” Journal of Money, Credit and Banking, Vol. 44, No. 2–3 (2012), pp. 367–84.

Fiscal Options: Reducing the Deficit and Promoting Inclusive Growth

A menu of fiscal measures could be used to reduce the augmented deficit, by around 5 percent of GDP over the medium term (as recommended by staff), while at the same time increasing social spending and fostering more inclusive growth.

Revenue measures

Extending VAT to servcies. In 2013, revenue from the VAT and business operation tax was 8.1 percent of GDP. If the VAT was extended to services (replacing the business operation tax) at the current standard rate of 17 percent rate on goods—as opposed to the 6 or11 percent being applied to some services—revenue would likely go up by over 2 percent of GDP. Given the benefits of minimizing the use of exemptions and multiple rates, a case could be made for using a single VAT rate for all goods and services. For example, applying a single VAT rate of around 13-14 percent for all goods and services would likely raise an additional ½–1 percent of GDP in revenue.

Personal income tax (PIT) and social security contributions (SSC). The PIT currently raises only 1 percent of GDP in revenue, which is low by international standards. While it already embeds a strong progressive schedule, the top marginal rates apply only to very high income brackets. Applying the top marginal rates to more households, combined with stronger enforcement and compliance, would increase revenue while also mitigating inequality. In addition, a broader reform could reduce the highly regressive SSC. Bringing PIT revenue closer to international levels would leave scope to reduce SSC for low income groups, and still raise an additional 2–3 percent of GDP in revenue.

Recurrent property tax. While the share of tax revenue from property is not low by international standards, China differs in that such revenue is mostly levied on transations. A gradual shift towards a recurrent property tax would yield higher and more stable revenue. For example, bringing the level close to the OECD average could raise additional revenue of 1–1½ percent of GDP.

Environmental tax and fees. China collected around 1½ percent of GDP in 2011 in environmental taxes and fees (mostly fees and penalties). An additional 1 percent of GDP could be raised by moving up to the advanced economy average. Also, switching from fees to taxes could help better protect the environment.

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Note: World Bank China 2030; data as of 2007, except for China as of 2008.

Expenditure measures

Less reliance on public investment. Public investment and infrastructure spending (including by LGFVs) could be reduced by about 5–6 percentage points of GDP over the medium term, returning it to roughly the same level that prevailed before the GFC.

Increase in social spending. A reform scenario in China 20301 proposed to increase public expenditures by 7–8 percent of GDP by 2030, including the effect of population aging (demographic changes are discussed in more detail in Box 4 of the previous year’s staff report) 1 percent of GDP for education; 2–3 percent of GDP for healthcare; and 3–4 percent of GDP to fully finance the basic old-age pension and meet the legacy costs of current obligations. If done gradually, social expenditure could reach 15–16 percent of GDP by 2020, which is around the average for middle income countries.

Box 6 Figures:
Box 6 Figures:
Box 6 Figures:

Fiscal Options: Reducing the Deficit and Promoting Inclusive Growth

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

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1 World Bank and the Development Research Center of the State Council, P. R. China. 2013. China 2030: Building a Modern, Harmonious, and Creative Society. Washington, DC: World Bank.

Fiscal Policy for Greener Growth

China’s economic success has come at a high cost to the environment.1 The authorities have recognized the need for reform and have taken steps to reduce the economy’s reliance on natural resources and energy. Market-driven reforms could complement the traditional more administrative approach.

Collection of environmental taxes and fees is low. While China levies a variety of resource and vehicle taxes and pollution fees, total collection is low compared to OECD countries and only a fraction of the levels required to fully internalize the costs of climate change, local pollution, and congestion externalities. The Third-Plenum blueprint calls for the prices of water, oil, natural gas and electricity to be deregulated. However, taxes and other market mechanisms should be used as well to ensure prices reflect the full cost of externalities from energy and resource use.

A01ufig23

Environmentally-Related Taxes in China

(In percent of GDP, 2011)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: OECD; and IMF staff calculations.

Several tax policy instruments are available to complement the government’s current reform agenda.

Carbon tax. An upstream tax on fossil fuels based on carbon emission rates could be considered. A tax imposed at the pollution’s point of entry in the economy (such as coal mine, energy plants, petroleum refineries) would reduce the number of agents to tax and thereby reduce the administrative burden. It would also build off the administrative structures already in place for China’s resource taxes. A carbon tax levied upstream would also provide the necessary incentives for emission-reducing behavior throughout the economy since energy prices would increase uniformly across all sectors of activity.

Tax on local air pollutants: The current pollution levies on SO2 and NOx emissions and small particulates could also be significantly increased, and their legal status upgraded to full fledge taxes. This would facilitate enforcement and would ensure they provide the necessary incentives to reduce emission levels as their current rates are only a fraction of estimated health costs of local pollution.

Fuel taxes: Excise duties on gasoline and other petroleum products could be further increased to cover the negative externalities associated with greenhouse gas emissions, local pollution, congestion and accidents. To cover these costs, the effective tax rate on gasoline could increase from its current level of 40¢ per liter to roughly 55¢ per liter. This would be comparable to other countries’ current tax levels on gasoline and significantly lower than Japan (75¢ per liter) and South Korea (85¢ per liter).

Vehicle taxes: China’s current sales taxes on vehicles are based on engine capacity. While this provides a reasonable proxy for the environmental damage caused by cars, an alternative would be to use a graduated system based on vehicles’ emissions level. This could take the form of an ad valorem excise tax on vehicle value to meet revenue objectives and revenue neutral ‘feebate’ on emission rates to promote environmental objectives. This feebate structure would impose an additional fee on cars that are more polluting than some predetermined reference threshold and provide a rebate for cars that generate less emissions than the threshold.

1 See IMF Country Report No. 13/211, .Box 3

RMB Internationalization

RMB internationalization continued to advance with trade and FDI settlement in RMB expanding rapidly in recent years. In 2013, RMB business further expanded to other financial centers beyond Hong Kong SAR. However, while growing fast, offshore RMB deposits are still a small share of total Mainland RMB deposits.

Strong growth in RMB settlement. According to SWIFT payment data, the RMB is now ranked seventh in the global payments. RMB trade settlement continued to increase in 2014 with the share of trade in goods settled in RMB up from 12 percent in 2013 to 17 percent from January–May 2014. However, the settlement share slowed in most recent months, possibly reflecting the depreciation of the RMB. The share of FDI settled in RMB increased to about 22 percent by end 2013.

A01ufig24

Cross-Border Trade Settlement

(In RMB bn)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC; and IMF staff calcualtions.

Offshore centers. Hong Kong SAR is a leading hub for RMB payment with a market share of over 70 percent, followed by Singapore (about 7 percent) and London (about 6 percent). Reflecting the growing cross-border use of RMB, RMB clearing banks have been set up in a number of financial centers including Seoul, Singapore, and Taiwan Province of China, Hong Kong SAR, and Macao SAR in Asia and the Pacific, and Frankfurt and London in Europe. Offshore RMB (CNH) in Hong Kong SAR became one of the most heavily traded EM currencies. CNH and CNY (onshore RMB) generally track each other closely. The dim sum bond market continued its strong growth with the value of year-to-date issuance almost reaching the total of 2013. RMB deposits in Hong Kong SAR increased to about 13 percent of deposits in the Hong Kong SAR banking system. For perspective, however, this represents just 0.9 percent of RMB deposits in the Mainland.

A01ufig25

RMB as World Payments Currency in Value

(May, 2014; customer initiated and institutional payments. Inbound and outbound traffic. Based on value.)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: SWIFT watch.
A01ufig26

Spot Exchange Rate

(In RMB/USD)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: Haver Analytics; Bloomberg; and IMF staff calculations.
A01ufig27

CNH Bonds: New Issuance

(In billions RMB; by issuer sector and type of rating)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: Bloomberg; and IMF staff estimates.1 YTD June, 2014

External Assessment

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

Recent balance of payments developments. The current account surplus fell to 1.9 percent of GDP in 2013 from 2.6 percent of GDP in 2012, on account of larger service and income account deficits while the trade surplus remained broadly unchanged. A significant part of the increased service deficit was driven by strong growth in outbound tourism spending. The current account surplus is projected to worsen slightly in 2014, and to increase to around 3 percent of GDP over the medium term. This is about 1 percent of GDP lower than projected at the time of the last external assessment, largely due to a revised outlook for the services account in light of recent developments. The average REER appreciated by 6 percent, similar to the 2012 appreciation. By May 2014, the REER was at about the same level as its 2013 average.

Foreign assets and liabilities. Gross foreign assets, at 65 percent of GDP at end-2013, are dominated by foreign reserves (42 percent of GDP), while gross liabilities, at 43 percent of GDP, mainly represent FDI liabilities (26 percent of GDP). The net IIP ratio (21 percent of GDP) has declined since the global financial crisis in light of the smaller current account surpluses, valuation changes, and still-fast growth of GDP. Given the large net IIP, international investment vulnerabilities are low.

FX intervention and reserves level. The pace of reserve accumulation slowed significantly in 2012, but picked up again in 2013 against the backdrop of large capital inflows induced by interest rate differentials, the relatively high real return of capital, and expectations of continued RMB appreciation. Further accumulation is unnecessary from a reserve adequacy perspective.

Estimate of Current Account and REER Gaps (EBA)

  • Current account gap. The External Balance Assessment (EBA) current account balance approach estimates that China’s 2013 surplus, adjusted for cyclical factors, is 1.6 percent of GDP above the level consistent with fundamentals and desirable policies (compared with 1.8 percent of GDP in last year’s EBA). The gap is mainly attributed to a lower-than-desired level of social spending and excess reserve accumulation. Accounting for uncertainty about the cyclical adjustment adds a range of +/-1 percent to the point estimate, which implies a current account gap of about 1–3 percent of GDP.

  • REER gap. The current account gap translates to an undervaluation of the REER of about 4-12 percent (applying the same trade elasticities as in the 2013 EBA). The EBA REER regression points to undervaluation of 12 percent (similar to last year’s EBA). 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. The REER appreciation has been consistent with changing underlying fundamentals (especially faster productivity growth than in trading partners), but not sufficient to eliminate a moderate undervaluation.

A01ufig28

Real Effective Exchange Rate

(2000=100)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

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

Potential Growth and Output Gap1

There is strong evidence that potential growth has slowed. Going forward, how fast the economy can grow will depend on reforms, especially those to boost productivity. The estimates of a small negative output gap do not call for a policy stimulus, but instead point to the need for domestic rebalancing to contain vulnerabilities.

Potential growth has declined. Several estimation methods point to a slowdown in potential growth to around 7½ percent. A cross-country convergence regression, moreover, suggests that this would be in line with the convergence path of fast-growing Asian economies.

The slowdown and future path of potential GDP are determined in large part by productivity growth. Estimates using a production function indicate that the slowdown in potential GDP largely comes from lower productivity growth (investment becomes less efficient). Continuing along a fast convergence path will require boosting productivity growth, which points to the importance of structural reforms.

A01ufig29

China: Potential growth decomposition

(In percent; contribution)

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Source: IMF Staff estimates and calculations.

The estimates suggest a small negative output gap, but stimulus to close it is not warranted in China’s case. Univariate filters or multivariate filters that link the output gap to inflation generally find a small negative gap. However, adding information about capacity utilization to the multivariate filters yield different results. A time series on capacity utilization is not available and the results are sensitive to the measure used. Measuring capacity utilization by diffusion indices points to a small negative gap, while the gap derived from extrapolating sector-specific capacity utilization—showing much more overcapacity—is large. This variation in the results highlights the degree of uncertainty, but on balance the smaller output gap seems more consistent with the dynamics of broad price indices (CPI and GDP deflator). However, such economy-wide measures of the gap hide differences between sectors: (i) several sectors (such as mining, steel, cement, and glass) suffer from overcapacity, with excess supply pushing down producer prices (PPI); (ii) other manufacturing sectors are more efficient, with productivity growth supporting low inflation, solid profits, and growing wages (suggesting little slack in the labor market); and (ii) the service sector expands steadily, with higher inflation reflecting strong demand and wage growth.

Including financial-cycle information highlights vulnerabilities in the structure of demand and the need for domestic rebalancing. Borio (2013) argues that while growth may be considered sustainable if it is consistent with low and stable inflation, in reality it may be on an unsustainable path when financial imbalances are building up. Including credit growth in the estimates for China yields a large positive output gap. This result, combined with the sectoral pattern discussed above, illustrates the potential imbalances between supply and demand. Credit-driven investment has increased economy-wide capacity without generating new sustainable sources of demand other than the investment itself, which cannot continue given growing inefficiencies and high leverage. Solving this requires rebalancing toward a more consumer-based growth model. One where rising household income—fueled by strong growth in the more labor-intensive service sector, supported by reforms—generates sustainable growth in demand for consumption, including for more services.

Box 10 Figures:
Box 10 Figures:

Measures of Output Gap

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff calculations.
1 Based on Maliszewski and Zhang (forthcoming), IMF Working Paper: “‘China’s Growth: Can Goldilocks Outgrow Bears?”

Giving Credit for China’s Slowdown—The Third-Plenum Reform Blueprint1

Reforms would put growth on a sounder footing with higher per capita income and consumption over the medium term, benefitting China and the global economy.

Three scenarios. The staff’s baseline scenario, which assumes gradual implementation of reforms, is compared to scenarios of “fast reform” and “no reform.” The baseline and fast reform scenarios include:

  • Financial sector reforms include accelerating deposit rate liberalization, establishing a formal deposit insurance system, and strengthening financial supervision and resolution framework. These would encourage a better pricing of risk (increasing average cost of credit) and redirect credits to more efficient uses.

  • Fiscal reforms include a gradual unwinding of borrowing from LGFVs, improving coverage and portability of basic pensions and health insurance, strengthening social safety nets, and more efficient and redistributive taxes. These measues (see Box 6 for details) would reduce investment, creating room to increase social spending for a gradual reduction of the augmented deficit by about 5 percentage points of GDP over the medium term. They would also gradually reduce the household saving rate due to a lower incentive for precautionary saving.

  • Structural reforms. Opening up markets, and SOE and resource pricing reforms would shift resources to the more efficient private sector, lifting economy-wide productivity. Urbanization through hukou reforms would increase the participation rate and also help raise productivity. Previous research (IMF 2013) suggests that these reforms would bring productivity gains of 1½–2 percentage points.

  • Exchange rate reforms include widening the trading band and allowing the currency to move more in line with market forces. Together with other reform measures these would contribute to continued domestic and external rebalancing, by reducing the savings rate by more than the targeted reduction of the investement/GDP ratio.

The “fast reform” scenario assumes that financial, exchange rate and structural reforms are implemented promptly, and fiscal reforms are phased in over a two-year lag (this compares to about five-year lag for reforms in the baseline).

“Fast reform”. Fast implementation would slow China’s growth in the near-term (by about ½ percentage point, largely due to faster fiscal adjustment and higher interest rates), but the long-run income is much higher and private consumption grows faster. With less LGFV borrowing, augmented debt is falling and credit growth is likely to be slower, leading to a faster reduction of vulnerabilities. The fast implementation would also generate sizeable benefits to the global economy. Simulation suggests that global growth could increase by 0.2 percentage points over the medium term, although growth may be slower in the near term, reflecting the upfront cost of reforms and steps to reduce vulnerabilities.

“No reform”. Without reforms, growth would be weaker (as productivity growth slows and investment becomes increasingly inefficient) and the likelihood of a sharp slowdown in the future higher, with knock-on effects to the global economy. Repeated reliance on credit and government intervention to prop up growth without reforms would boost near-term growth, but reduce future growth and exacerbate vulnerabilities, increasing the risk of a disorderly adjustment, stalling the convergence process, and adversely affecting the global economy. This would map into annual growth of less than 4 percent by 2030, with considerable risk of an even sharper slowdown.

Box 11 Figures:
Box 11 Figures:

China’s Third-Plenum Reform Blueprint

Citation: IMF Staff Country Reports 2014, 235; 10.5089/9781498308571.002.A001

1 This note uses the Flexible System of Global Models (FSGM) to assess the spillover impact. The model is also used in Spillover Reports by the International Monetary Fund. For details, see forthcoming working paper.
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.

Expenditure-based nominal GDP is used throughout in calculations of shares.

The 2013 NAO audit indicated the debt to GDP ratio as of end-2012 is 39.4 percent of GDP. Staff estimates are based on the explicit debt and fractions (ranging from 14–19 percent according to the NAO estimate) of the government guaranteed debt and liabilities that the government may incur. Staff estimates exclude the central government debt issued for China Railway Corporation.

Adjustments are made to the authorities’ fiscal budgetary balances to reflect consolidated general government balance, including government-managed funds, state-administered SOE funds, adjustment to the stabilization fund, and social security fund.

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.

The 2013 NAO audit indicated the debt to GDP ratio as of end-2012 is 39.4 percent of GDP. Staff estimates are based on the explicit debt and fractions (ranging from 14–19 percent according to the NAO estimate) of the government guaranteed debt and liabilities that the government may incur. Staff estimates exclude the central government debt issued for China Railway Corporation.

Shanghai Stock Exchange, A-share.

Includes gold.

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

Data provided by the Chinese authorities.

Debt of banking sector not included.

IMF staff estimates.

Table 4.

China: Monetary Developments

(In billions of RMB, unless otherwise noted)

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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.