People’s Republic of China: Staff Report for the 2015 Article IV Consultation

China is moving to a ‘new normal,’ characterized by slower yet safer and more sustainable growth. The transition is challenging, but the authorities are committed to it. They have made progress in reining in vulnerabilities built-up since the global financial crisis and embarked on a comprehensive reform program. With China now the globe’s largest economy, success is critical for both China and the world.

Abstract

China is moving to a ‘new normal,’ characterized by slower yet safer and more sustainable growth. The transition is challenging, but the authorities are committed to it. They have made progress in reining in vulnerabilities built-up since the global financial crisis and embarked on a comprehensive reform program. With China now the globe’s largest economy, success is critical for both China and the world.

Context

1. China’s success, China’s challenge. China is now the world’s largest economy (PPP basis), which is testament to its record of successful reforms and development policies. But the country is far from rich: per capita income (PPP basis) was 24 percent of the U.S. level in 2014, and 14 percent in U.S. dollar terms. Thus, China still has considerable room to grow and catch-up to advanced economy status. However, as evidenced by international experience and the literature on the middle income trap, convergence is by no means guaranteed. China’s future success, like its past accomplishments, will depend on continued implementation of necessary yet often difficult macro policies and reforms.

2. New leadership, new direction for the economy. The current leaders have now been in power for two years. Historically, this is a time when policy implementation has often accelerated. It is also the time to formulate the thirteenth five-year plan (2016–20). The leadership has emphasized an economic agenda focused on enduring improvements in people’s livelihood. This includes promoting inclusive growth, improving the environment, and fighting corruption. The Third Plenum reform blueprint, announced in late-2013, set out a comprehensive agenda to be completed by 2020. On the economic side, the aim is to move to a more sustainable growth model, including by giving the market a decisive role in the economy. It also covers issues such as urbanization, rural land reform, one-child policy, environment, and institutional frameworks.

3. Adjustment underway. The authorities’ plans are in line with previous staff advice and progress has been made. Credit growth, in particular the ‘shadow bank’ component, has slowed; the real estate sector is undergoing a needed adjustment; and a new budget law is tackling the challenges of local government finances. Reforms aimed at liberalizing the financial system have also advanced (Appendix I). Key achievements include the introduction of deposit insurance and progress in liberalizing interest rates.

4. Significant challenges still ahead. Faster progress on growth-enhancing reforms is critical. Since the global financial crisis, the pattern of growth has relied on an unsustainable mix of credit and investment. This has led to rising government and corporate debt, increasing pressure on the financial system, and declining investment efficiency. Moving to a safer and more sustainable growth path requires reversing these trends. Doing so will reduce demand, and thus unavoidably slow near-term growth. Managing this slowdown is a key challenge: Going too slow will lead to a continued rise in vulnerabilities, while going too fast risks a disorderly adjustment. The key to managing this trade off is structural reforms to boost potential growth.

Recent Economic Developments and Outlook

5. Moving to slower yet safer growth. Growth in China is moderating, a slowdown that is largely a by-product of moving the economy away from the unsustainable growth path since the global financial crisis. Staff projects China to grow at 6.8 percent this year, consistent with the authorities’ target of around 7 percent and within the 6½-7 percent range staff considers appropriate for this year.

A. Recent Developments: Adjustment Underway

6. Continued moderate slowdown of growth. In 2014, the economy grew by 7.4 percent, in line with the official target of “around” 7½ percent (Figure 1). It marked the first time in recent history that growth came in below the headline target. Developments so far this year are consistent with staff projections and recommendations. Growth was 7.0 percent in the first quarter (year-on-year) and recent supply side indicators—such as industrial value added and electricity production—show continued moderation. While demand indicators also point to moderation, led by a correction in real estate construction, household consumption and retail sales have held up well, largely on the back of a robust labor market that reflects the ongoing transition to more labor-intensive growth. In terms of regions, the slowdown is concentrated: six provinces (Tianjin, Liaoning, Jilin, Hebei, Shanxi, and Yunnan) that together account for only 15 percent of GDP explain over 80 percent of the decline in real growth from the 2012–13 average of 7.8 percent to 7.4 percent last year.

Figure 1.
Figure 1.

Real Sector Developments

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates and projections.
A01ufig1

Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; and IMF staff estimates and projections.

7. Inflation has decelerated, but mainly due to supply shocks. Core inflation has been fairly flat and hovered in the 1–2 percent range for nearly five years. While headline inflation has been more volatile, this largely reflects supply-related shocks to food prices and the effect of real effective exchange rate (REER) appreciation rather than changes in the output gap. Thus, the current slowdown in economic activity does not appear to be a significant driver of slowing inflation (Box 1). Meanwhile, producer prices have been declining for several years. The most recent drop is due to falling global commodity prices effective renminbi appreciation. More broadly, external factors appear to be playing an important role in explaining PPI movements in China and much of the rest of Asia.

A01ufig2

Inflation

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; and IMF staff calculations.
A01ufig32

Interest Rates

(In percent, period-average)

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Source: CEIC.

8. Credit growth, especially in shadow banking, has declined considerably. In the aftermath of the global financial crisis, total social financing (TSF), a broad measure of credit, increased dramatically. However, since 2014, the pace of TSF growth has decelerated considerably, from the peak of 34.4 percent (TSF stock, year-on-year) at end-2009 to 12.4 percent in May 2015 (estimated by IMF staff, Figure 2). The change in dynamics was even more dramatic for the flow of credit, which contracted 19 percent in 2015 (January-May, year-on-year). The reversal was a result of stricter regulation of shadow banking activities, which also helped improve the composition of TSF growth toward conventional bank loans. TSF growth has also been affected by tighter financial conditions as reflected in REER appreciation and, earlier this year, rising real interest rates (from falling inflation). The central bank has, since last November, lowered the benchmark lending rate by 90 basis points in three steps and twice cut reserve requirements.1 While these steps initially coincided with a rise in interbank interest rates, the seven-day interbank repo and one-year interest rate swap have both declined since March.

Figure 2.
Figure 2.

Monetary and Financial Developments

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

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

9. Fiscal developments continue to be dominated by off-budget activity. Fiscal policy has supported growth significantly since 2008, mainly through off-budget spending. As a result, the official budget deficit is not a good indicator of the fiscal stance, as evidenced by the sizable gap between the budget deficit and an augmented deficit measure (staff estimate of the deficit including off-budget activity). Preliminary staff estimates point to a modest reduction last year in the augmented deficit to around 10 percent of GDP. This estimate is subject to considerable uncertainty due to data gaps (Table 5). The official fiscal stance in 2015 continues to be ‘proactive.’ The 2015 budget implies a positive fiscal impulse of about 0.4 percentage points of GDP, with the on-budget deficit expected to widen to around 2½ percent of GDP. The new budget law and declining land sales may constrain local government (LG) spending this year (see below), but so far infrastructure investment has remained buoyant.

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.

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 and projections.

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.

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

Twelve-month change as percent of beginning-period stock of monetary liabilities.

The growth rates are corrected for the transfer of NPLs from banks to the AMCs.

The growth rates are based on official announcements, which correct for the definitional changes in the series.

Annualized contribution to reserve money growth, percent.

In percent of total bank deposits.

Table 5.

China: General Government Fiscal Data

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Sources: CEIC, Data Co. Ltd.; China Ministry of Finance; NAO; and IMF staff estimates.

Includes central and local governments’ withdrawal from budget stabilization funds.

Includes adjustments for local government balance carried forward and redemption of local government bonds.

Estimated from local government bond market financing.

Net land sale proceeds refer to the portion used to finance current and infrastructure spending, which is estimated by subtracting the acquisition cost, compensation to farmers, and land development from the gross land sale proceeds.

Derived from net changes in estimated market financing of local government financing vehicles (LGFVs).

The overall net lending/borrowing includes net land sale proceeds as a decrease in nonfinancial assets recorded above the line.

Include major components of market financing of local governments, including bank loans, corporate bonds, trust loans, and LG bonds issued by central government on their behalf. Beginning 2009–10, local governments expanded market borrowing through the use of local government financing vehicles (LGFVs). The NAO 2013 report also lists out other new funding sources of local governments, including build-to-transfers (BT), credit and wages payable, lease financing etc.

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.

A01ufig4

General Government Balance

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

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; and IMF staff estimates.

10. Authorities’ view. The authorities recognized the economy is transitioning from a high to a medium-to-high growth rate, which is one of the characteristics as China enters a new normal. They remained confident of achieving their target of around 7 percent growth for this year. Growth moderated, but was still within a reasonable range. While downward pressures remained significant, they expected activity to firm in the coming months as the effect of recent policy measures filtered through the economy. On inflation, they agreed that supply shocks, not slower growth, were the main factor driving down headline CPI. They considered that inflation was likely to stay positive. A recent PBC publication2 had projections for this year close to staff’s, including growth of 7 percent, inflation of 1.4 percent, and a current account surplus of 2.9 percent of GDP.

B. Rebalancing

11. Progress in domestic rebalancing. Shifting to a more consumption-oriented economy will involve both lowering the household saving rate and increasing household’s share of income. Consumption has been playing a more important role in driving growth in recent years. In 2014, staff estimates suggest that consumption contributed 0.1 percentage points more to growth than gross fixed capital formation, and consumption’s share of GDP increased (Figure 3). Other indicators also point to some progress in rebalancing, with wage growth that seems to be outpacing GDP (pushing up the share of labor income). These developments are attributable, in part, to the rising share of the tertiary (service) sector in employment and output. GDP is thus becoming more labor intensive, which helps explain the resilience in the labor market and consumption (Box 2).

Figure 3.
Figure 3.

Domestic Rebalancing

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC Data Company Ltd.; Household Surveys; UN Population Database; IMF World Economic Outlook; and IMF staff estimates and projections.
A01ufig5

Contribution to Growth

(In percentage points)

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; and IMF staff calculations.

12. Considerable progress in external rebalancing, but the job is unfinished. The current account surplus last year was 2.1 percent of GDP, a big reduction from the 2007 peak of around 10 percent of GDP. Likewise, the renminbi has appreciated considerably in REER terms, up 55 percent since the exchange rate reform in 2005 (Figure 4). Over the past year, the REER has appreciated by over 13 percent (April, year-on-year), in tandem with the rise in the U.S. dollar. Despite this appreciation, Q1 registered a strong trade surplus, driven largely by lower commodity prices and the domestic slowdown. However, capital outflows have also been strong, and monthly proxies for intervention suggest that the PBC has not intervened to buy foreign currency since July 2014. Indeed, the PBC appears to have been selling reserves since late last year, with proxies suggesting cumulative sales of 137 billion U.S. dollars from October 2014 to May 2015.

Figure 4.
Figure 4.

External Developments

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; Bloomberg; and IMF staff calculations.
A01ufig6

Current Account Balance and REER

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; and IMF staff estimates and calculations.1/ Calculated as 4-quarter rolling sum.

13. External assessment. The external position in 2014 was moderately stronger compared with the level consistent with medium-term fundamentals and desirable policy settings, and the renminbi was moderately undervalued (Appendix II). Since then, as noted, there has been substantial appreciation in real effective terms. Nonetheless, staff projections for 2015 suggest that the external position probably remains moderately stronger than fundamentals. There are several factors influencing a country’s external position, with the exchange rate being one of them. While undervaluation of the renminbi was a major factor causing the large imbalances in the past, staff’s current assessment is that the real effective appreciation over the past year has brought the exchange rate to a level that is no longer undervalued. However, staff’s assessment that the external position is probably still too strong highlights the need for other policy reforms—which are indeed part of the authorities’ agenda—to reduce excess savings and achieve sustained external balance (paragraph 23). Reserves were at 149 percent of the IMF’s composite metric at end-2014 (down from 160 percent in 2013); relative to the metric adjusted for capital controls, reserves were at 238 percent, down from 254 percent in 2013. Given China’s progress and plans with capital account liberalization, the appropriate metric is shifting toward the unadjusted one; under either metric, further accumulation is unnecessary from a reserve adequacy perspective.

14. Authorities’ views. The authorities concurred with the staff assessment of the progress in domestic rebalancing, citing the stable labor market and job creation, rising household incomes, relatively strong retail sales, and continued expansion of the service sector. They reiterated their commitment to transforming the economy toward the new growth model, and considered the speed of ongoing rebalancing as appropriate. Investment, they noted, would still play a critical role, but the challenge was to make it more efficient while also relying more on consumption as a driver of growth. On external rebalancing, the authorities welcomed the assessment that the renminbi was no longer undervalued. However, they thought the current account surplus last year was in a reasonable range and that the external position was close to equilibrium.

The Challenge: Managing the Slowdown, Adjustment, and Reform

15. Discussions focused on the challenges of addressing vulnerabilities, managing growth, and implementing reforms. Vulnerabilities have reached the point that addressing them is an urgent priority. Adjustment cannot be too sharp, as this would be destabilizing, but at the same time it cannot be delayed, as that would only make the problem bigger. Reducing vulnerabilities will inevitably lead to slower growth in the near term. Over the medium term, potential growth will be determined by the progress with structural reforms. The staff baseline assumes that the authorities succeed in reining in vulnerabilities and implementing their reform agenda. Growth is therefore projected to moderate further in the coming years as vulnerabilities are reduced, then stabilize over the medium term as the benefits of structural reform take hold.

A. Vulnerabilities

16. Despite progress in addressing vulnerabilities, much work remains. Progress is evident in slower real estate investment and credit growth, especially shadow banking. However, so far this slowdown has largely just reduced the rate at which vulnerabilities are rising (Figure 5). Further progress, therefore, is needed to put vulnerabilities on a firmly declining path.

Figure 5.
Figure 5.

Reduction in Vulnerabilities

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

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

17. Rising fiscal debt. Continued fiscal policy support since the global financial crisis, manifested in the high augmented deficit, has brought the augmented government debt-to-GDP ratio to about 57 percent of GDP. While this is still manageable, with the rise in debt contained by the favorable interest-growth rate deferential, the dynamic is changing as growth slows. Although there is still fiscal space to support activity in the transition to the new growth model, the augmented deficit has to come down over the medium term.

A01ufig7

Public Debt and Fiscal Deficit

(In percent of GDP, 2014)

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC; NAO; IMF World Economic Outlook; and IMF staff estimates and calculations.1NAO 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.

18. Rising credit and risks to financial stability. A variety of indicators suggests that credit has risen to an excessive level. These include the Bank for International Settlements (BIS) credit gap measure and the high credit-to-GDP ratio in China relative to other economies at a similar income level (Box 3). The credit-to-GDP ratio is still growing, albeit at a slower rate given the recent slowdown in credit flow. Official banking indicators appear healthy, but there are reasons to believe they could weaken going forward. The nonperforming loans (NPLs) ratio—albeit still low at 1.4 percent—has been rising and the sum of NPLs and special-mention loans now constitute about 5.4 percent of GDP. There has also been a significant increase in disposals (26 percent of the gross stock of NPLs in 2014 compared to 18 percent in 2013). Loss-absorbing buffers in the banking sector, thus, could be eroded. Deleveraging and a further slowdown in the economy could reveal more problems with credit quality, especially in the SOE sector—SOEs account for the bulk of corporate liabilities and their performance indicators have weakened since 2008 (Figure 7). The equity market rally is another source of financial sector risk, especially given the increasing role of margin financing (Box 4).3 Global debt issuance by Chinese firms and their offshore subsidiaries has also increased considerably, but remains small relative to the stock of TSF and thus does not pose significant risks for financial stability (Figure 8).

Figure 6.
Figure 6.

Growth Projections

Citation: IMF Staff Country Reports 2015, 234; 10.5089/9781513512907.002.A001

Sources: CEIC Data Company Ltd.; National Bureau of Statistics; IMF World Economic Outlook; and IMF staff estimates and projections.
Figure 7.