People’s Republic of China: Staff Report for the 2015 Article IV Consultation
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International Monetary Fund. Asia and Pacific Dept
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Publication Date:
14 Aug 2015
eISBN:
9781513512907
Language:
English
Keywords:
ISCR; CR; authority; market; financing; China; monetary policy; capital account; interest rate; financial crisis; U.S. dollar; market share; Inflation; Global; labor market
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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

article image
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)

article image
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

article image
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)

article image
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

article image
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.
Figure 7.

State-Owned Enterprises

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

Sources: CEIC Data Company Ltd.; NBS; WIND; and IMF staff calculations.
Figure 8.
Figure 8.

External Debt

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

Sources: CEIC Data Company Ltd.; BIS; Haver Analytics; Orbis; VESD; Bloomberg; CVU; and IMF staff estimates.

Financial Soundness Indicators

(In percent)

article image
Source: CEIC.

Data after 2013 are under Basel III definition.

Percent of total loans.

19. Buildup of housing inventory. Years of very high real estate investment have resulted in considerable oversupply. Residential real estate investment—which accounts for more than two-thirds of total real estate investment—has been an important source of growth and employment, including by boosting activity in related industries. However, housing inventories have risen a lot, especially in smaller (Tier 3 and 4) cities, which on average have unsold supply of around three years of sales. These smaller cities are macro relevant as they account for over half of real estate investment. While a correction in real estate has started and growth in real estate investment has slowed, working off the excess inventories will require a multiyear adjustment (paragraph 37 and Box 5).

A01ufig8

Residential Real Estate Inventory Ratio by Tiers1/

(In years)

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

Sources: Local Housing Administrative Bureau (Fangguanju); Wigram Capital Advisors; and IMF staff calculations.1/Inventory ratio is measured as floor space unsold/sold.

20. Authorities’ views. The authorities agreed on the importance of shifting the pattern of growth and reducing vulnerabilities. On the augmented fiscal deficit and debt, they continued to consider the staff’s estimates as too high, especially as some of the LG debt was commercial. However, they did not provide alternative estimates, and noted that the local government submissions of outstanding debt earlier in the year were still being reviewed and verified. On credit, they acknowledged the rapid rise, but noted that part of the increase represented financial market deepening and a welcome shift toward more market-based financial intermediation.

B. Impact of Reforms

21. Staying with the current growth model is not an option. In the near term, it may result in higher growth, but at the expense of a continued rise in vulnerabilities. China still has the buffers and tools to prop up growth through continued reliance on credit and investment-fueled growth. However, over time, declining efficiency of investment would weigh on growth and further strain the repayment capacity of the corporate sector. A no-reform scenario illustrates these dynamics: at current levels of productivity, keeping growth at about 7 percent for the next two years would require another substantial increase in investment (Box 6). Given falling corporate profitability, such investment would require a commensurate increase in credit flow, boosting further the credit-to-GDP ratio and credit gap. Investment efficiency would continue to drop and eventually financial conditions for the private sector would tighten, leading to a sharp reduction in investment, much slower growth, and increasing risk of disorderly adjustment.

A01ufig9

No-reform Scenario: Debt Ratios and GDP Growth

(In percent of GDP unless otherwise specified)

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

Source: IMF staff estimates and projections.

22. In contrast, staff baseline projections assume steady progress in addressing vulnerabilities and implementing reform. Growth slows in the near term as a reduction in unsustainable demand weighs on activity. This includes slower credit growth to eliminate the debt overhang and a multiyear correction in real estate investment to bring down excess housing inventories. Growth thus falls to 6¼ percent in 2016 and 6.0 percent in 2017, cushioned by productivity gains from structural reforms. Starting in 2018, overall growth picks up modestly as those productivity gains begin to dominate. Staff analysis—based on the experience of other fast-growing Asian economies, modeling exercises, and growth convergence regressions—suggests that growth of around 6½ percent in 2020 is ambitious yet achievable with successful reforms (Box 6 and Figure 6).

A01ufig10

Baseline vs. No-reform Scenario

(In percent)

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

Source: IMF staff estimates and projections.

23. Toward internal and external balance by 2020. The staff baseline assumes that the Third Plenum blueprint is implemented by 2020 as announced by the authorities.4 Implementing these reforms—including social security, financial sector, fiscal, exchange rate, capital account, and SOE reforms—will reduce excess savings, lower investment, raise productivity, and boost consumption. The investment-to-GDP ratio declines as growth becomes less capital intensive and shifts to more labor-intensive services. At the same time, reforms increase income and lower savings by households (with better social security and financial systems) as well as corporates (financial, SOE, and resource pricing reforms). As a result, national savings fall by more than investment, and the external position moves gradually to a level consistent with fundamentals and desirable policies (a current account surplus of less than 1 percent of GDP). This also assumes that the REER adjusts with changes in fundamentals and, for example, appreciates in line with faster productivity growth in China (relative to its trading partners). Although the shift from investment to consumption (domestic rebalancing) continues beyond 2020, the current account surplus remains unchanged as savings falls in line with investment.

24. Authorities’ views. While the authorities clearly recognized that the current growth model needs to change, they considered that growth may stay close to the current level without jeopardizing long-term sustainability. They viewed China’s existing buffers as sufficiently large, and had a more benign view on the efficiency of investment and therefore the outlook for potential growth. They also considered that the excess inventories in housing were less than staff estimated, thus the correction in the market could be shorter and smaller.

Policies

A. Reducing Vulnerabilities while Managing Demand

25. Demand management—finding the right balance. For this year, staff continues to see GDP growth of 6½–7 percent as striking the right balance between addressing vulnerabilities and minimizing the risk of too sharp a slowdown/disorderly adjustment. Compared to 2014, this would allow for a further moderation in the growth rates of investment, especially residential real estate, and TSF. If incoming data suggest that growth is likely to exceed 7 percent, then measures should be taken to reduce vulnerabilities faster. If instead growth looks set to dip below 6½ percent, then fiscal policy should be eased. Fiscal stimulus, if needed, should be on-budget and rely on measures that protect the vulnerable, support rebalancing, and are consistent with the reform agenda. All goals that can be best achieved through fiscal policy. For 2016, to allow further progress in addressing vulnerabilities, GDP growth should be permitted to slow to 6–6½ percent.

26. Current macro policy stance is adequate. While it is difficult to assess the monetary and fiscal policy stance in China using conventional definitions, staff considers that the current policy setting is broadly consistent with the macro outcomes in the staff baseline (Box 7). However, the impact of recent developments—such as appreciation of the real exchange rate, slowing exports, adjustments in RRR and interest rates, and measures to support local government financing—is still reverberating through the economy. Thus, further policy adjustments may be needed. The staff baseline assumes that the authorities make such adjustments as needed to generate GDP growth of 6.8 percent, with an augmented fiscal deficit of around 10 percent of GDP, TSF growth of 12 percent, and a decline in residential real estate investment. For next year, staff assumes that policies are calibrated to achieve 6.3 percent growth, which is below consensus, consistent with further moderate slowing of TSF growth and the ongoing correction in real estate.

A01ufig110

Real GDP Forecasts

(In percent)

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

Sources: Consensus Forecast; and IMF staff estimates and projections.

Fiscal Policy: Reform While Avoiding a ‘Fiscal Cliff’

27. Off-budget fiscal activity remains substantial and bringing it on-budget has proven challenging. Adoption of the new budget law in late 2014 was as an important milestone in fiscal management. It will create a much-needed framework for local government borrowing, improve transparency, and strengthen medium-term fiscal planning. A key goal of the new framework is to bring all spending that is fiscal in nature into the budget and finance it transparently, while clarifying that other, commercial investment projects of local governments do not have an explicit or implicit government guarantee. The transition to this new framework is complex and will take some time, especially for ongoing projects started under the previous regime where the perimeter between government and commercial activity was not clear and financing arrangements often were not consistent with the projects’ future cash flow.

28. Avoiding the fiscal cliff. Staff advice is to keep the augmented deficit in 2015 broadly unchanged at 10 percent of GDP. Strict implementation of the new budget law could generate a sharp contraction in LG spending (‘fiscal cliff’) that would reduce the augmented deficit to well below 10 percent of GDP. This would have a large adverse impact on near-term growth, which should be avoided. Accordingly, the authorities have taken a series of measures to ensure that local governments can meet their ongoing financing needs, facilitating both the refinancing of maturing obligations and the funding of ongoing and new projects (by issuing LG bonds, extending bank loans falling due, and public-private partnerships—PPPs—for which new guidelines were issued in May). The staff recommends that a clear and comprehensive transition plan for LG financing under the new budget law be announced as soon as possible. The solution will need to find a balance between (i) preventing an abrupt contraction in fiscal spending; (ii) not undermining the budget law through excessive forbearance; (iii) minimizing moral hazard from rewarding imprudent borrowing by local governments; and (iv) limiting damage to the financial system from uncertainty and shifting the costs to banks.

29. Medium-term fiscal adjustment. Gradual fiscal adjustment should start next year, with a modest reduction in the augmented fiscal balance of around percent of GDP each year. Over the coming years, the pace of adjustment could accelerate as the headwinds from reining in vulnerabilities dissipate and the benefits of structural reform take hold. The staff baseline assumes a gradual consolidation in the augmented deficit to around 8 percent of GDP by 2020. While augmented debt would continue to rise, it would peak at around 70 percent of GDP in 2020 (Appendix III). The structure of fiscal spending is also assumed to adjust in line with structural reforms to promote rebalancing, with lower investment creating room for higher on-budget current expenditures reflecting additional spending on health, strengthening of the social safety net, and bringing some of the legacy social security obligations on budget as discussed below.5

30. Authorities’ views. The authorities were confident that the fiscal risk was being resolved gradually without undermining the goal of the new budget law to discipline the spending and financing behavior of local governments. They had developed a transitional plan that ensured that ongoing projects, with contracts signed up to last year, continued to receive financing. They did not regard this as overburdening banks, as many local government projects were commercially viable and did not pose significant credit risk. They highlighted that a key goal of the new budget law was to move all government activity to the budget, thereby clearly distinguishing that all other borrowing must be on commercial terms (such as PPPs) and without a government guarantee. Thus, they continued to question the usefulness of the augmented debt and deficit data. They also reiterated that fiscal policy this year would remain ‘proactive,’ supporting growth as necessary.

Monetary Policy: ‘Wait and See’

31. The current stance of monetary policy is consistent with achieving appropriate inflation and growth outcomes. The ongoing slowdown is part of a needed adjustment to more sustainable growth and not a cyclical weakening that warrants a monetary response; and the outlook for inflation is benign, with recent disinflation related mainly to transitory supply shocks. Following the recent steps by the central bank (RRR and benchmark interest rate cuts) and the relaxation of LG borrowing constraints, the staff expects that TSF growth and private credit will be in line with the 2015 projections (12 percent for TSF and 11 percent for private credit—TSF excluding LGFVs). There is room, however, for further RRR reductions (offset by OMOs as needed) as part of the PBC’s liquidity management.

32. Financial stability. Going forward, the credit-to-GDP ratio needs to be brought to more comfortable levels. The baseline scenario assumes that this occurs through a gradual reduction in investment and credit flows, with private credit growth dropping to around 8 percent by 2020 (Box 3). Such a path is consistent with the gradual reduction investment while avoiding a credit crunch that would result in too sharp a correction. As financial sector reforms advance, including continued development of capital markets to increase the share of equity and bond financing, the efficiency of financial intermediation will improve. As private sector firms gain better access to financing, productivity gains will allow a given growth rate to be achieved with less investment and credit. Staff also discussed the benefits of a more proactive policy of encouraging write-offs and corporate restructuring, which would help more quickly to release both credit and physical resources to more efficient uses (see Box 3).

33. Authorities’ views. The authorities explained that the monetary policy stance remained neutral, and that the recent benchmark rate and require reserve ratio (RRR) cuts were done to offset the reduction of liquidity arising from the decline of foreign exchange deposits, and the tightening in monetary conditions from falling inflation. Going forward, the policy stance would remain the same. Although they saw space for additional cuts in benchmark rates and RRRs if needed to keep the stance neutral, they remained mindful of the need to contain leverage. Policies would continue to work on strengthening the monetary transmission mechanism, and facilitate the broader reform agenda for a more market-based financial system. Regarding deleveraging, the authorities were working to simplify the process of write-offs for nonperforming loans, including through changes in relevant tax policy and legal procedures.

Real Estate: A Multi-Year Adjustment

34. Real Estate Adjustment. A multiyear correction in real estate investment—with some variation by city—is necessary to reduce the new supply coming on the market and allow time to work through the existing inventories. The staff baseline scenario assumes that real estate fixed asset investment decelerates further (from 10 percent growth in 2014), turning to negative growth in 2015–2017. The challenge is to ensure that the correction continues, but at an orderly pace. In particular, this means a continued decline in housing construction, but healthy growth in housing demand, to allow time for demand to catch up to supply. To achieve this, policy options—to be calibrated depending on local real estate market conditions—include adjusting mortgage terms, varying restrictions put in place during years of rapid growth, and provision of affordable housing. In March 2015, the authorities introduced a package of measures, including reducing land supply in cities with excess housing inventory; increasing the loan-to-value ratio for second mortgages from 40 percent to 60 percent; and shortening the minimum period for housing sales tax exemption from five to two years of residency. Social housing investment and shanty town renovation projects have also been increased. These policies have helped cushion the adjustment as evidenced by the recent stabilization of prices and floor space sold; going forward policies must be careful to avoid rekindling investment in the real estate market, particularly where housing inventory is elevated.

A01ufig121

Residential Market Overbuilding and Adjustment Scenario

(In millions of square meters)

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

1/ Excess supply is measured as the difference between floor space started and sold (2 years lead).

35. Authorities’ views on real estate. While acknowledging some structural imbalances at the regional level, the authorities regarded the ongoing correction in real estate as largely a cyclical phenomenon, while underlying housing demand remained strong. They were confident that the set of measures introduced to stabilize the market had a desired impact, and that further measures could be deployed in case of a deeper slowdown. They also considered that the imbalances were smaller than estimated by staff, and that measures to boost demand could play a stronger role in restoring balance in the market.

B. Reforms for Growth

36. Structural reforms to unleash new sources of growth. While a period of slower growth is necessary to reduce vulnerabilities, slower growth is not a goal unto itself. Instead, the goal is to move the economy to a safer and higher-quality growth path. The Third Plenum reforms will achieve this, but faster implementation is needed—the faster the progress, the sooner the benefits will materialize.

Monetary and Financial

37. Good progress has been made in liberalizing the financial system, especially interest rates. The floor on lending rates was eliminated in 2013 and the deposit rate ceiling has been progressively raised to 1.5 times the benchmark rate. In June, 9 core banks were authorized to offer negotiable certificates of deposit (NCDs) for large deposits at maturities ranging from one month to five years. The NCDs have no interest rate ceiling, and can be fixed or floating (benchmarked to SHIBOR). A deposit insurance system was introduced in May. It insures deposits up to RMB 0.5 million (about US$80,000), which covers slightly under half of deposits but over 99 percent of accounts. The authorities have granted licenses to five new private banks, including some affiliated with large internet companies.

A01ufig132

Benchmark Lending and Deposit Rates

(In percent pa; 1 year)

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

Sources: CEIC; and IMF staff calculations.1/ Lending rate floor was removed in July 2013.

38. Moving to a market-based financial system. This means completing interest rate liberalization, ending the over reliance on window guidance and moral suasion, and removing implicit guarantees. A defining characteristic of a market-based financial system is that banks set their deposit rates, lending rates, and loan policies based on market conditions and commercial considerations. Without this, it will not be possible to get the better allocation of resources—through improved access to credit and lower borrowing costs for the private sector—that is critical for transforming the growth model.

39. Liberalization with strengthened supervision. The deposit rate ceiling is the last remaining formal interest rate control, but it has a significant impact on the costs of funds and thus interest rates throughout the system. The time has come to complete the liberalization of deposit rates. Deposit insurance is in place, flexibility has been progressively increased, and the ceiling does not appear to be binding for most of the banking system. Concerns about destabilizing competition, especially among smaller banks, should be addressed through supervision and regulation. More broadly, the progress made in strengthening supervision and regulation should continue. Looking ahead, priorities include (i) continuing with efforts to manage risks from shadow banking (and shift intermediation back to bank balance sheets) and (ii) guarding against new pockets of risk, such as rising leverage in the equity market. The upcoming FSAP will offer an opportunity to discuss a wider range of financial sector reforms.

40. Breaking the web of implicit guarantees. Implicit guarantees are prevalent throughout the financial system, leading to mispricing of risk and misallocation of resources. Breaking this web will introduce greater uncertainty into the financial system and cannot be done overnight. At the same time, the process must start and will involve greater acceptance of defaults, credit events, and bankruptcies. This applies, in particular, to state-owned enterprises (SOEs), which benefit from preferential access to financing supported by a perceived state backing of their liabilities. Such perceptions create an uneven playing field that distorts the allocation of financing toward SOEs, crowds out the private sector, and lowers productivity growth.

41. Upgrading the monetary policy framework. A key element of a market-based financial system is a monetary policy that uses market-based interest rates as the primary instrument. Building on the progress already achieved, establishing a policy interest rate and using it as the main tool to adjust monetary conditions and signal changes in policy is a priority. Preparatory steps should include reducing the volatility in interbank interest rates through an effective interest rate corridor, improving the functioning of standing facilities, and introducing reserve averaging. Required reserve ratios (RRRs) remain high (18.5 percent for large banks), which imposes an implicit tax on banks that hurts depositors and borrowers and encourages shadow banking. RRRs should be lowered gradually and, if needed, the liquidity impact offset by increased OMOs. In addition, the central bank’s efforts to improve communications are welcome, although there is currently no clear interest rate signal for the authorities’ policy objectives. A further strengthening of communications—including by explaining monetary policy in the broader context of macroeconomic risks and developments—will be an important part of upgrading the monetary policy framework.

42. Authorities’ views. The transition to a market-based financial system and monetary policy was progressing, the authorities explained. The monetary transmission mechanism, however, was posing challenges, and, thus, the focus should be on facilitating the transmission mechanism of benchmark lending rate and strengthening the yield curve, especially SHIBOR; introduce reserve averaging; improve the PBC’s standing facilities; and enhance the flexibility of open-market operations (OMOs). They noted the progress on interest rate liberalization, and for next steps, the PBC would continue to expand the scope of pricing discretion by financial institutions, and will select the right opportunities to complete interest rate liberalization. Regulation and supervision had been strengthened, especially to limit risks from off-balance sheet activity. Regarding implicit guarantees, they agreed that resolving these would improve credit allocation, but flagged the need to advance gradually to avoid widespread defaults that may pose systemic and macroeconomic risks.

SOE and Fiscal

43. Deepening SOE reform to level the playing field. Leveling the playing field between private and public enterprises is critical to unleashing new sources of growth. Progress with SOE reform, however, has been too slow. Important reforms include accelerating the increase in dividend payments, ensuring dividends flow to the budget instead of being recycled to other SOEs, eliminating direct or indirect subsidies of factor costs (land, energy, capital), strengthening governance, and improving the commercial orientation. Ultimately, successful SOE reform will also have to include greater tolerance of SOE bankruptcy and exit while exposing them fully to private competition, especially in the tertiary sector (including financial services, logistics, health, and education). Similar to the SOE reforms in the late 1990s and WTO-related opening of manufacturing, these reforms have the potential significantly to boost productivity growth and create millions of jobs.

44. Authorities’ views. The authorities’ stressed that deepening SOE reform remained one of the priorities, and disagreed with the assessment that it was going too slow. They noted that there had been steady progress, including increasing dividend payouts, tighter rules on compensation, and advances in mixed-ownership and governance. Moreover, they had implemented measures to encourage private entrepreneurship, such as streamlining business registration, and the number of newly registered private firms has surged since last year. They noted that SOE reform featured prominently in the Third Plenum and that they would continue to press ahead with reforms, including leveling the playing field. This would also need to include the costs associated with addressing legacy problems and spinning off social functions of SOEs. Regarding exit of unviable SOEs, they agreed that this was also important, but considered the problem to be substantially smaller than in the late-1990s due to better social safety nets and stronger SOE finances. On dividends, they were committed to reaching the target of 30 percent payout to the budget by 2020.

45. Continued fiscal reforms. Fiscal reforms are advancing on many fronts, and Fund management recently signed a multiyear technical cooperation agreement with the MOF. Continued progress is being made in extending the VAT to services, and the authorities plan to finish this by the end of the year. Minimizing the number of VAT rates to, ideally, a single rate would have significant administrative benefits, and the policy objectives of multiple rates could be achieved with other fiscal instruments. Recent increases in petrol taxes and ongoing reforms to natural resource taxation are positive steps that will promote more environment-friendly growth. Following the landmark new budget law, finding a long-term solution to the imbalance between local government spending responsibilities and revenue assignments remains a priority. The national rollout of a property tax will help in this regard by providing an important source of local government revenue.

46. Further social security reform. Pension reforms are crucial for achieving the desired rebalancing of the economy toward consumption. The authorities continue making strides toward a more equitable, sustainable, and integrated social insurance system (Box 8). After rapid expansion, pension and health insurance will soon reach universal coverage. Efforts to reduce pension fragmentation include the unification of the pension schemes for rural and urban residents, and recently unveiled plans to integrate the systems for civil service and enterprise workers. The scheme for enterprise workers remains unsustainable in the long term—already today, contributions (excluding subsidies) are only 87 percent of benefits, according to 2015 social security fund budget. Parametric reforms are needed to help address looming deficits related to population aging. A key step is to increase retirement ages, which would improve pension system finances and help boost labor supply. Another priority is to lower the current high and regressive contribution rates—mandatory contributions to pension, medical, unemployment, occupational injury, and maternity benefits add to over 40 percent of wages. The lost revenue will need to be offset by a combination of parametric reforms and a broader reform of the tax system and the financing of social insurance programs.

47. Authorities’ views. The authorities noted that tax reform remained an ongoing priority. They explained that the VAT reform was proceeding well and that, while they understood the rationale behind a single rate, multiple rates were helping to smooth the transition to the wider VAT. They highlighted that ongoing work on tax reforms was focused on improving the personal income tax system, including a lower burden on low and middle-income households; strengthening resource taxation to help protect the environment; and introducing a nationwide property tax. The authorities were committed to achieving universal social insurance coverage by 2020. They were equally committed to maintaining the long-term sustainability of the pension system, while ensuring proper incentives to participate in a multi-pillar structure. In addition, they were aiming to improve information systems to facilitate the exchange of records across social security and health insurance systems and provinces, which should help increase portability among social security systems and facilitate policy coordination.

External

48. Greater exchange rate flexibility. A more flexible, market-determined exchange rate is needed for allowing the market to play a more decisive role in the economy, rebalancing toward consumption, and maintaining an independent monetary policy as the capital account opens. With capital flows sizable and growing, the “impossible trinity” (inability to have an open capital account, independent monetary policy, and tightly managed exchange rate) will become increasingly binding. Thus, without more exchange rate flexibility, China will have less and less room for its own monetary policy, appropriate for its specific cyclical and structural conditions. Reform should aim to achieve an effectively floating exchange rate—with intervention limited to avoiding disorderly market conditions or excessive volatility—within 2–3 years. International experience suggests there are many options for advancing reform (Box 9). Steps over the next few months could include a further widening of the band and changes to how the central parity is set.

49. Capital account liberalization. The past year has seen continued, gradual progress in opening the capital account, including the establishment of the Hong Kong-Shanghai Stock Connect scheme, increased quotas under various cross-border investment programs, introduction of mutual recognition of eligible mutual funds between Hong Kong SAR and the Mainland, and opening the onshore repo market to offshore renminbi clearing and participating banks (up to the limit of their onshore renminbi bonds). This is a key component of the broader financial reform agenda, aimed at enhancing the efficiency of corporate funding and widening the range of investment options available to residents. To achieve this, capital account opening has to be sequenced carefully with reforms to strengthen the financial system, safeguard macrofinancial stability, and make the exchange rate more flexible.

50. SDR. The authorities expressed interest in having the renminbi included in the SDR basket and are undertaking reforms to support the international use of renminbi. This issue will be covered in the forthcoming review of the method of valuation of the SDR.

51. Data. The authorities are working closely with staff to complete the technical work for China to subscribe to SDDS. Staff encourages the authorities to participate in the Coordinate Portfolio Investment Survey (CPIS).

52. Authorities’ views. The authorities shared the goal of moving to a more flexible, market-determined exchange rate, and noted the progress they had made. In particular, after years of accumulating foreign reserves, the central bank had retired from day-to-day intervention since the second quarter of 2014. Still, they would step into the market occasionally to reduce unwarranted fluctuations and contain excessive speculative pressures. Regarding the capital account, the authorities planned to continue gradually liberalizing toward “managed convertibility”—supplemented with close monitoring, microprudential limits, and macroprudential and capital flows measures as necessary. Upcoming reforms could include a new qualified domestic individual investors scheme (so-called QDII2) and Hong Kong-Shenzhen Connect for equities. On data, they were committed to continue improving them and were on-track to complete the subscription to SDDS this year.

Spillovers, Downside Risks, and Alternative Scenarios

A. Spillovers

53. Reforms are good for China and the world. The near-term slowdown in economic activity in China is a price worth paying for safer and more sustainable growth. Staff simulations based on the FSGM model suggest that the impact of such a slowdown on other major economies is relatively minor, while slow progress in reforms or containing vulnerabilities—resulting in much lower income in China over time—would have significant negative spillovers in the medium to long term.

A01ufig143

Contribution to Global Growth

(In percentage points)

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

Sources: IMF World Economic Outlook; and IMF staff calculations.

54. Global benefits are not distributed uniformly. While China’s transition is beneficial for the global economy, benefits accruing to individual countries vary at different stages of this process:

A01ufig1513

Commodity Prices and Real GDP Growth

(In percent, year-on-year)

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

Source: IMF staff calculations.

  • Growth transition and commodity prices. The post-global financial crisis investment drive was associated with a significant increase in the demand for commodities, particularly steel and other metals. The demand from China has therefore been seen as supporting world commodity prices in the aftermath of the global financial crisis, and this view has been strengthened by the association between the slowdown in China’s investment growth and the recent decline in commodity prices. Staff empirical estimates based on a structural VAR indicate that the impact of China on global commodity prices has indeed been increasing and is now sizable. Simulations based on the GIMF model suggest that the impact depends on how the slowdown is perceived: it would be largest if fully anticipated, which could be interpreted as a substantial revision of expectations regarding growth prospects (or, equivalently, a misperception about growth prospects before the slowdown, which could have led to excessive investment in future supply). While this would have an adverse impact on commodity producers, simulations suggest that it would not have a major deflationary impact on the world economy given the cushioning effect of lower commodity prices on global demand and solid medium-term growth prospects in China.

  • China moving up the global value chain. While the post-global financial crisis investment boom had a major impact on China’s trade pattern, deep structural changes played an equally important role in shaping China’s role in the global economy. In the last two decades China graduated from a low-skill, labor-intensive exporter towards more sophisticated products, increasing domestic value addded and reducing import content of exports (Box 10). Such changes have posed challenges and opportunities for its trading partners, particularly in the region. For example, the move up the value chain has contributed to a sharp improvement in China’s trade deficit with the main Asian electronics supplier countries even as its surplus with the United States and the European Union has continued to rise. Meanwhile, the exit from labor intensive goods—albeit gradual given remaining pockets of relatively cheap labor in inland China—has allowed low-income Asia (such as Bangladesh, Cambodia, and Vietnam) to fill the space vacated by China.6

A01ufig164

Domestic Value Addded

(In percent of world’s domestic value added)

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

Sources: OECD June 2015 TiVA database; and IMF staff

55. Authorities views. The authorities broadly agreed with staff’s assessment, emphasizing positive spillovers from the steady rise of the Chinese economy. They also noted potential spillovers from the ‘One Belt One Road’ initiative, which would bring substantial benefits to both China and the region through greater integration, improvement in infrastructure, and increased trade. While they also concurred with staff assessment that opportunities for growth in low-value added industries are limited, given the ongoing transition to higher-value added products with associated increases in wages, they maintained that reservoirs of relatively cheaper labor in inland China could still allow for some growth in labor-intensive industries, particularly given improvements in infrastructure in less developed regions.

B. Downside Risks

56. The biggest risk is inadequate progress in advancing reforms and containing vulnerabilities. As illustrated in the no-reform scenario discussed above, vulnerabilities would continue to rise if the unsustainable pattern of growth persisted and reform progress was too slow. Over the medium term, the likelihood of China falling into a period of protracted weak growth would rise considerably, and the risk of a sharp and disorderly correction would increase as the existing buffers—a still relatively healthy public sector balance sheet and large domestic savings—would diminish. This risk would also increase with the opening up of the capital account—potentially leading to large outflows should market sentiment change—pointing to the importance of careful coordination of liberalization steps with other structural reforms. As noted, achieving a ‘soft landing’ of this economy while addressing vulnerabilities and advancing structural reforms, as envisaged in the baseline, will be challenging. Thus, staff considers this risk to be of medium likelihood. The illustrative no-reform scenario and related spillovers analysis suggest that the realization of this risk would have a high impact on China and the global economy.

57. Near-term risks are manageable. The hard-landing risk described above is considered to be of low probability in the near term. Fiscal and financial buffers, combined with the still-important role of the state, leave the authorities with sufficient tools to respond effectively to support growth if needed. While these buffers are diminishing over time, they should still allow the authorities to prevent a shock—such as widespread credit events, disorderly correction in real estate, or policy mistake—from triggering a negative feedback loop that spirals out of control. Other risks include:

A01ufig175

Real FAI Growth 1/

(In percent, year-on-year)

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

1/ Deflated using quarterly FAI prices published by authorities.2/ 15Q2 is average of April-May 2015.

  • External risks. China’s large size, limited financial integration, capital controls, and sizable reserves provide cushions against global shocks (see Appendix IV for the Risk Assessment Matrix).

  • Fiscal cliff. Tighter fiscal control over local government finances combined with falling land sales revenue could lead to a sharp reduction in local government spending. However, as discussed above, so far infrastructure spending has held up in 2015 (a good proxy for local government off-budget spending) and measures have been introduced to ensure financing.

  • Equity market. The stock market shows signs of froth. Wealth effects from an asset price correction are likely to be small. Thus, while a correction could take place, it is unlikely to have a significant macro impact, although risks are rising given the fast increase in leverage (Box 4). The authorities have taken steps to contain risks, especially from margin lending; staff recommends continued vigilance to prevent macro risks, including potential linkages to the banking system.

  • Deflation. While a deeper-than-expected slowdown could contribute to deflationary pressures, particularly in upstream industries benefitting from the past investment boom, staff assess the risk of deflation as low at the current juncture. As noted above, disinflation so far appears largely explained by supply shocks, and price declines in overcapacity sectors do not translate to wider deflationary pressures given robust labor market and consumption. However, the risk of deflation bears close watching.

58. Authorities’ views. The authorities broadly agree with the staff assessment that risks are low in the near term. In their view, they also had substantial buffers that would be sufficient to fend off any pressures in the medium term, and therefore the trade-off between addressing vulnerabilities and supporting economic activity was not as sharp as illustrated in staff scenarios. They were monitoring closely the developments in equity markets and were confident that their approach was appropriate, aiming to prevent macro risks without being overly interventionist.

C. Alternative Scenarios

59. Faster transition. While the baseline scenario assumes the authorities succeed in addressing vulnerabilities and implementing reforms, there is scope for even faster progress. Staff discussed the following options:

  • Deleveraging. Keeping credit and labor resources in inefficient activities diminishes growth prospects and leads to a further deterioration in balance sheets. A more proactive restructuring—which could include increased write-offs of NPLs, bankruptcies, and exits (including of unviable SOEs)—would more quickly break this trend. It would help unclog credit intermediation, allowing the dynamic firms that will drive future growth to get better access to credit, and free up labor that could flow to more productive activities. While it would initially hurt bank balance sheets and increase unemployment, these problems could be addressed by a comprehensive plan that would include a strong social safety net for laid-off workers, and a financial sector restructuring program to deal with bad assets and recapitalize banks as needed. Moving faster may ultimately prove less costly than trying to “grow out of the problem” though a protracted period of fairly tight credit conditions.

  • Fiscal spending. The fiscal adjustment in the baseline assumes a gradual reduction in public sector investment (particularly by LGs), partly offset by increased social spending. Given high multipliers from investment spending, this path supports growth, but at the cost of prolonging potentially inefficient spending. A more aggressive restructuring could more quickly replace it by on-budget spending (while keeping the adjustment path broadly unchanged), which would help accelerate the transition towards consumption-led growth.

60. Simulation results show higher medium-term growth and less risks. While the immediate growth impact would be negative in the faster transition scenario (given potential costs of restructuring under faster restructuring and lower multipliers from higher social spending), these policies would also contribute to faster deleveraging and restructuring of the economy, higher medium-term growth (largely through efficiency gains) and a more sustainable growth pattern.

A01ufig186

Different Scenarios

(In percent)

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

Source: IMF staff estimates and projections.
A01ufig197

Faster Transition Scenario: Debt Ratios and GDP Growth

(In percent of GDP unless otherwise specified)

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

Source: IMF staff estimates and projections.

61. Authorities’ views. The authorities considered that the current speed of transition struck the right balance between addressing vulnerabilities and supporting growth. While optimization of resources allocation was a key reform goal, it was promoted through several other policy initiatives in the Third Plenum blueprint (such as market-oriented reforms of SOEs), and moving too fast would be both potentially unnecessary and costly. Similarly, the authorities considered the process of implementing the new budget law as orderly and fiscal policy as sufficiently ‘proactive,’ and they did not see a need for higher budget expenditures to offset the impact of the new budget law on local government spending.

Staff Appraisal

62. China’s development over the last 35 years has been remarkable. Since 1980, the economy averaged growth of around 10 percent a year, real per capita income quadrupled, and some 600 million people were lifted out of poverty. These achievements are testament to China’s success in implementing critical, yet often difficult, economic policies and reforms. As a result, China is now the largest economy in the world (PPP basis). At the same time, income per capita is still a large distance from advanced-economy levels. China thus can, and needs to, continue along its remarkable development path for decades to come. But to do so, it must also continue to implement critical, yet often difficult, economic policies and reforms.

63. The road ahead is challenging. Since the global financial crisis, the reliance on credit-financed investment as the prime engine of growth has created large vulnerabilities in the fiscal, real estate, financial, and corporate sectors. Addressing these will inevitably slow growth. Thus, a key challenge is to ensure sufficient progress in reducing vulnerabilities while preventing growth from slowing too much. Slower growth, of course, is not a goal unto itself but an unavoidable by-product of reining in vulnerabilities. Over the medium term, this unpleasant tradeoff can only be improved by structural reforms that create new sources of growth. The faster the progress, the sooner the growth will bottom out in a sustainable way.

64. The staff’s baseline scenario assumes China succeeds in this transition to a ‘new normal,’ characterized by slower yet safer and higher-quality growth. This assumption is justified by the authorities’ progress in addressing vulnerabilities, willingness to let growth slow, and announced reform agenda. In the baseline, growth is forecast gradually to slow to 6 percent in 2017 before stabilizing in the 6 to 6½ percent range through 2020.

65. Vulnerabilities have risen to the point that reining them in is a priority; while notable progress has been made, more needs to be done. Credit growth has slowed significantly over the past few years, and shadow banking has been reined in; investment is cooling, led by a reduction in residential real estate growth; and a new budget law was passed to address off-budget borrowing. However, in most areas the progress has just succeeded in slowing the pace at which vulnerabilities rise. For example, TSF growth slowed, but is still increasing faster than GDP; and residential real estate investment is still increasing and, thus, adding to the excess supply of housing. Further progress, therefore, is needed to put vulnerabilities on a downward path, including a decline in the level of residential real estate investment, multiyear deleveraging to help close the credit gap, and medium-term fiscal consolidation.

66. The challenge for macro policy is to manage the slowdown. Growth will slow as vulnerabilities are reined in. However, adjusting too fast could prove destabilizing. Macro policies, therefore, should be calibrated to achieve an orderly adjustment by aiming for growth of 6½ to 7 percent this year and 6 to 6½ percent next year. With growth this year on track in this range and the inflation outlook benign, monetary policy should take a wait-and-see approach, especially as significant easing would risk exacerbating the credit and investment vulnerabilities. Further cuts in RRR, however, are warranted not as an easing measure but as part of effective liquidity management. The augmented fiscal deficit should remain broadly unchanged this year, given the headwinds to growth from slowing credit and real estate investment. Next year, it would be appropriate to start a gradual consolidation that lowers the augmented deficit to 8 percent of GDP by 2020 and puts public finances on a sustainable path.

67. Despite progress, the unfinished reform agenda is long and complex. In the decade before the global financial crisis, a series of bold reforms made the economy more open and market-based. The result was rapid growth, fueled by productivity gains as workers moved from farm to factory. The challenge now is to take the next steps in the transformation to a more open and market-based economy, which will again require bold reforms. These include moving to a more market-based financial system and monetary policy framework; SOE reforms, including increased dividend payments, leveling the playing field (especially in services), and exit of unviable SOEs; having an effectively floating exchange rate within 2–3 years; and strengthening the fiscal framework, including local-central relations, the social security system, and tax policy. All of these elements are in the authorities’ reform agenda. With steadfast and timely implementation, China can avoid falling into a low-growth pattern and continue its remarkable convergence to advanced-economy income levels.

68. China’s success is critical for China and the world. Continuing along the old growth path is not an option. The biggest risk is that progress in reining vulnerabilities and advancing structural reforms is too slow and that China, therefore, stays on the old growth path for too long. This would eventually result in a major slowdown in China that would have significant negative spillovers to the global economy. Thus, staff commends the authorities for undertaking the transformation to a ‘new normal.’ While this means somewhat slower growth in the near term, it is a tradeoff worth making for much higher income in China over the medium term. An outcome that brings higher living standards to China and stronger growth worldwide.

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

Risk of Deflation1

Inflation in China has declined, largely reflecting lower global energy prices and currency appreciation. With inflation expectations appearing well anchored and still-healthy wage growth, the risk of deflation in the near-term appears moderate.

CPI inflation has decelerated. As of end-May, headline inflation had fallen to 1.2 percent (year-on-year), after averaging 2 percent in 2014. The decline is largely related to food and energy prices (Figure 1). Core inflation, meanwhile, has been stable and remained between 1–2 percent for some time.

Slower growth is also weighing down inflation, but the impact is relatively small. Previous research has found a fairly weak relationship between the output gap and inflation. For example, Maliszewski and Zhang (forthcoming) estimate a Philips Curve using a system of equations based on a production function, and find that 1 percentage point widening of the output gap pulls down inflation by only 0.1 percentage points.2 Simple regressions find a larger impact of changes in the business cycle (based on HP filter) on inflation, operating mainly through food prices. These results suggest that a 1 percent widening of the business cycle would increase inflation one year ahead by 0.5 percentage points. However, the current growth slowdown is more structural than cyclical—HP filter also shows this—and thus turns out not to be a quantitatively important driver of current inflation developments.

More anecdotal evidence also suggests that deflation is not a significant near-term risk. Wages, as discussed in the Labor Market box, have continued to grow at a healthy pace. Thus, there is little evidence of a wage-price downward spiral. Market inflation projections are low and stable: the latest consensus forecast is for 2 percent average inflation in 2016, similar to staff’s forecast of 1.8 percent. Staff’s forecast assumes that inflation picks up gradually in the second half of 2015 as the base effect of the oil price shock wanes.

The pass-through from falling producer prices (PPI) to CPI will be limited. Since 2012, CPI inflation has been consistently higher than PPI inflation. The declining PPI could reflect a variety of factors, including excess capacity in some sectors, global developments (PPIs have followed a similar pattern in several Asian economies), and, more recently, falling commodity prices. While the lack of pass through in recent years is not fully understood, it could be related to a Balassa-Samuelson effect (faster productivity growth in tradable sectors drives up wages in all sectors, resulting in rising nontradable prices). Consistent with this, nontradable good prices are rising faster than tradable, as evidenced by prices in tertiary (service) sector growing faster than secondary (manufacturing) sector prices.

A01ufig208

Inflation vs. Business Cycle

(In percent)

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

Sources: CEIC; and IMF staff estimates.1/ Difference between GDP and HP filter trend (in percent of trend).
A01ufig219
Sources: CEIC Data Company Ltd.; Haver Analytics; Consensus Forecast; and IMF staff calculations.
1 S. Jung and L. Zhang, “Deflation in China: Myths and Facts,” IMF Working Paper (Washington: forthcoming). 2 W. Maliszewski and L. Zhang, “China’s Growth: Can Goldilocks Outgrow Bears?” IMF Working Paper No. 15/113 (Washington: International Monetary Fund, 2015).

Labor Market Developments1

The labor market has so far been resilient to slowing growth, but reforms are key to the performance going forward.

Based on official data, labor market conditions appear to have held up well so far, despite the growth slowdown. Newly-created urban jobs reached 13.2 million in 2014, exceeding the official target of 10 million new jobs; and Q1:2015 saw an additional 3.2 million of new urban jobs created. Available data for wages also suggest that, on average, demand for urban labor has remained quite robust, growing by around 8 percent in line with GDP growth. Since the global financial crisis, demand for urban labor has consistently outstripped supply, wages have grown faster than nominal GDP, and the official registered unemployment rate remained stable at around 4 percent (and the unemployment rate based on surveys around 5 percent). Migrant workers’ wages have stayed at about 60 percent of urban workers over the past few years, after growing significantly faster than urban wages during late 1990s and early 2000s.

Several factors may explain the apparent resilience of labor market conditions. The impact of slowing GDP growth is likely mitigated by favorable longer-term trends that support labor market conditions, including continuing urbanization and the expansion of (more labor-intensive) services sectors. Also, anecdotal evidence suggests that state-owned enterprises (SOEs) may be keeping workers formally employed despite overcapacity and weakening profitability, and that the use of migrant labor is declining. And finally, data shortcomings make an accurate, up-to-date assessment of labor market conditions difficult—while key data series on labor markets are available, their coverage, frequency, and timeliness have important limitations. For example, the registered unemployment rate is based on self-registration for unemployment insurance, which misses the migrant workers that return home when losing their job.

Going forward, implementation of the reform agenda will play a key role in labor market conditions. The planned reform or the household registration system (‘hukou’) and less labor hoarding in SOEs will likely increase the supply of labor, which in turn should be absorbed by new employment opportunities that will arise from opening up the services sector and other, productivity-enhancing reforms. At the same time, fiscal reforms on taxation, health care, pensions, and education will help narrow the urban-rural income gap (Lam and Wingender, 2015), which will limit rural-urban (migrant) labor flows and unemployment pressures. (Empirical analysis based on provincial data and international comparison suggests that migrant labor flows are driven strongly by growth and the urban-rural income gap, while the services sector share of output and employment is closely related to per-capita GDP.)

Staff analysis suggests that, with reforms, urban employment growth could stay around 10 million per year. A quantitative scenario analysis illustrates the impact of structural trends, demographics, and reform implementation on labor market conditions (taking into account demographic trends). It finds that, with medium-term growth of around 6–6½ percent, net urban employment could stay near 10 million per year—meeting the current policy target.2 Stepped-up reform of SOEs and adjustment in overcapacity sectors would, in the near term, release excess labor and push up unemployment rate by ½–¾ percentage points. However, this would facilitate the structural transformation—including services sector expansion and new investment in productive enterprise—to a more sustainable growth path. In contrast, delays in reform implementation would further build up vulnerabilities and weaken medium-term employment prospects.

A01ufig220
Sources: CEIC Data Company Ltd.; National authorities; Xinhua News; World Development Index; Lu (2012); and IMF staff estimates and projections.
1Prepared based on W. Lam, X. Liu, and A. Schipke, “Can China’s Labor Market Stay Resilient during Economic Transformation,” IMF Working Paper (forthcoming). 2The policy target refers to the ‘newly urban created jobs’, which cannot be directly observed but is correlated with the net annual change of urban employment and the change in nonagricultural employment.

Deleveraging1

Credit in China has risen rapidly and is high by many metrics. The corporate sector, in particular, has increased debt-to-GDP ratios since the global financial crisis and a period of deleveraging is warranted.

Credit is high. Total social financing (TSF) and the BIS measure of credit to the private sector are complementary ways to measure credit to the nonfinancial private (that is, nongovernment) sector. Both increased dramatically since the global financial crisis. Subtracting from TSF equity and borrowing by LGFV, still leaves a significant rise in credit in the past few years. Although the pace of growth has moderated, the credit-to-GDP ratio remains high and exceeds the level implied by economic fundamentals as indicated by the BIS ‘credit gap’ measure2 and cross-country comparisons. The rise has been driven by the corporate sector, particularly in real estate firms, SOEs, and over-capacity sectors. Household debt has doubled since 2008, but is still low. It is primarily for mortgages (with relatively low loan-to-value ratios), represents just a fraction of household wealth, and is actually less than household deposits.

Total Social Financing Components

(In percent of GDP)

article image
Sources: CEIC; and IMF staff estimates.

The high level of credit could weigh on China’s growth and financial stability. Cross-country evidence suggests that episodes of similar credit booms often ended abruptly, accompanied by financial crises or prolonged slowdowns in GDP growth3 (see figures). This risk is still low in China, but it is growing. The steep rise in corporate investment after the global financial crisis has been financed by credit. But the efficiency of investment has been falling, with a commensurate fall in corporate sector profitability. This makes debt servicing costs more difficult and therefore debt more risky. In particular, the interest-coverage ratio has been falling in SOEs and in over-capacity sectors (which together account for the bulk of the increase in credit). While the high level of domestic saving has made it easier to finance this growth model, it is not sustainable as falling investment efficiency will eventually drag down GDP, household income, and thus savings. A decline in asset prices would also pose risks. While the average debt-to-asset ratio is relatively benign compared to other countries, the ongoing housing market correction may erode the asset side of corporate balance sheets (especially land and property), particularly in the real estate sector.

Going forward, investment remains an important driver of growth, thus large credit flows are still needed to finance new projects. Under staff baseline projections for gross fixed capital formation, this implies TSF growth staying relatively high, although falling gradually from around 12 percent in 2015 to 8 percent in 2020. This assumes only a moderate increase in corporate profitability, as productivity-enhancing reforms are largely offset by the rationalization of factor costs (including higher wages). Greater reliance on capital markets to raise financing would reduce the need for credit for the corporate sector, but this is offset by growing lending and borrowing within sectors, particularly the process of financial deepening facilitating access to financing for households.

A01ufig231
Sources: CEIC; and IMF estimates and projections.

Faster debt write-offs would help improve credit flow and investment efficiency, and reduce risks. While there is no evidence that the credit channel is impaired in China, financing for the private sector appears to have been crowded out by lending to SOEs. This is especially a problem if banks allocate credit to support unviable or inefficient SOEs. Write-offs—combined with restructuring of viable companies and steps to facilitate exit and bankruptcy of nonviable firms—could reduce the burden on banks and allow them to reallocate credit to more efficient sectors. Companies’ restructuring and exits would also release physical resources (a strong social safety net to cushion the impact of layoffs), which would support private sector growth. The result would be that the credit-to-GDP ratio would come down faster. In contrast, in the no-reform scenario (with faster initial growth driven by higher investment; see Box 6), the credit-to-GDP ratio would continue to rise on an unsustainable path. This shows that ‘growing out of the debt’ is not an option under the old growth model.

A01ufig2522

TSF Flow and Corporate Net Lending

(In billions of RMB)

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

Sources: CEIC, BIS; and IMF staff projections.

The size of potential write-offs would be manageable. Staff estimates that closing the BIS ‘credit gap’ by 2020—would require write-offs averaging around 1 percent of current debt (around 1.5 percent of GDP) per year, relying on a combination of transferring bad assets to asset management companies and public sector support. The scenario assumes that capital buffers and provisioning remains unchanged, which would allow banks to lend to new and more productive projects. The gross fiscal costs in this scenario would be under 10 percent of GDP excluding the cost of putting in place an enhanced social safety net. This, however, assumes no recoveries and overstates the net cost to the public sector to the extent that the write-offs facilitate exit of unviable and loss-making SOEs (removing implicit subsidies, and potentially leading to an increase in dividend payments to the budget from remaining SOEs as overcapacity is reduced). Any fiscal support to banks or companies should be done in an incentive-compatible way that minimizes moral hazard going forward. For the banks, an immediate step should be a rigorous quality assessment of loan portfolios, setting the stage for addressing NPLs and the potential need for bank recapitalizations. Recapitalization should be conditional on reforms to prevent a repeat accumulation of bad loans.

A01ufig263
Sources: CEIC Data Company Ltd.; BIS; WIND; IMF World Economic Outlook; and IMF staff calculations.
1 S. Arslanalp, W. Lam, W. Liao, and W. Maliszewski, “Deleverage China,” IMF Working Paper (forthcoming). 2 Defined as the gap between the credit-to-GDP ratio and its trend, as recommended by the BIS in the guidance for national authorities operating the countercyclical capital buffer regime. 3 W. Liao and W. Maliszewski, “Credit Boom in China,” IMF Working Paper (forthcoming).

China’s Equity Market: Recent Developments and Risks

The stock market has more than doubled over the last year, despite a slowing economy and declining profit growth. The influx of new investors, a surge in margin lending, and rising leverage and interconnectedness of securities firms pose potential financial stability risks. The broader risks for growth are rising, but likely still relatively small.

Sharp rise in prices. The market’s rapid ascent since the middle of 2014 understandably raises concerns about the prospect for future price volatility and the possible implications for broader financial stability. The market’s more than 150 percent gain stands in sharp contrast to modest price changes for international markets and has come even as domestic economic growth has moderated. The upswing has been broad based, encompassing almost every listed stock, with some segments of the market such as the technology sector experiencing particularly dramatic price gains. These developments have pushed equity valuations above emerging market peers for some, but not all, commonly-used yardsticks (see figures).

A01ufig274

Equity Market Prices and Profits

(In percent, year-on-year)

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

Sources: MSCI; Thomson Datastream; and IMF staff calculations.

A number of factors may have pushed prices higher. Some market participants point to comments by high-level officials that may have been interpreted as offering “official support” to the market. The authorities and securities exchanges have implemented measures to promote equity investment including easing rules for margin borrowing (April 2013), liberalizing mutual funds (August 2014), and allowing investors to open multiple brokerage accounts (April 2015). Inflows to the equity market may also have been boosted by households reallocating saving away from real estate and optimism about shareholder-friendly SOE reforms.

A01ufig285

New Stock trading Accounts Opened Each Week

(In millions of accounts)

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

Source: CDCC.

China’s financial development benefits from sustainable growth in the stock market. Boosting equity issuance from relatively low levels can diversify corporate financing, reduce the reliance on debt and shadow banking, facilitate deleveraging for more indebted sectors, and advance SOE reform through mixed ownership. An efficient and representative market can also provide opportunities for households and institutional investors to achieve a more desirable risk-return profile for their savings and assets. Through end-May, there had not been a substantial increase in capital raised through domestic (A share) public offerings.

A01ufig2926

Capital Raised through Public Offerings

(In percent of GDP)

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

Sources: China Securities Regulatory Commission; CEIC; and IMF staff calculations.*YTD 2015 is Jan-Apr 2015.

The rally is associated with rising risks, such as a sharp rise in margin financing. An influx of new, potentially less informed, investors and rising leverage increase the risk of a disorderly market correction. New investors are flooding into the market and retail investors account for about 80 percent of traded volume. The amount of money investors have borrowed from securities firms to buy equities has risen more than five-fold since end-Q2:2014, to RMB 2.2 trillion or 8 percent of the free-float market capitalization (3.2 percent of GDP). The regulator’s increased scrutiny of securities firms’ lending has done little to slow the rise in borrowing. Until recently, wealthy investors were accessing leverage multiples far higher than brokerage accounts through structured products known as “umbrella trusts,” with the funding provided by other investors, including wealth management products. Such borrowing is estimated by some analysts to have reached RMB 1 trillion, and regulators have recently taken steps to tighten the regulation on umbrella trust.

Wealth effects from changes in equity prices are rising, but previous studies suggest they are likely to be small. This holds even after accounting for the recent increase in the market’s size and number of investors.1 Based on free-float capitalization, a 25 percent change in prices would change the value of household, corporate, and institutional investor equity holdings by about RMB 7 trillion, equivalent to 10 percent of GDP and 9 percent of household financial assets at the end of 2013. As a comparison, an equivalent price change in the United States would lead to a change in free-float value of over 30 percent of GDP. Moreover, survey data suggest that financial assets account for just 5 percent of total household assets; financial assets are primarily bank savings and cash (text chart); and only 9 percent of households own equities and 4 percent mutual funds. Financial services have also been contributing more to growth, especially since the equity rally started. A correction, especially if it has implications on the financial sector, could directly reduce growth with knock-on effects to the rest of the economy.

A01ufig306

Components of Household Financial Assets

(In percent of total)

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

Sources: China Household Finance Survey, Texas A&M University and Southwestern University of Finance and Economics; http://chfs.swufe.edu.cn/
A01ufig317

Real GDP: Banking and Insurance

(In percent, year-on-year unless otherwise specified)

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

Sources: CEIC; and IMF staff calculations.
A01ufig328
Sources: CEIC Data Company Ltd.; NYSE; MSCI; Thomson Datastream; Dealogic; IMF World Economic Outlook; WIND; Bloomberg; and IMF staff calculations.
1 Y. Hu and C. Guo, “Stock Wealth, Signaling and Consumption of Urban Residents in China,” Economic Research, Issue No. 3, pp. 115–26 (2012); and F. Wang, G. Zhou, Z. Chen, “Stock market Wealth Effect and Consumption Expenditure Analysis,” Securities Market Herald, No. 11, pp. 48–57 (2009).

How Big Is the Risk of a Real Estate Slowdown and Does It Matter?

China’s housing market has softened visibly since 2014, reflecting oversupply in most cities. More adjustment is likely.

All indicators point to weakness in China’s housing market. Housing prices have been moderating both at the national level and across all city tiers, with the weakest performance among the smaller cities. Floor space sold, a good indicator of housing, has declined on a year-on-year basis since mid-2013 (sales volume picked up slightly at end-2014, following the relaxation of home purchase restrictions and easing of mortgage financing). On the supply side, floor space starts contracted by 14.4 percent in 2014, compared with 11.6 percent growth in 2013. This is mirrored by slowing real estate fixed asset investment, from about 20 percent growth in 2013 to 9.2 percent in 2014.

Housing inventory ratio—floor space unsold to floor space sold—shows a buildup since 2013, suggesting oversupply. Even though there is uncertainty regarding the level (National Bureau of Statistics (NBS) data show inventory of four months, while data from local housing bureaus suggest higher than two years), the direction of the buildup is clear. Inventory is especially high in Tier 3 and Tier 4 cities.1, 2

Continued adjustment in floor space starts is warranted to let demand catch up with supply. To better understand how the oversupply came about and how the real estate market may return to equilibrium, staff analyzed China’s housing demand and supply dynamics. The oversupply is measured by the cumulative gap between floor space starts and floor space sold (1–2 years ahead to account for the average construction time). Floor space sold is projected taking into account fundamental determinants of demand, which indicates that a continuation of the historical demand trend is likely. The baseline scenario assumes that the oversupply is eliminated by 2020, broadly in a linear fashion, through a moderate contraction in floor space starts. A stronger pickup in demand could help marginally to narrow the excess supply gap, but it is unlikely to fully offset a potential contraction in floor space starts.

The adjustment will have significant impact on GDP growth. Given the estimated relationship between growth in floor space starts and in real estate gross fixed capital formation (GFCF), real estate GFCF could slow to -2 to -4 percent in 2015 from about 3 percent in 2014.3 As real estate GFCF accounts for about 9 percent of GDP, this would imply a drop of GDP growth by about ½ percentage point in the baseline scenario. This abstracts from the indirect effect arising from real estate linkages to upstream and downstream sectors. Some of these sectors suffer from oversupply, and a slowdown in construction activity could bring losses, exposing vulnerabilities and posing risks (IMF, 2014).

A01ufig339
Sources: CEIC Data Company Ltd.; NBS; Local Housing Administrative Bureau (Fangguanju); Wigram Capital Advisors; and IMF staff estimates and projections.
1The differences may be attributable to different methodologies in data collection. The NBS data rely on developers’ self-reporting registration that is subject to underreporting in unsold units and over-reporting in sales, while data from local housing bureaus record all real estate registration, including buildings that have obtained permits to sell. 2Chinese cities are generally grouped into four categories: Tier 1 cities include Beijing, Shanghai, Guangzhou, and Shenzhen; Tier 2 cities include 35 cities, mostly provincial capitals; other small and medium-sized cities are grouped into Tier 3 or Tier 4 cities. 3Staff uses the real estate GFCF series estimated using the NBS data to keep the investment concept compatible with the national account (GDP) data. Staff estimates the real estate GFCF series by taking a share of real estate investment in total fixed asset investment (both series from the NBS) and apply it to the measure of GFCF in the national account.

Growth Scenarios

Although growth is initially higher under a no-reform scenario, the benefits are ephemeral. Over the medium term, the staff baseline results in both higher and more sustainable growth.

How fast can China’s economy grow? Implementation of the authorities’ reform agenda is critical for boosting potential growth. Without reforms, vulnerabilities would continue to rise. On the supply side, there would be strong headwinds from falling productivity and negative labor force dynamics. On the demand side, the dynamics of credit and investment would be unsustainable due to a combination of rising interest costs in the highly indebted corporate sector and local governments, and falling returns on investment. This would increase the risk of a sharp or protracted growth slowdown over the medium term, even though policy buffers limit risks in the near term. On the other hand, the implementation of the authorities’ reform program would lead to an initially slower, but ultimately more robust and higher growth.

Without reforms, growth would gradually fall to around 5 percent in 2020, with steeply increasing debt ratios. A no-reform scenario is constructed that assumes the authorities attempt to stabilize growth at around 7 percent. This strategy would eventually fail, as growth would slow as the marginal product of capital falls and productivity growth stagnates. The slowdown would be due largely to the falling contribution from capital accumulation and productivity growth:

  • Productivity growth stays low. Investment efficiency has been adversely affected by the rapid scale-up, and the contribution of total factor productivity (TFP) to GDP growth has fallen to about 1½ percent per year. The no-reform scenario assumes the decline is permanent, with TFP growth gradually stabilizing at around 1 percent per year by 2030.

  • Labor force dynamics start subtracting from growth. The contribution of employment to growth has remained positive, but has been falling fast (from ½ percent per year in early 2000s to ¼ percent now). Population aging combined with a falling participation rate will further reduce labor force growth, which is projected to drop to zero by 2020 and then turn negative, stabilizing at about -¼ percent per year.

  • Capital contribution starts falling. The investment ratio would stay high initially, as the authorities attempt to stabilize growth at around 7 percent by relying on old growth engines (credit and investment). But this investment would contribute proportionally less to the capital stock than in the past, and the investment ratio would subsequently fall given the unsustainable credit-investment dynamics. The decline would be gradual, though, and the ratio would stay well above 40 percent of GDP by 2020.

  • Credit intensity of growth continues to be high given the reliance on investment, which translates to increasing debt ratios both for the private and public sector.

The policies assumed in the staff baseline would translate to higher and more efficient growth. Specifically, reining vulnerabilities and implementation of Third Plenum reforms would improve resource allocation and facilitate the transition to more sustainable growth. These objectives translate to lower, but more efficient investment. Staff estimates based on a broad range of previous studies (Barnes and others, 2011)1 suggest that gains in TFP growth would be in the 1–1½ percent range per year (Lam and Maliszewski, forthcoming).2 Although activity would temporarily weaken with slower investment, the reforms would ultimately lead to higher growth with less investment and credit, which the overall debt ratio (private and public sector) of about 15 percent of GDP lower than in the no-reform scenario.

A01ufig340
Sources: CEIC Data Company Ltd.; Penn World Table, version 8.0; IMF World Economic Outlook; and IMF staff estimates and projections.
1S. Barnes, R. Bouis, P. Briard, S. Dougherty, and M. Eris, “The GDP Impact of Reform: A Simple Simulation Framework,” OECD Economics Department Working Papers 834 (2011). 2W. Lam and W. Maliszewski, “Giving Credit to China’s Slowdown,” IMF Working Paper (forthcoming).

Monetary and Fiscal Policy Stance: Assessing and Projecting

Assessing the monetary and fiscal policy stance in China is difficult. Monetary policy lacks a policy interest rate to signal changes in the stance, and the bulk of fiscal borrowing occurs off budget and is recorded as private credit, which blurs the line between monetary and fiscal policy. To deal with these issues, staff constructs complementary monetary and fiscal indicators to help assess developments and make projections.

What is the current fiscal and monetary policy stance? It is difficult to categorize the policy stance in China using conventional definitions. The official budget excludes a substantial amount of off-budget fiscal activity. Thus, staff considers the augmented deficit a better indicator of the fiscal stance, but it is hard to estimate and there is no budget for such activity. On the monetary side, there is no policy interest rate to signal changes in the monetary stance. Policy is conducted using a variety of tools including benchmark interest rates, liquidity management (OMOs and RRRs), and window guidance. Several indicators provide a sense of the stance—including benchmark interest rates, interbank interest rates, M2, and TSF—but may send conflicting signals and reflect developments as much as policies. For example, slow credit growth could reflect tight monetary policy, weak credit demand, or both. Moreover, the line between monetary and fiscal developments is also blurred by the fact that LGFV borrowing—a fiscal activity—shows up in TSF, the most commonly used measure of private credit.

Augmented fiscal deficit indicates the fiscal stance. LGFV borrowing accelerated in the aftermath of the global financial crisis as a way for local governments to support demand while circumventing the rules against local government borrowing (see figures). While some LGFV activity is commercial, staff considers that the bulk of it is fiscal in nature. This is supported by the 2013 NAO report, which found that the government was ultimately responsible for two-thirds of the stock of debt from LGFVs (and other local entities). Moreover, it is not feasible to separately identify the commercial portion of LGFV borrowing based on available data. Thus, staff constructs augmented fiscal data by expanding the perimeter of government to include all LGFVs.1 However, data on LGFV borrowing from banks—which is the main source of LGFV financing—are generally not available. Staff estimates of the augmented deficit are thus subject to considerable uncertainty.

LGFV borrowing has been sizable, thus adjusting the monetary and fiscal data for LGFV borrowing is important. Since LGFVs are included in the augmented fiscal data, their borrowing should be removed from TSF. This avoids double-counting and makes the TSF data a better indicator of lending to the private sector, defined to include SOEs but exclude government and the financial sector. Private credit is thus defined as TSF less equity financing (which is in TSF) and less LGFVs. For end-2014, this adjustment reduces TSF and raises government debt by 37 percent of GDP. Moreover, this adjustment is becoming increasingly important with the rollout of the new budget law. The law could result in a reclassification of local government liabilities from TSF to government debt as both local borrowing shifts to more on-budget financing and part of the existing stock of local liabilities is swapped into government bonds. While TSF and government debt are impacted by these changes, staff estimates of the augmented deficit and private credit are not. The staff-constructed measures, thus, provide a more consistent series for assessing and distinguishing between monetary and fiscal developments.

Staff’s macro projections are based on explicit assumptions for the augmented fiscal deficit and private credit. For 2015, staff forecasts the augmented deficit to be 10 percent of GDP, including 6 percent of GDP (RMB 4.1 trillion) in LGFV financing recorded in TSF. Private credit is forecast to grow by around 11 percent, which is consistent with financing the private investment assumed in the staff baseline. TSF growth will depend on whether local infrastructure spending is financed through government bonds or LGFVs; staff assumes that, in line with past practice, it is financed through LGFVs.2 Regardless of how it is financed, the staff projections are predicated on an augmented deficit of 10 percent of GDP and private credit growth of around 11 percent. Projections for later years are done the same way, with explicit forecasts of the augmented deficit and private credit, and private credit linked to forecasts of private investment (see Box 3).

Staff’s baseline assumes that monetary policy is adjusted as necessary to achieve the forecasted growth in private credit. For this year, private credit growth of 11 percent translates into a 7.6 percent decline in the flow of private credit. This likely requires a pick-up in the flow of private credit in the remainder of the year. The flow of TSF was minus 18 percent (May, year-to-date), and while some of this is likely due to sluggish LGFV borrowing in the early part of the year—the extent is hard to estimate with available data—private credit growth was also likely weak. However, the benchmark interest rate cuts and, more recently, declines in interbank interest rates are still working through the economy and will provide some support to credit in the remainder of the year. The staff baseline assumes that further steps are taken, if needed, to adjust the pace of private credit growth to reach staff’s year-end forecast.

Likewise, the staff baseline assumes that local government financing is consistent with a 10 percent of GDP augmented deficit. The augmented deficit treats land sales as a financing item, whereas the augmented net borrowing is the more relevant measure for financing needs. With land sales proceeds expected to decline this year, augmented net borrowing is forecast to rise somewhat to around 8 percent of GDP. The local government financing need is estimated to be RMB 6 trillion. Local governments have been authorized to issue bonds to swap for maturing debt and to finance the current year deficit (text table). Through mid-June, around RMB 500 billion of such bonds had been issued or placed with banks. After Jiangsu province initially had to postpone its issuance—reportedly due to the high yields demanded by buyers—steps were taken to make the bonds more attractive to banks. These included putting a ceiling on the interest rate (1.3 times of sovereign yields) and allowing the bonds to be used as collateral for repos with the central bank. These steps were widely seen as providing an implicit central government guarantee to the bonds, which have since been issued at yields quite close to the sovereign. In addition, LGFVs have continued to issue bonds on the interbank market.

Additional measures may be needed to meet local government financing needs. In May 2015, the state council issued a directive (GuoFa Document 40) that asked banks to continue to finance ongoing projects based on existing contracts signed before this year. For those LGFVs that cannot meet their debt service obligations, banks and local governments can negotiate to refinance LGFV debt by extending the maturity of the debt and/or requiring additional collateral. The remaining financing need is expected to be met through policy banks, PPPs and, if needed, additional measures. This could include a drawdown of fiscal deposits, asset sales, or authorization for additional borrowing.

Financing Needs for LGFVs and Other Local Government Entities in 2015

(In trillions of RMB)

article image

Excludes 0.9 billion local government contingent liabilities.

Total announced PPP investment is about RMB 2 trillion, assuming the executed contribution for 2015 financing stands at 10 percent based on various analyst estimates.

From Mizuho and UBS estimates.

A01ufig351

Monetary and Fiscal Policy Stance: Assessing and Projecting 1/

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

Sources: CEIC Data Company Ltd.; NAO report (2013); and IMF staff estimates and projections.1/ Private credit is calculated as total TSF minus LGFV borrowings and equity issuance.
1See Appendix III and Box 3 in People’s Republic of China—Staff Report, IMF Country Report No. 14/235 (2014). 2This assumes that the 2 trillion local government bonds from the debt swap program will still be included in TSF. If instead these bonds are recorded as government debt, then this year’s TSF growth would fall to 10.4 percent.

Toward an Equitable, Sustainable, and Integrated Social Insurance System

Coverage has been expanded. Remaining challenges include addressing disparities, ensuring adequate benefits, and increasing incentives to participate in formal employment, while maintaining long-term fiscal sustainability.

China has a dual social insurance system with nearly universal coverage. Separate schemes provide insurance for old age and health care for workers in the formal enterprise sector (Urban Workers and Staff, UWS), and nonsalaried workers (Urban and Rural Residents, URR). After a rapid expansion of schemes for URR over the past five years, coverage is nearly universal (health care insurance coverage is about 95 percent and pensions cover nearly 100 percent of those more than 60 years old). However, large disparities remain in terms of the adequacy of benefits across schemes. For example, average URR pensions are under 5 percent of those for enterprise retirees. Reducing this gap remains an important challenge.

The pension system needs reforms to ensure its long-term sustainability, and reduce inequities. The pension scheme for UWS has a sizable long-term imbalance reflecting the prospects of population aging—the present discounted value of expenditure minus contributions over 2015 to 2050 is 67 percent of 2014 GDP. Parametric reforms could help address these looming deficits. One priority includes increasing retirement ages, which would improve the system finances and help boost labor supply. In contrast, in the pension scheme for URR, it seems crucial to boost the adequacy of benefits. In particular, policies should aim to reduce gaps in contributions to the individual-account component of this scheme, and raise contribution levels (today, most participants contribute only the minimum allowable). This would allow for a larger role of contributory pensions in the future. In addition, the modest noncontributory basic pension for the current elderly (about 2½ percent of the average private urban wage) could be raised and moved to the budget, given that these benefits constitute an element of the social safety net.

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Pensions and health care insurance remain fragmented. This is true both geographically (the central government provides guidelines and financing, but social insurance is administered at the provincial level), and across schemes (UWS and URR are not integrated). It impedes the development of an integrated national labor market, and contributes to rural-urban income disparities. Further integration could improve the pooling of demographic and economic risks, simplify administration, and increase the portability of benefits.

The relatively high level of social security contributions is a concern. For the UWS—mandatory contributions to pension, medical, unemployment, occupational injury, and maternity benefits add to over 40 percent of wages. Reviewing the financing sources so as to reducing this burden would be crucial in the medium term as part of a broader tax reform.

Moving To a More Flexible Exchange Rate Regime

Since 2005, the exchange rate regime has been made gradually more flexible. However, accelerated progress is becoming increasingly important for managing the economy and transforming the growth model. While there are many options for moving forward, conditions are ripe for taking the next steps.

The exchange rate regime has improved a lot over the past 10 years. Since the reform in July 2005, the intraday band has been gradually widened and the regime has facilitated considerable adjustment (the renminbi appreciated about 30 percent against the U.S. dollar since 2005). Currently, flexibility is limited by a daily 2 percent trading band around a central parity. Officially, the parity is determined by the weighted average of preopening market quotes, without any limit on day-to-day movements. Thus, in theory the parity could move significantly from day-to-day, while in reality it moves very little and much less than suggested by market conditions.

More flexibility is becoming increasingly critical to move to an effectively floating exchange rate. It is necessary for allowing the market to play a more decisive role in the economy, rebalancing toward consumption, and maintaining an independent monetary policy as the capital account opens. With capital flows sizable and growing, the “impossible trinity” (inability to have an open capital account, independent monetary policy, and tightly managed exchange rate) will become increasingly relevant. Thus, without more exchange rate flexibility, China will have less and less room for its own monetary policy, appropriate for its specific cyclical and structural conditions.

There are many options for transitioning to a floating exchange rate. International experience provides some lessons, but China’s strategy will have to be tailored to China’s specific characteristics. Unlike many historical cases, China is proceeding from a position of strength with considerable international reserves, a current account surplus, relatively strong growth, and low inflation. Key elements of the reform strategy include:

  • Band widening. Several countries (Chile, Israel, and Poland) have advanced by gradually widening the band around a central parity. China has already been doing this and conditions are good for taking the next step. The exchange rate often closes at or near an edge of the band, highlighting that the band is generally a binding constraint. Widening it, therefore, will promote more flexibility.

  • Central parity. This is the most challenging element. The principle should be to allow the central parity to move over time in line with market forces. In theory, this would be easy if the rate was at the market equilibrium. However, in practice the market equilibrium is both unknown and changing. The challenge is that moving too slowly to the market equilibrium will invite speculative flows, while going too fast will undermine the parity’s role as an anchor in the system. One option is to set the parity based on a basket. This will introduce more flexibility against the U.S. dollar and allow the parity to move automatically in line with global currency movements. Countries have tried various strategies for adjusting the parity, ranging from rules-based systems (Russia) to a preannounced crawl (Israel and Poland). Another option would be to adopt a system where the central bank explicitly sets the central parity and adjusts it on a discretionary basis. The principle is to have a system that sets ‘speed limits’ on exchange rate movements, dampening fluctuations due to temporary shocks, but adjusts in the event of sizable and persistent pressures.

  • Intervention. To allow market forces to play a stronger role, intervention should be limited to the edges of the intra-day band or follow a rules-based system. Sustained one-way intervention should be avoided and, if it occurs under a given band, be a cause for adjusting the central parity and/or widening the band. Russia, for example, had a rules-based system that entailed no intervention if the rate was near the parity, and increasing intervention (by predetermined and preannounced amounts) as the rate moved toward an edge. Moreover, the central parity was adjusted using a formula based on the cumulative amount of intervention, thus allowing the parity automatically to adjust in line with evolving market conditions. Staff simulations illustrate the relative advantages of different systems. For example, a Russian-style system can better accommodate persistent fundamental shocks, as the central parity would adjust—based on the preannounced rule—to a period of one-sided intervention (the bottom left panel). Pre-committed bands, as used in Poland and Israel, could accommodate persistent shocks if they are wide enough, but the process of widening typically takes time, and intervention in the meantime could be sizable. A credible band can have a self-stabilizing effect because of the expected intervention near the edges, but this effect might be dampened if band widening is a possibility (the bottom right panel).

  • Rules versus discretion. A rules-based system has advantages of making adjustments automatic and shielding the system from political pressure to move rate one way or another. However, discretion would allow for easier adjustment to unusual or unforeseen developments, especially as it is difficult to design a rule that could work in all situations.

  • Transparency. Countries vary in how much information is shared about the system design and operation, including data on intervention (e.g., India, Russia, and several countries in Latin America publish intervention data, while most other emerging countries do not). Openness has the benefit of promoting accountability, but could also facilitate destabilizing speculative flows by making the system too predictable.

Complementary reforms would facilitate the move to greater exchange rate flexibility. India quickly liberalized the exchange rate by ending intervention and switching to relying on interest rates as the primary monetary instrument—in tandem with steps to strengthen interest rate management. This highlights the complementary role of reforms to strengthen the monetary policy framework, especially the use of interest rates to influence liquidity conditions and help achieve both internal and external balance. Another consideration is hedging. Onshore and offshore hedging instruments exist, though are not widely used. There is an aspect of a “chicken and egg” problem, as firms may not want to hedge given the lack of volatility in the exchange rate. However, the infrastructure for hedging is largely in place and could readily be upgraded as needed to accommodate an increase in demand.

Exchange rate reform will result in more volatility of the renminbi against the U.S. dollar. The stability against the U.S. dollar, however, is creating instability elsewhere in the economy. In particular, it can lead to sizable, unintended changes in the effective (trade-weighted) exchange rate, even over relatively short periods of time; contribute to significant volatility in capital flows, and fuel excessive risk taking in both real and financial investments as firms make decisions predicated on continued stability against the U.S. dollar.

The next step is to develop a reform strategy. An effectively floating exchange rate should be in place within 2–3 years, before the full liberalization of the capital account. Any number of combinations of the elements described above could work, so the key is to forge a domestic consensus so that implementation can proceed, with the understanding that there will be some learning-by-doing and fine tuning along the way.

A01ufig362
* The figure is from Russian Federation: 2014 Article IV Consultation—Staff Report, IMF Country Report No. 14/175.** The figure is from IMF, “Moving to Greater Exchange Rate Flexibility-Operational Aspects Based on Lessons from Detailed Country Experiences,” Occasional Paper 256 (2007).

Spillovers from Changing Patterns in Chinese Trade

China’s share of global exports grew rapidly. It has also been evolving, with domestic value added rising and signs that China is losing competitiveness in some labor-intensive sectors. These changes create both challenges and opportunities for other economies.

China has experienced a rapid export growth in the past two decades, especially before 2009. China’s export market share rose from 2 percent in 1990 to 7 percent in 2001 (when it joined the WTO) and 13 percent in 2013. This rise has largely come at the expense of advanced economies. Their market share is characterized by depth, such as 56 percent of global computer equipment exports or 65 percent of global plastic toy exports; as well as breadth, as China has at least a 10 percent global market share in one-third of all categories measured by Comtrade.

China has also moved up the value chain throughout this period. China’s value added as a share of global totals has risen from 2 percent in 2000 to 8 percent in 2011, leaving it only below the United States at 10 percent. China’s value added as a share of its own gross exports is still below levels of the mid-90s, but this simply reflects the initial stages of China joining the global supply chain in which gross trade rises rapidly.

The rise in the value chain resulted in less dependence on imports for a given level of exports. China is increasingly producing sophisticated inputs at home rather than importing them. Processing exports, a customs classification which indicates high import content, has fallen from 56 percent of total trade in 2005 to 35 percent in recent data. This is also evident in the import intensity of specific export goods. For example, the amount of intermediate parts imported for a final computer or telephone has plummeted.

China has lost some competitiveness in low-end categories, but less so than other economies at the same stage of development. The higher productivity which has allowed production of more sophisticated inputs has been accompanied by some loss of competitiveness in certain low-end categories. In furniture, footwear, apparel and plastic toys—the categories where China first made its export mark—global market share has reached an inflection point in recent years with mild signs of decline. However, this inflection point has only come after reaching a market share in apparel of 50 percent, as compared to 13 percent for Hong Kong SAR and Korea. Moreover, such an inflection point is still not evident in other labor intensive sectors like electronics assembly. This is a testament to China’s deep supply of low-wage labor and scope for moving production inland

Changes in China’s trade patterns have posed challenges and opportunities for its trading partners, particularly in the region. For example, the move up the value chain has contributed to a sharp improvement in China’s trade deficit with the main Asian electronics supplier countries even as its surplus with the United States and European Union has continued to rise. Meanwhile, the exit from labor intensive goods such as apparel has already created opportunities for other Asian economies, including Bangladesh, Cambodia, Indonesia, and Vietnam.

A01ufig373
Sources: UN COMTRADE database; Haver Analytics; OECD June 2015 TiVA database; and IMF staff calculations.
Table 6.

China: Illustrative Medium-Term Scenario 1/

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

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

Contribution to annual growth in percent.

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.

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.

Percentage change of annual average.

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

“Augmented fiscal balance” = “augmented net lending/borrowing” - “net land sales proceeds” (in percent of GDP) as we treat net land sales proceeds as financing.

Appendix I. Implementation of Main Recommendations from the 2014–15 FSAP for China

The authorities have made steady progress since the 2014 Article IV Consultation in advancing implementation of the high priority recommendations from the 2010 FSAP. A number of market-oriented reforms have been introduced focusing on interest rate and foreign exchange market liberalization. Interest rate reform has focused on relaxing the constraints of interest rate ceilings. Most importantly, the ceiling on the floating range of renminbi deposit interest rates has been increased to 1.5 times the benchmark deposit rate. The efficiency of institutions and the regulatory framework has been enhanced by greater interdepartmental collaboration and a comprehensive restructuring of the banking regulator aimed at boosting regulatory capacity. The authorities strengthened the financial stability and liquidity framework by expanding stress test coverage and introducing new liquidity facilities. Efforts to build a representative yield curve continued with more regular issuance of bonds across maturities.

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Information as reported by the authorities, with staff providing translation and minor edits.

Appendix II. External Sector Assessment

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Appendix III. Debt Sustainability Analysis

The debt sustainability analysis assesses both general government debt and augmented debt, which represent the lower and upper bound of fiscal obligations. While China’s general government debt remains low and sustainable, augmented debt is on a slight upward trajectory in the baseline. Augmented debt is sensitive to contingent liability shocks, but the risk of debt distress is low given China’s favorable debt profile.

China’s public debt sustainability analysis (DSA) is based on the following assumptions:

  • Public debt coverage. Two definitions of government debt are used. General government debt includes central government debt and local government bonds.1 Augmented debt adds other types of local government borrowing, including off-budget borrowing by Local Government Financing Vehicles (LGFVs) via bank loans, bonds, trust loans and other funding sources. The augmented deficit is the flow counterpart of augmented debt. Augmented fiscal data are a complement to general government data. Since some nongovernment activity is included, the augmented debt and deficit estimates should be viewed as an upper bound.

  • Macroeconomic assumptions:

    The projection reflects a gradual slowdown of real GDP growth to a more sustainable level and low inflation. In the baseline, growth converges to 6.3 percent by 2020 though is lower in some of the intervening years. Inflation is projected to drop to 0.4 percent in 2016 and then rise to 2 percent over the medium term.

  • Fiscal assumptions:

    • Fiscal balance assumptions. In line with the authorities’ gradual withdrawal of fiscal stimulus, the augmented fiscal deficit is projected to decline from around 10 percent of GDP in 2015 to around 8 percent of GDP by 2020. Local government expenditure to GDP ratio is projected to decline. This is due to: (i) lower expenditure financed by net land sales; and (ii) the authorities’ reforms to limit local government borrowing. Meanwhile, the general government net borrowing is projected to increase slightly due to the shift from off-budget spending to on-budget spending.

    • Local government financing. While many local governments relied on net revenue from land sales and LGFV borrowing to finance their investment in the past, the DSA assumes that future financing needs will be met by bond issuance, in line with the authorities’ reform plan and recent progress on local government bond issuance. Three bond types are assumed: (i) central government bonds; (ii) local government bonds, and (iii) a separate bond to repay existing local government debt according to amortization scheme in the NAO 2013 report.

    • Interest rates and amortization. The interest rates for central government and local government bonds are assumed to follow the historical pattern. The interest rates of local government bonds are assumed to be higher than central government bonds. The amortization profile is not central to the analysis because we assume all maturing debt is rolled over and that all debt is subject to a variable interest rate.

In the baseline, China’s general government debt is on a declining path, but augmented debt continues to rise.

  • The general government debt is slightly above 20 percent of GDP over the projection periods. Augmented debt, however, rises to about 71 percent of GDP in 2020 from less than 57 percent of GDP in 2014. Even with the favorable interest rate-growth differential, augmented debt rises over the medium term as the augmented deficit is assumed to decline gradually. The drag on growth from fiscal consolidation will thus spread out to provide time for growth enhancing structural reforms to take hold.

  • The projected general government and augmented debt-to-GDP ratios are higher than in the 2014 DSA. This reflects that the baseline now assumes larger fiscal deficits, lower inflation, and slower growth than in the 2014 DSA.

China faces relatively low risks to debt sustainability, but is vulnerable to contingent liability shocks.

  • General government debt remains relatively low and on a stable path in all standard stress tests except for the scenario with contingent liability shocks. A contingent liability shock in 2016 will result in a sharp increase in debt level from about 19 percent of GDP in 2015 to about 41 percent of GDP in 2016.2 While the debt level is manageable, the authorities would potentially have to deal with an increase in gross financing needs that could be sensitive to market financing condition. Without any extra fiscal consolidation, the debt-to-GDP ratio will stay around 44 percent of GDP over the medium term under a contingent liability shock. A real GDP growth shock—with growth in 2016 and 2017 each 2 percentage points lower than in the baseline—would have a minimal impact on government debt (2020 debt-to-GDP ratio would be around 25 percent compared to 22 percent in the baseline scenario).

  • The augmented debt level is also sensitive to a contingent liability shock, which would push debt to near 100 percent of GDP in 2020. Such a shock, for instance, could be a large-scale bank recapitalization or financial system bailout to deal, for example, with a potential rise in NPLs from deleveraging. A combined macrofiscal shock would increase the debt-to-GDP ratio from about 71 percent to 78 percent in 2020.

  • Overall, China’s debt profile is favorable as most of the public debt is financed through a domestic investor base, and the small external debt is mostly from official creditors. In addition, the DSA focuses on gross debt. The analysis thus ignores that China has considerable state assets, including around US$4 trillion in foreign exchange reserves and sizable equity holdings in state owned enterprises (many of which are listed on domestic and international stock exchanges).

A01ufig384

China: Public Sector Debt Sustainability Analysis (General Government Debt—Baseline Scenario)

(In percent of GDP, unless otherwise indicated)

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

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ Long-term bond spread over U.S. bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
A01ufig395

China: Public DSA—Composition of General Government Debt and Alternative Scenarios

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

Source: IMF staff.
A01ufig406

China Public Sector Debt Sustainability Analysis (General Government Debt-Stress Tests)

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

Source: IMF staff.
A01ufig417

China: Public Sector Debt Sustainability Analysis (Augmented Debt—Baseline Scenario)

(In percent of GDP unless otherwise indicated)

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

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ Long-term bond spread over U.S. bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
A01ufig428

China: Public DSA—Composition of Augmented Debt and Alternative Scenarios

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

Source: IMF staff
A01ufig439

China: Public Sector Debt Sustainability Analysis (Augmented Debt-Stress Tests)

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

Source: IMF staff.

Appendix IV. Global Risk Assessment Matrix

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1

After the report was written, the authorities announced a further reduction in benchmark interest rates (25 basis points) and targeted reduction in RRRs. This will be covered in a staff supplement that will be issued after the release of second quarter data on July 15.

2

Jun Ma and others, “2015 Mid-Year China Macro Forecast,” PBC Working Paper No. 9 (2015).

3

The latest developments in the equity market, including the authorities’ policy response, will be covered in a staff supplement (see footnote 1).

4

See Appendix I in the People’s Republic of China—Staff Report, IMF Country Report No. 14/235 (2014).

5

See also Box 6 in the People’s Republic of China—Staff Report, IMF Country Report No. 14/235 (2014).

6

See G. Gottlieb, G. Hong, S. Jung, K. Mathai, J. Schmittmann, J. Yu, “China and the CLMV: Integration, Evolution, and Implications,” IMF Occasional Paper (forthcoming).

1

It corresponds to “General government debt if incl. only LG bonds (excl. swap)” in Table 5.

2

Mechanically, the standard contingent liability shock in IMF DSA toolkit assumes that 10 percent of banking system assets stock would turn into government liabilities. The banking system assets stock is slightly above 205 percent of GDP in 2014.

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Cover IMF Staff Country Reports
People’s Republic of China: Staff Report for the 2015 Article IV Consultation
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2015: Issue 234
Publisher:
International Monetary Fund
ISBN:
9781513512907
ISSN:
1934-7685
Pages:
123
DOI:
https://doi.org/10.5089/9781513512907.002
Figure 1.

Real Sector Developments

Real GDP Growth

(In percent)

Inflation

(In percent, year-on-year)

Interest Rates

(In percent, period-average)
Figure 2.

Monetary and Financial Developments

General Government Balance

(In percent of GDP; including state-administered SOE funds and social security)
Figure 3.

Domestic Rebalancing

Contribution to Growth

(In percentage points)
Figure 4.

External Developments

Current Account Balance and REER
Figure 5.

Reduction in Vulnerabilities

Public Debt and Fiscal Deficit

(In percent of GDP, 2014)
Figure 6.

Growth Projections
Figure 7.

State-Owned Enterprises
Figure 8.

External Debt

Residential Real Estate Inventory Ratio by Tiers1/

(In years)

No-reform Scenario: Debt Ratios and GDP Growth

(In percent of GDP unless otherwise specified)

Baseline vs. No-reform Scenario

(In percent)

Real GDP Forecasts

(In percent)

Residential Market Overbuilding and Adjustment Scenario

(In millions of square meters)

Benchmark Lending and Deposit Rates

(In percent pa; 1 year)

Contribution to Global Growth

(In percentage points)

Commodity Prices and Real GDP Growth

(In percent, year-on-year)

Domestic Value Addded

(In percent of world’s domestic value added)

Real FAI Growth 1/

(In percent, year-on-year)

Different Scenarios

(In percent)

Faster Transition Scenario: Debt Ratios and GDP Growth

(In percent of GDP unless otherwise specified)

Inflation vs. Business Cycle

(In percent)

TSF Flow and Corporate Net Lending

(In billions of RMB)

Equity Market Prices and Profits

(In percent, year-on-year)

New Stock trading Accounts Opened Each Week

(In millions of accounts)

Capital Raised through Public Offerings

(In percent of GDP)

Components of Household Financial Assets

(In percent of total)

Real GDP: Banking and Insurance

(In percent, year-on-year unless otherwise specified)

Monetary and Fiscal Policy Stance: Assessing and Projecting 1/

China: Public Sector Debt Sustainability Analysis (General Government Debt—Baseline Scenario)

(In percent of GDP, unless otherwise indicated)

China: Public DSA—Composition of General Government Debt and Alternative Scenarios

China Public Sector Debt Sustainability Analysis (General Government Debt-Stress Tests)

China: Public Sector Debt Sustainability Analysis (Augmented Debt—Baseline Scenario)

(In percent of GDP unless otherwise indicated)

China: Public DSA—Composition of Augmented Debt and Alternative Scenarios

China: Public Sector Debt Sustainability Analysis (Augmented Debt-Stress Tests)