People’s Republic of China: Staff Report for the 2016 Article IV Consultation

China continues its transition to a sustainable growth path. Rebalancing has progressed on many dimensions, particularly switching from industry to services and from investment to consumption, but less on reining in rapid credit growth. Reforms have advanced impressively across a wide domain, but lagged in some critical areas, and the transition to sustainable growth is proving difficult, with sizable economic and financial volatility. Vulnerabilities are still rising on a dangerous trajectory and fiscal and foreign exchange buffers, while still adequate, are eroding.


China continues its transition to a sustainable growth path. Rebalancing has progressed on many dimensions, particularly switching from industry to services and from investment to consumption, but less on reining in rapid credit growth. Reforms have advanced impressively across a wide domain, but lagged in some critical areas, and the transition to sustainable growth is proving difficult, with sizable economic and financial volatility. Vulnerabilities are still rising on a dangerous trajectory and fiscal and foreign exchange buffers, while still adequate, are eroding.


“The new normal means… a farewell to the unbalanced, uncoordinated and unsustainable growth model” (Premier Li, 2016). But the transition is proving difficult and bumpy.


Rebalancing Scorecard

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Macro and policy developments

1. Activity slowed modestly through early 2016, shored up by accommodative policies, and rebalancing progressed (see Selected Issues; Figures 1 and 2).

Figure 1.
Figure 1.

Activity: Slowing Trend, Bumpy

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.
Figure 2.
Figure 2.

Rebalancing: Some Progress

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.
  • Supply-side indicators. Industrial production has moderated steadily, with a needed rotation from excess-capacity upstream sectors (cement, steel, glass) to more consumer-oriented manufacturing (autos, computers, home appliances). Service sector activity has remained strong, even after stripping out the outsized contribution from financial services. Supply rebalancing—the switch from industry to services—continued its trend traced over the period of the previous five-year plan (2011–2015).


Rising Consumption Contribution to Growth

(In percentage points, yoy contribution)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff estimates.
  • Demand-side indicators. Retail sales have remained strong on the back of steady growth in household income. Investment has stabilized following the recovery in real estate in recent months. Demand rebalancing progressed, with consumption accounting for two-thirds of growth in 2015 and 2016:Q1.

  • Inflation remained well anchored. Core inflation has been stable around 1½ percent. Headline CPI inflation accelerated recently due to food prices. Producer price deflation is still sizable (though moderated recently), reflecting excess capacity in real estate and heavy industry, and weak commodity prices.

  • Policy support. Benchmark lending rates were cut five times in 2015, and in the second half of the year, fiscal policy turned expansionary, infrastructure spending picked up (supported by policy bank lending and the local government debt/loan swap), and credit growth accelerated.

  • External sector. Exports have been subdued, reflecting weak external demand and real exchange rate appreciation through mid-2015. But import volumes have been weak as well, in line with slower domestic demand growth (Box 1). Positive terms of trade effects lifted the current account surplus in 2015 to 3 percent of GDP, but the external accounts came under substantial pressure due to large capital outflows.

  • Exchange rate. The real effective rate appreciated by close to 10 percent from mid-2014 through mid-2015 due to the (then) tight link to the U.S. dollar, and has declined 4½ percent since then. The renminbi remains broadly in line with fundamentals (Appendix I).

Reform progress

2. Reform progress continued on many fronts, especially in improving the monetary and fiscal frameworks, and supporting urbanization (Box 2).

  • Monetary framework. Interest rate liberalization was formally completed and the PBC advanced toward an interest rate corridor centered on the seven-day repo rate (see Selected Issues). The more market-based fixing mechanism for the RMB in August 2015 and the greater reference to a currency basket from December 2015 have allowed more flexibility against the U.S. dollar. Together, these reforms help move China towards an independent, market-based, monetary policy.


    RMB Increasingly Referencing a Basket 1/

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: Bloomberg LP; and IMF staff estimates.1/ Standard deviation caculated on a 30-business-day forward rolling window.

  • Fiscal framework. A wide range of reforms are underway: the new budget law is being implemented (aimed at improving transparency and accountability of local government finances); the VAT extension to services was completed; a carbon emission trading scheme (the largest in the world) will be rolled out nationwide in 2017; social security reforms to unify pension schemes for urban/rural residents and public/private employees were announced, as was a review of revenue and spending responsibilities across levels of government (which should help address the large vertical imbalances that currently limit local governments’ ability to implement social spending reform).

  • Urbanization. The government has continued to encourage rural residents to settle in urban areas—key for boosting productivity through specialization and knowledge spillovers—including by advancing rural land reforms, allocating basic public education spending to the central budget and improving the portability of pensions. Several provinces are rolling out a new household registration system whereby migrants can gradually qualify for basic social welfare and residency benefits.

  • Corporate restructuring. The restructuring of unviable “zombie” state-owned enterprises (SOEs) has begun on a small scale at the local level, led by provinces with relative strength in public finances and more diverse economic structures.

3. The government adopted a new five-year plan (2016-20), centered on rebalancing the economy. It aims to boost consumption, expand the service sector, protect the environment, further open up the economy, expand public services, and reduce poverty. The government has also announced elements of a reform plan for SOEs and capacity reduction targets in the coal and steel sectors (10–15 percent of existing capacity over the next 3–5 years), together with a RMB 100 billion restructuring fund to re-employ and resettle an expected 1.8 million affected workers. However, in many areas, especially SOE reform, more details and guidelines are awaited.

What’s Behind the Import Slowdown? 1/

Chinese imports have slowed significantly over the past two years in real terms. Weaker investment, partly due to progress in rebalancing from investment to consumption, accounts for about 40–50 percent of this slowdown. Weaker exports also account for about 40 percent of slowdown, of which about a quarter is due to stronger RMB.

The sharp decline in nominal imports has been largely due to prices. In 2015, goods imports were down 9½ percent in RMB nominal terms, mostly driven by lower import prices, of which two thirds is due to the sharp fall in commodity prices (which alone improves the trade balance by about 1½ percent of GDP). Real imports were up by only 1 percent (compared to about 9 percent on average over the previous three years), accounting for about half of the deceleration in real imports globally.

The weakness in goods imports is broad based. Machinery and transport imports (accounting for about 40 percent of total imports) are decelerating as re-export demand is falling and rebalancing away from investment-based growth continues. Electronics is relatively more resilient. Commodities (accounting for about 30 percent of total imports) have also decelerated as a result of the slowdown in industry and weak real estate and infrastructure investment.

Several factors have contributed to the slowdown in real imports. Overall domestic demand has moderated after the strong surge following the fiscal stimulus in response to the global financial crisis. The economy is undergoing structural change to a model driven increasingly by consumption, with lower import intensity than investment and exports. China has also been substituting imports of higher value-added products with its own production. In addition, sizable currency appreciation has eroded price competitiveness of exports, and thus lowered demand for processing imports.

Staff analysis finds that weaker investment and exports have been the key drivers. Estimation for the post-WTO accession period (2002:Q1–2015:Q3) suggests that weaker investment has been the main factor, accounting for about 40–50 percent of the slowdown over the last two years. Weaker exports also account for about 40 percent of the slowdown, of which about a quarter is due to stronger RMB. Substitution of imported intermediate inputs with domestic production (“onshoring” measured as the ratio of processing imports to total exports) has not been an additional drag over this period but it continues to slow import growth at a constant pace.


Contribution to Import Growth

(In percent, year-on-year growth)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: CEIC Data Company Ltd.; and IMF staff estimates.
1/ See J. Kang and W. Liao, IMF Working Paper 16/106.

Recent Reforms

Key reforms have been to improve the monetary and fiscal frameworks and to promote urbanization.

Financial sector reforms

  • Deposit insurance introduced (May 2015)

  • Interest rates formally fully liberalized (October 2015)

  • PBC launched the Macro Prudential Assessment (MPA) mechanism (January 2016)

  • Pilot programs on securitization initiated (February 2016,)

  • Equalized capital requirements and risk weights for certain off- and on-balance sheet activity (CBRC Notice 82, May 2016)

  • Applied the “period-average” in monitoring financial institutions’ reserve requirements (September 2015)

Structural reforms

  • Capacity reduction targets (about 10–15 percent over the next 3–5 years) announced for coal and steel sectors (February 2016)

  • A restructuring fund of RMB 100 billion was established for re-employment and resettlement of affected workers in overcapacity sectors (February 2016)

  • Published guidelines on SOE reforms; ten pilot programs were implemented (September 2015, February 2016)

  • Reduced the number of prices set by central government (December 2015)

  • Relaxed the one-child policy (December 2015)

  • Property rights for rural land clarified, including use as collateral for securing agricultural loans (March 2016)

  • About 30 provinces announced guidelines on “hukou” (household registration) reforms (April 2016); a new household registration system is being rolled out by end-2016

  • Social housing program extended (May 2016)

  • Certain provinces have commenced restructuring unviable provincial SOEs (June 2016)

  • SOE social functions (provision of certain utilities and property services) to be reduced (June 2016)

Fiscal reforms

  • Implementation of the new budget law (January 2015)

  • Business tax fully converted to VAT for remaining services (May 2016)

  • Employer contributions toward social security payments reduced (April 2016)

  • Improved regulation and reduced number of fees paid to various government funds by firms (February 2016)

  • New fiscal accounting framework introduced from January 2016

  • Revised price adjustment mechanism for oil products (January 2016)

  • Expanded zero rating for exports (October 2015)

  • Tax cuts implemented for small and high tech firms (September and November 2015)

  • Reform of the Personal Income Tax to further promote equity and redistribution

  • New environmental protection and resource tax laws; carbon emission trading scheme (will be introduced in 2017)

External sector reforms

  • Mutual Recognition of Funds program introduced (July 2015) to allow mutual funds domiciled in Mainland China and Hong Kong SAR to mobilize funds from the other jurisdiction

  • Access to onshore fixed income and FX markets eased for official sector and qualified institutional investors (July 2015; October 2015; February 2016)

  • RMB increasingly referencing a basket of currencies rather than the U.S. dollar; additional basket of currencies (“CFETS”) announced with weights (December 2015)

  • RMB to be included in the SDR basket effective October 2016 (November 2015)

  • RQFII quota announced for United States (June 2016)

Policy obstacles

4. While strategic announcements have been in the right direction, obstacles impede implementation and vulnerabilities are rising.

  • Traditional stimulus. In response to slowing growth in mid-2015, the government boosted infrastructure spending, real estate activity and credit, supporting near-term growth but raising vulnerabilities. It also set a growth target for 2016 of 6–7 percent, above staff’s recommended sustainable range of 6–6½ percent.

  • Uneven reform progress. A corollary of the focus on near-term growth is less focus on reforms critical for medium-term growth, but growth detracting in the short term. Progress has been relatively slow on some key structural reforms, especially strengthening governance and imposing hard budget constraints for SOEs, tackling excessive corporate debt, and opening up state-dominated service sectors. As a result, resource misallocation continues.

  • Lack of policy clarity. Government policy and pronouncements seem to alternate between prioritizing reform and growth. Some of these difficulties are to be expected, as the transition from the ‘old growth model’ is complex and politically challenging. In particular, the task of further liberalizing the economy while disentangling the still-pervasive web of distortions requires a broad set of well-timed and carefully designed policies and will involve learning-by-doing along the way. Nevertheless, the seeming lack of consistency at times feeds market concerns about the commitment to reform (e.g., the heavy-handed response to the equity market correction in June 2015) and prospects for engineering a smooth transition to sustainable growth. In part, this reflects inherent tension in an economic strategy that simultaneously aims to allow the market a “decisive” role in the allocation of resources, yet also affirms the “dominant” role of the state.

Rising vulnerabilities

  • ‘Hard landing’ in overcapacity sectors/regions. Overcapacity sectors were simultaneously hit by falling demand from real estate, lower global commodity prices, exchange rate appreciation, and higher labor costs. The stress is most pronounced in SOEs, where profits have fallen sharply, and in the north.


    Two-speed Economy

    (In percent, year-on-year growth)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

    Wide Regional Growth Disparity

    (In percent, year-on-year growth, 2015)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

  • Weakening corporate fundamentals (Figure 3). Industrial profits fell in 2015 for the first year since the late 1990s against a backdrop of excess capacity, moderating domestic demand, weak external demand, and declining producer prices. Intercorporate payment arrears are growing—the median number of days for outstanding receivables among listed firms has gone up to 45 from less than 30 in 2010. Defaults and downgrades are increasing. A rising fraction of debt is held by firms with weak interest coverage—about 14 percent by firms with profits less than interest payments. Impaired loans, largely to corporates, are rising fast, especially in smaller banks.

    Figure 3.
    Figure 3.

    Corporate Sector: Rising Stress

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: Bloomberg; CEIC Data Company Ltd.; Haver Analytics; Standard & Poor’s Capital IQ; and IMF staff estimates.

    Corporate Credit: High vs. Peers

    (Selected economies, 2014)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: Bank for International Settlments (BIS); and IMF staff estimates.1/ Calculated as total social financing minus equity and household loans.2/ Calculated as total social financing minus equity, LGFV borrowing and household loans.

  • High and rising credit growth

  • An increasingly large, leveraged, interconnected, and opaque financial system (see Selected Issues; Figure 4). Behind the rapid credit growth of recent years lies a complex network of links between banks and nonbanks and a proliferation of investment products. Such innovation can enhance financial inclusion. But it also reflects regulatory arbitrage, makes it more difficult for supervisors to identify emerging vulnerabilities, increases the potential for contagion across market segments, and could amplify financial stress in a downturn. The growing interconnectedness across asset classes and intermediaries is seen through a variety of channels:

    Figure 4.
    Figure 4.

    Credit: Seeking Yield

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: CEIC Data Company Ltd.; WIND database; Chinese authorities’ websites; and IMF staff estimates.

  • A propensity for asset price booms. China has recently experienced a sequence of booms in various asset prices—property, equity and bonds. This propensity is a symptom of a large stock of savings searching for yield, rising leverage, and a belief that the web of implicit guarantees will limit losses. This distorts the pricing of risk and facilitates bouts of speculative excess. Most recently, Tier-1 cities such as Shenzhen, Shanghai, and Beijing, are seeing large housing price increases as bank lending for home purchases increased strongly.

  • Capital outflows. Despite an external position moderately stronger than fundamentals (Figures 5 and 6), capital outflows in 2015 and early 2016 were in excess of the current account surplus, prompting a substantial fall in FX reserves. The degree of outflows suggests a de facto more porous capital account than de jure restrictions would suggest. Several factors appear behind these outflows (see Selected Issues), including:

    Figure 5.
    Figure 5.

    External Sector: A Reversal of Trends?

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: Bloomberg; CEIC Data Company Ltd.; HKMA; and IMF staff estimates.
    Figure 6.
    Figure 6.

    FX and Stock Markets: Pressures Easing?

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

    • A shift in expectations about relative near-term returns on RMB assets, as domestic rate cuts, higher FX volatility, and the approaching Fed liftoff reduced the attractiveness of the carry trade. Many investors and market analysts expected the growth slowdown last year to trigger progressive policy easing and, eventually, RMB depreciation—an expectation seemingly reinforced by the August 2015 change in the exchange rate system.

    • Rising investor concerns about the growth outlook, near and longer term. Some also questioned China’s longer-term growth prospects amidst doubts about the government’s ability to carry out the reform agenda. Such concerns may explain, in part, the surge in outward investment during the last year.

Outlook and Risks

In staff’s baseline growth falls to about 6 percent by 2018 and continues declining thereafter. The lack of decisive progress on addressing corporate debt and governance in SOEs in the baseline implies that the credit-to-GDP ratio continues to rise, with increasing risk of a disruptive adjustment. The baseline does, however, assume continued pro-consumption and pro-service reforms, including strengthening the social safety net and deregulating the service sector; as a result, the structure of demand and production would shift further toward consumption and services.

5. Near-term growth. The economy is expected to grow by 6.6 percent in 2016, slowing to 6.2 percent in 2017. This assumes:

  • Domestic demand holds up on generally robust labor market conditions, with consumption contributing more than half of overall growth. Investment growth is expected to pick up slightly in 2016—as strong infrastructure spending and a rebound in real estate and SOE investment offset weakness in manufacturing and non-SOE investment—but to moderate in 2017 as stimulus measures wane.

  • External demand is expected to remain subdued, with net exports dragging growth in 2016–17. Export growth will stay tepid, while imports are likely to pick up in line with investment.

  • Policy support provides a positive fiscal impulse in 2016, returning to gradual consolidation in 2017. The projection assumes a slightly higher ‘augmented’ deficit relative to last year, resulting from a larger on-budget deficit as well as slightly stronger off-budget local government spending supported through policy bank lending and the new special construction fund (Appendix II).1

  • Credit growth is assumed at 15 percent year-on-year in 2016, based on the authorities’ total social financing (TSF) projection and staff adjustments for local government debt/loan swaps.2 In 2017, credit growth is assumed to slow to 13 percent as investment growth moderates and corporate profitability improves with the pick-up in producer price inflation and progress in reducing overcapacity.

6. Inflation is expected to gradually pick up reflecting the rebound in commodity prices, the exchange rate depreciation since mid-2015, and progress in cutting overcapacity, but to remain contained at 2–2½ this year and next. Over the medium term, inflation is expected to rise gradually to around 3 percent as commodity prices recover and wage pressures build with the slower growth of the labor force.

7. Current Account. The current account surplus is expected to narrow to just under 2½ percent of GDP in 2016, driven by an increase in the services and income deficit.

  • The trade surplus is projected to remain stable in 2016 at slightly over 5 percent of GDP, with terms of trade effects broadly offsetting the pick-up in imports. Over the medium term, as the economy rotates further toward private consumption and away from external demand, the trade surplus is expected to decline to below 4 percent of GDP. The services deficit is expected to continually rise with healthy outward tourism, while the income deficit is expected to remain broadly stable.

  • Over the medium term, the current account surplus is expected to fall to around ½ percent of GDP by 2021. Savings are projected to decline from 48 percent of GDP in 2015 to around 42 percent by 2021. This reflects an expected fall in household savings, owing to demographic effects and a stronger social safety net, lower corporate savings as factor costs rise and efficiency diminishes, and a decline in public savings as social spending increases. Investment is expected to decline from 45 percent of GDP in 2015 to around 41 percent of GDP by 2021, reflecting both moderating private investment, as returns diminish in a slowing economy, and less excess in public investment.

8. Capital flows. The volume of capital outflows is expected to be broadly similar to last year as a percent of GDP. The large outflow seen in 2015:Q3–2016:Q1 will gradually moderate as the pressure from external debt repayment peters out. The secular trend of residents’ acquisition of foreign assets to balance their investment portfolio is expected to continue, but not materially accelerate from current levels.

9. Rebalancing. The high national savings rate, the crux of China’s internal and external imbalance, is expected to fall gradually due to aging and a stronger social safety net. Household consumption is expected to continue to pick up on the back of falling household savings and rising disposable income, which, in turn, derives from labor-intensive services increasingly replacing industry as the main fulcrum of activity on the supply side (which should also reduce the carbon intensity of output and income inequality). But the baseline assumes only modest progress on corporate restructuring and SOE reform; hence credit rebalancing is projected to progress only slowly.


Consumption Share to Rise…

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Source: IMF staff estimates and projections.

… and Services

(In percent of total employment)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

10. Medium-term growth prospects. The near-term reliance on policy easing and credit-financed investment, and the lack of decisive progress on addressing corporate debt restructuring, SOE reform, and entry of dynamic private firms is expected to add to the existing stock of vulnerabilities and worsen resource allocation. The price of achieving stronger near-term growth in this way is that the economy will likely encounter further diminishing returns, slowing to 6 percent by 2018 and declining further into the medium term. In particular, the credit intensity of growth is projected to decrease only modestly, resulting in a continuously rising nonfinancial private sector credit/GDP ratio. This gives rise to an increasing risk of disruptive adjustment (banking crisis and/or sharply slower growth), as credit booms often have in other countries.

11. Despite the relatively benign near-term outlook, downside risks dominate (Appendix III).


Credit Booms Tend to End Badly

(In percentage points)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Source: IMF staff estimates.1/ Average growth differential between 5-year post-boom and 5-year pre-boom periods.2/ No growth change as China’s boom has not ended.
  • Downside:

    • Near term: the key risks are a loss of investor confidence, disorderly corporate defaults, a sharp fall in asset prices, and a quicker fading of the stimulus impact. With high leverage, corporates are especially sensitive to declines in profitability and higher borrowing costs (but less so to FX risk given low aggregate FX exposure). These could be amplified by the financial system, with renewed capital outflows and exchange rate pressure.

    • Medium term: the key risk is slow progress on reform and continued reliance on policy stimulus and unsustainable credit growth, which would add to vulnerabilities, worsen resource misallocation, and lead to permanently lower growth. While near-term growth will be temporarily boosted, medium-term growth would continuously fall under an illustrative “no-reform” scenario, reflecting a sustained TFP growth slowdown. The nonfinancial private credit/GDP ratio would rise significantly higher than under the baseline, as would the risk of a disruptive adjustment.

    • UK / European Union. The direct impact of UK voters’ June 23 decision to exit the European Union (EU) is likely to be limited (for example, the UK accounts for 2½ percent of China’s exports). However, should growth in the EU be affected significantly, the adverse effect on China could be material (exports to the EU, including those routed via Hong Kong SAR, are equivalent to almost 4 percent of China’s GDP). Staff estimates suggest that a 1 percentage point growth slowdown in the EU is associated with a reduction in Chinese growth by about 0.3 percentage points. Financial spillovers are also expected to be contained, given the modest direct financial exposures to the EU and the authorities’ readiness to respond.


      Brexit: Limited Direct Exposure

      (In percent of Chinese GDP)

      Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

  • Upside:

    • Near term: the stimulus may have a bigger and more sustained impact, with a larger pick-up in real estate and a slower reduction in overcapacity investment (though this would increase medium-term risks).

    • Medium term: Faster progress on enacting structural reform (especially SOE reform), curbing credit growth, and improving overall resource efficiency would lift medium-term growth prospects. Under an illustrative “proactive” scenario, near-term growth could dip to 6 percent reflecting the faster adjustment partially offset by high-quality fiscal support (without such support, growth would fall to about 5½ percent), while medium-term growth would rise to 6½ percent driven by higher TFP growth. The improved efficiency would reduce credit intensity further, and stabilize the nonfinancial private debt/GDP ratio by 2021 significantly lower compared to the baseline. The pace of rebalancing from investment to consumption would also be faster.


GDP Growth: Illustrative Scenarios

(In percent, year-on-year growth)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

Credit Ratio: Illustrative Scenarios 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: CEIC Data Company Ltd.; World Economic Outlook (WEO) and IMF staff estimates.1/ Nonfinancial private debt, calculated as total social financing stock adjusted for local governemnt debt swap minus equity financing and LGFV borrowings.

Explaining the “Fan” in the Illustrative Growth Scenarios Graphic

  • In the no-reform growth scenario (left chart), the upper bound of the “fan” is the growth rate absent a disruptive adjustment. The lower bound is growth in an illustrative disruptive adjustment simulated by staff, adjusted by the probability of such an event.

  • The probability of the disruptive adjustment is derived from cross-country evidence linking disruptive adjustments to the size and duration of credit booms (Dell’Ariccia and others, 2016).

  • The baseline, and especially the “proactive” reform scenario, would have lower risk, but still significant given the growing credit/GDP ratio even under these scenarios.

12. Buffers, while still adequate, are shrinking fast, calling for urgent action to address these rising risks. China used around 20 percent of its FX reserves (relative to the mid-2014 peak) in supporting the currency, but the buffer remains above reserve adequacy metrics. Similarly, despite high public spending on infrastructure in recent years, augmented general government debt (i.e., including contingent liabilities from estimated off-budget local government borrowing) remains relatively low at around 60 percent of GDP and explicitly recognized general government debt at only about 40 percent of GDP, with a highly favorable growth-interest rate differential. These buffers have been deployed to combat outflow pressure and support growth over the past several months. But as vulnerabilities grow, contingent liabilities expand, and the buffers erode, the window for reforms and preventing downside risks from materializing will close.


Gross Government Debt …Not High

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: World Economic Outlook (WEO); and IMF staff estimates.1/ Including all explicit government (central and local) liabilities and part of the contingent liabilities that the government might be responsible for.

Reserves Still Adequate

(In percent of IMF Reserve Adequacy Metric)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: Assessing Reserve Adequacy; IMF Policy Papers; February 14, 2011.

Authorities’ views

13. Outlook. The authorities viewed the economy as well on track to achieve the target growth range of 6½ to 7 percent this year. They disagreed with staff’s view that policy support was adding to vulnerabilities, emphasizing, in particular, that higher infrastructure spending in less developed parts of the country would help boost long-term growth prospects. They also noted that policy support had stabilized momentum and a handoff to private activity was underway with real estate and related sectors taking the lead. In general, corporate investment remained soft, but recent high-frequency indicators pointed to an uptick ahead. The authorities highlighted that the quality of growth was improving, evidenced by stable employment, robust wages, rising contributions of private consumption on the demand side and labor-intensive services on the supply side, and reductions in the energy intensity of GDP. Over the medium term, the authorities expected growth to remain in the range of 6–7 percent, which, they emphasized, was sustainable considering the potential for restructuring, upgrading, and convergence in less developed regions. They further noted that the range is consistent with the 2020 goal of doubling the level of income per capita relative to 2010.

14. External position. The authorities observed that despite a recent recovery in exports, the trade surplus was expected to be broadly unchanged from last year as imports were likely to firm with the recovery in commodity prices and improvements in domestic demand over the rest of the year. The services deficit was expected to widen on stronger tourism outflows, while the income balance was likely to be uncertain, depending on whether lower returns on reserves could be compensated by higher returns on outward investment and lower interest payments on external debt. Over the medium term, the authorities expected the current account surplus to remain at 2–3 percent of GDP, with investment and savings staying broadly at current levels. The authorities concurred that the large net outflows in 2015 were mainly due to repayment of liabilities, and expected outflows to moderate this year since external debt is now lower and market understanding of the more market-based and flexible exchange rate regime had improved. They viewed the economy as well prepared to weather a Fed rate hike in the months ahead.

15. Risks. The authorities observed that there were downside risks to the outlook, especially from a weakening external environment. Their key concerns were depressed investment and uncertain prospects in several emerging markets (EMs); sluggish and tentative recoveries in AEs; rising geopolitical tensions; and an intensification of the refugee crisis in Europe. They viewed the likely fallout from the UK’s June 23 decision to exit the EU as manageable, but nevertheless stood ready to take appropriate measures to support aggregate demand, and ensure interbank liquidity remained adequate and market conditions orderly. On domestic risks, the authorities agreed with staff that corporate debt had risen excessively, but took the view that China’s large pool of domestic savings, the largely state-owned entities involved both on borrower and creditor sides, ample banking system buffers, and ongoing equity market development would facilitate a smooth adjustment. They concurred, however, that further substantive progress was needed on deleveraging and capacity reduction, without which there was a tangible risk of permanently lower medium-term growth. The authorities observed that property prices were beginning to show signs of moderation in Tier 1 cities, while equity prices were more in line with fundamentals after the substantial correction over the last 12 months. They recognized that there were some financial sector risks, but that these were limited and the supervisors were responding proactively.


16. China’s transition will be positive overall for the global economy, but continue to produce large spillovers that vary by country/region.

  • China will continue to drive global growth during its transition. Despite its growth slowing, China doubled its real GDP since 2009, thus continuing to account for about a third of global growth in 2015 (more than it did in 2010 when China was growing in double digits).


    Contribution to Global Growth: Still Large

    (In percentage points)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: World Economic Outlook (WEO); and IMF staff estimates.

  • Sustained progress on reforms and reining-in of vulnerabilities will reduce downside risks, thereby boosting sentiment and lifting investment in trading partners. The announced capacity reductions in coal and steel, if implemented, could also have a sizable effect on global capacity (e.g., the envisaged cuts in steel capacity over the next 3–5 years are broadly equivalent to recent annual steel output of the world’s second-largest producer, Japan).

  • The counterfactual to China’s transition is not everlasting, investment/import-intensive, double-digit growth, but much slower growth, and possibly a sharp slowdown, which would have much more significant negative spillovers.

17. The evolution of China’s production mix is already creating opportunities for frontier and developing economies. Staff analysis shows that China’s movement up the value chain with its wages rising has led China to exit some lower-end, more labor-intensive sectors. This trend is creating opportunities for frontier and developing economies, particularly in Asia (e.g., Cambodia, Lao P.D.R, Myanmar, and Vietnam) to enter those sectors and to satisfy rising Chinese consumption demand.

18. That said, developments in China’s will continue to produce large global spillovers, some of which will be negative for some countries/regions.

  • Spillovers through trade. Economies most adversely affected by trade spillovers are those that have been closely integrated with China through the global value chain, such as Korea, Malaysia, and Taiwan Province of China, as these economies are heavily exposed to China’s investment activity. In contrast, New Zealand will be least negatively affected, as its exports to China will benefit from the increase in China’s consumption demand. Staff analysis (April 2016 World Economic Outlook) suggests that a 1 percentage point investment-driven drop in China’s output growth would reduce G20 growth by ¼ percentage point.


    Spillover Channels and Countries

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Source: IMF staff estimats.

  • Spillovers through commodity prices. China is a major importer across a range of commodities, especially metals, where it accounted for about 40 percent of global demand in 2014. China’s investment slowdown has had a significant impact on the demand for, and prices of, commodities closely related to investment activities. Staff analysis suggests that China’s rebalancing might account for between a fifth and a half of the declines in broad commodity price indices, with marked difference across commodities.

  • Spillovers through financial markets. Financial spillovers from China have increased, in particular since the global financial crisis, magnified by direct trade exposures. Staff analysis suggests that purely financial contagion effects remain less significant, but the impact of shocks to economic fundamentals, such as news about China’s growth, on equity returns in both emerging market and advanced economies has been rising. Over the past year, for example, China has likely transmitted more shocks to other countries than it has received (see Selected Issues).

  • Overall, countries most heavily exposed to China’s growth slowdown are those within the Asian regional supply chain and heavy commodity and machinery exporters.

Authorities’ views

19. The authorities acknowledged that the needed slowdown in heavy industrial sectors in China could have transitional negative effects on commodity prices and trading partners’ growth, but that this adjustment, by placing China on a sustainable growth path, would benefit the global economy in the long run. The authorities agreed that financial spillovers from China appeared to be rising, but cautioned that establishing a causal relationship was difficult. Several other factors have contributed to global risk-off episodes in recent years, including general weakness in EMs and uncertainty about the direction of unconventional monetary policy stances in AEs. The authorities also observed that negative interest rate policies in some advanced economies appeared to have hurt prospects for bank profitability, at times adding to pressure on equity prices and fueling contagion effects in international markets.

Policies to Secure The Transition

Preventing downside risks and ensuring the transition to more robust, sustainable medium-term growth requires decisively implementing a proactive and comprehensive policy package. The challenge for policymakers will be to focus less on traditional investment stimulus to support short-term growth, and more on fostering a well-regulated, consumer-oriented private sector to generate stronger, and more sustainable, growth in the medium term.

A. Tackling the Corporate Debt Problem

20. International experience, including China’s own in the 1990s, suggests that tackling a systemic corporate debt problem requires a comprehensive approach. Without this, individual initiatives, like debt-equity conversions, will likely fail. The strategy outlined below cuts across topics and government agencies, affects swathes of people, firms, cities, banks, investors, and regions, and requires politically challenging decisions. There may thus be merit in establishing a well-staffed, high-level group with a clear mandate for policy formulation and communication. Progress should be kick-started in the next few months with a few high-profile pilot restructurings/liquidations of weak SOEs in more dynamic regions where it is relatively easier for displaced workers to find new employment, building on the plans for “zombie” company exits already underway in a few provinces (see Selected Issues). Key elements include:

21. High-level decision. Upfront and most importantly, a high-level decision is needed to stop financing weak firms, strengthen corporate governance, mitigate social costs, and accept the likely lower growth. This decision should be reflected in the coordinated action of all involved public bodies, especially SOEs, local governments, and financial supervisors.

22. Hardening budget constraints. Reducing the access to credit of weak firms is critical not only to help address the existing debt overhang, but also to improve the efficiency of new credit allocation. This requires hardening budget constraints by removing implicit guarantees and subsidies and allocating losses to firms and investors carefully in a system relatively unaccustomed to defaults. Indeed, the number of firms defaulting on bond coupon payments has increased in recent months, as have ratings downgrades and issuance cancellations. These developments will help investors to price risk more accurately (as seen in the recent widening of credit spreads) and improve the allocation of credit over time.


Bond Rating Downgrades to Speculative Grades Increasing1/

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: WIND; and IMF staff estimates.1/ Rated at or below BB+.

Spreads Between Ratings Widening

(In basis point)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: WIND; and IMF staff estimates.

23. Triage. Continued support of fundamentally unviable firms will only result in greater losses in the future and further resource misallocation. Thus, firms facing difficulties servicing their debts should be triaged into the viable, which should be restructured, and nonviable, which should be liquidated. From the government’s perspective, this means triaging the universe of SOEs and beginning to liquidate nonviable firms, with fiscal support to help meet the welfare costs of laid-off workers, along the lines of the recently announced restructuring fund for coal and steel sectors. Viable but insolvent SOEs will need a restructuring plan and a management that can execute it (which will likely require a greater role for the private sector). Their nonmarket objectives and responsibilities should be removed. This plan should also involve scaling back subsidies (e.g., for land use and preferential access to credit) to these firms and raising their dividend payouts to the budget to the targeted 30 percent.

24. Loss recognition. Regulatory and supervisory oversight should require banks proactively to recognize and manage impaired assets. Critical policies include loan classification and provisioning; bank capital; collateral valuation; prudential reporting; and a supervisory review approach fostering proactive NPL resolution (restructuring, write off, or sale). Asset quality recognition standards should be applied equally to loans and to securities whose underlying assets embody credit or market risk, and encompass both banks and nonbank financial institutions. Once losses are recognized, techniques such as debt-equity conversions, NPL securitization, and sales to AMCs, can be useful to workout impaired assets, if nested in a comprehensive strategy and with the right design.3

25. Burden sharing. Recognizing the full extent of impaired assets will likely result in significant losses. A plan to allocate these losses, taking into account appropriate hierarchy of claims among banks, corporates, and investors, and if necessary backstop them with government funds, will be critical. This in turn calls for an active role for the state, which China is well placed to undertake.

26. Restructuring mechanism. While the legal framework for enterprise insolvency does not seem significantly to deviate from best international practice, its application has been extremely limited. Large-scale and expedited restructuring requires creative approaches to complement the existing framework, such as an out-of-court debt restructuring mechanism for priority-distressed companies that would use independent restructuring experts to provide valuations and restructuring/liquidation proposals. This process should be market based, rather than relying on forced mergers between weak and strong firms, and transparent, to prevent corruption and the state losing value.


Insolvency Little Used

(Number of cases, 2014)

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Sources: China Court; Sinotrust; Euler Hermes; US Trust Offices; Credireform; and UK Insolvency Service.

27. Distressed debt market. A more market-based system for resolving distressed debt would facilitate the disposal of nonperforming loans. This may require greater involvement of specialist financial institutions and legal workout agencies, and would also benefit from better functioning collateral auctions to help increase recovery values. Existing AMCs can also play a role in jump-starting the market for distressed assets, provided they have the right incentives and independence.

28. Social costs. A comprehensive restructuring will involve substantial social welfare costs, such as layoffs. Staff estimate potential employment losses in the excess capacity sectors (aluminum, cement, coal, construction, plate glass, and steel) at close to 8 million—some 1 percent of total employment. Given the likely regional concentration of this economic hardship, the central government should bear a portion of the welfare costs related to displaced workers. The costs of structural unemployment and worker resettlement are best borne by targeted assistance through earmarked funds to complement existing local social security programs, such as with the RMB 100 billion Restructuring Fund for the coal and steel sectors.

29. Facilitating market entry. Improving resource allocation is not just about the exit of nonviable firms, but equally the entry of dynamic private firms. Where possible, markets should be made more contestable by lowering barriers to entry for potential competitors and dismantling monopolies, for instance in services (especially telecommunications and healthcare) and utilities (electricity, gas, and water). The recently announced SOE reform strategy has underscored some of these elements—the key is to follow through with decisive implementation (see Selected Issues).

Authorities’ views

30. The authorities emphasized that the key focus areas in the 13th Five Year Plan—drawn up keeping in mind corporate debt-related vulnerabilities and financial stability considerations—were supply side structural reforms, deleveraging, destocking, reducing energy intensity, facilitating entry, and giving markets a more decisive role in resource allocation. They noted that a list of state-owned “zombie” companies was being prepared, mostly in the coal and steel industries, and that capacity reduction was underway in these sectors. Disbursements from the restructuring fund to facilitate worker resettlement had begun, with close to RMB 30 billion (a third of the total) already transferred to provinces that had provided commitments on capacity reduction. The authorities, however, cautioned that the process would be necessarily slow due to complicated corporate structures involving overlapping balance sheets and control of assets among parent, subsidiary, and affiliated companies that made valuation assessments difficult. Ultimately, they saw a need for more market involvement—rather than government directives—in the process, with creditors discriminating more carefully among borrowers and thereby hardening budget constraints.

31. The authorities further noted that implicit support to SOEs had been largely phased out and they were increasingly competing on an equal footing with private firms. They also expected the envisaged mixed ownership reforms in SOEs would instill professional management, strengthen corporate governance, and attract private participation to improve efficiency. The authorities also observed that entry was being facilitated with approval procedures for capital injection in new growth areas cut by a third.

B. Accepting the Slowdown

32. Macro policies should be consistent with lowering vulnerabilities and the resulting moderately slower near-term growth. Restructuring will likely entail slower growth in the near term. This should be accepted in the interest of achieving higher, better-quality, and more robust longer-term growth. Some of the negative impact on near-term growth may be offset if sentiment were lifted by sending a strong signal of policy intent. On-budget, pro-consumption fiscal stimulus can be used if growth threatens to fall excessively.

33. Targets. The practice of setting annual growth targets (rather than projections) has fostered an undesirable focus on short-term, low-quality stimulus measures. If annual targets are to be maintained, they should be downplayed in importance compared to other indicators (such as household income growth), set flexibly (wider ranges) and at sustainable levels—for 2017, around 6 percent.

34. Credit growth, most importantly, needs to fall substantially to stabilize the nonfinancial private credit/GDP ratio. This should be done by decisively tackling the problem at source—soft budget constraints on SOEs and local governments, the web of implicit and explicit guarantees, excessive risk taking by financial institutions and the pursuit of unsustainably-high growth.


Monetary Policy Looser than Implied 1/

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Source: IMF staff estimates.1/ The monetary policy stance index is constructed on the basis of a short-term interest rate, reserve requirement ratio, open market operations and credit growth. The implied policy index is estimated with a simple Taylor rule that includes inflation and output developments.

35. Interest rates. Staff’s monetary policy index suggests rate cuts have gone beyond what the historical relationship with output and inflation would imply as necessary. Short-term rates are barely positive in real terms and likely below the longer-run neutral level. Interest rates should rise towards less accommodative levels as inflation picks up as projected. This should be data dependent, with an earlier upward move if, for example, inflation strengthens faster than envisaged, growth surprises on the upside, or capital outflows intensify substantially. Stronger prudential settings—which, in the past, have contributed to a significant slowing of credit expansion—should be the main financial policy tool to restrain credit growth, but somewhat higher interest rates could play a complementary role, for example, by reaching parts of the financial system that prudential measures may miss (such as shadow banking and the corporate bond market). That said, higher rates should be used with caution as they could intensify corporate distress and worsen credit conditions for SMEs.

36. Fiscal stance:

  • Monitoring the fiscal stance in China is especially difficult. Much spending and most of the deficit and financing occurs off budget with little transparency, and the line between public and private is blurred. Staff’s estimates of the “augmented” balance and debt (i.e., including estimated off-budget spending/financing) are thus subject to a particularly high degree of uncertainty, but likely reflect more accurately the effective fiscal position than the official budget balance and debt.


    Fiscal Deficit Remains Large, But More on Budget

    (In percent of GDP)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

  • Over the medium term, the large augmented deficit should gradually decline towards around 7 percent of GDP, to slow and eventually stabilize debt. The projected increase in the augmented deficit in 2016 is thus not warranted from a structural perspective. Neither is it warranted from a cyclical perspective given the growth outlook. For 2017, a moderate reduction of the augmented deficit seems appropriate. Only if growth threatens to fall sharply (well below staff’s projection of 6.2 percent) should the deficit widen (and if so, with measures that promote rebalancing, as detailed below).

  • The on-budget fiscal deficit is projected to increase from 2.7 percent of GDP in 2015 to 3 percent of GDP in 2016. Going forward, the reallocation of fiscal resources from off-budget investment towards on-budget measures that support rebalancing (boosting household incomes and consumption) and restructuring should continue. Such a reallocation could be helped by setting fiscal policy within a sound multi-year budgeting framework and greater coordination between the various bodies responsible for fiscal policy and planning. Provincial government quotas for new debt issuance should be set consistent with this overall envelope, with the aim of curtailing off-budget local government borrowing and bringing it on budget.

  • Increasing on-budget support for consumption should include raising pensions, social assistance, education and health spending, unemployment benefits and providing restructuring funds, while cutting minimum social security contributions and raising SOE dividend payments. Increases in social benefits should be targeted to ensure progressivity.

  • Substantially raising taxes on fossil fuel and pollution (e.g., a carbon or coal tax) would help curtail emissions, improve energy efficiency, raise revenue and prevent almost 4 million premature deaths by 2030 (see Selected Issues).


    Pollution-Related Premature Deaths: 2015-2030

    (In millions of deaths, aggressive policy scenarios)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Source: IMF staff estimates.Note: Columns indicate cumulative deaths prevented.

  • Progress should continue on structural fiscal reforms that will facilitate better use of public resources and reduce the distortions and costs imposed on the private sector (see D. Lipton, Finance and Development, March 2016). Key reforms include: (1) implementing the new budget law, improving the transparency of local government financing, and closing new “back-doors” for continued quasi-fiscal borrowing/spending (2) modernizing the tax system and making it more progressive (e.g., relying more on direct taxes and allocating local governments revenues to match their spending responsibilities) and (3) expanding social security and improving the portability of all types of benefits, liberalizing residency restrictions, and improving active labor market policies.

Authorities’ views

37. The authorities emphasized that monetary and fiscal policies would provide a supportive environment for supply-side restructuring. They viewed the level of interest rates as appropriate from a cyclical perspective. They expected credit growth to normalize in the remainder of the year, observing that the exceptional pace of expansion in early 2016 was in part driven by the real estate sector—which would likely moderate going forward. The authorities highlighted that the pace of credit growth would fall over the medium term, given the emphasis on deleveraging and structural reforms in the 13th Five Year Plan. They noted, however, that the speed of deleveraging would need to be gradual to prevent adverse feedback loops between the financial sector and the real economy, as seen for example in Europe after the financial crisis. The authorities also emphasized that reducing the pace of credit growth would mean foremost reining in credit to unviable “zombie” firms, while ensuring that dynamic firms continued to have access to finance.

38. The authorities noted that fiscal policy would proactively take the lead in supporting aggregate demand, with a higher on-budget deficit projected this year compared to last. They questioned staff’s ‘augmented’ balance, arguing that the concept was no longer relevant since local government off-budget spending had been prohibited. The authorities observed that the implementation of the new budget law was largely on track, although some local governments continued to guarantee borrowing by LGFVs, requiring the central government to step up its monitoring and enforcement of the rules. They emphasized that losses on any new loans to these entities would be shouldered by the financial institutions advancing the credit. The authorities also highlighted that tax reforms were underway, including to the personal income tax, environmental protection, resource and excise taxes. However, they questioned staff’s estimate of the expected health benefits of a carbon or coal tax, arguing that causal links from higher tax rates to lower mortality rates had not been conclusively identified.

C. Guarding Against Financial Stability Risks

39. Securing financial stability requires action on multiple fronts.

  • Banks

    • ➢ Provisioning and loan classification regulations should be examined to foster more proactive recognition of potential loss. This could involve, for example, classifying all loans with overdue payments beyond 90 days as nonperforming. This process could usefully be complemented by a focused asset quality review (e.g., of a random selection of assets or those from a particular sector).

    • ➢ Capital ratios should be increased. Increasing loan-loss provisions will help absorb higher potential NPLs, but banks face a broad variety of risks, which call for a stronger layer of equity capital. This can be achieved, for example, by imposing a high countercyclical capital buffer and encouraging common equity issuance (helped by removing constraints on issuing when valuations are below book).

  • Funding. As banks and other financial institutions have grown total assets far faster than deposits, funding has shifted toward wholesale, short-tenor, and more volatile instruments. Banks’ reliance on interbank funding has increased, leverage has risen in the repo bond market, and collateral quality is deteriorating. These developments should be kept under close review and measures considered to strengthen liquidity in stress scenarios. These should include a strong supervisory focus on the adequacy of liquidity risk management as set out in the Liquidity Coverage Ratio standard and associated Basel guidance, and paying close attention to collateral standards.

  • Shadow products. The proliferation of shadow credit products calls for a holistic approach to their supervision. The recently published “CBRC Notice 82” appears to close some regulatory arbitrage opportunities and should be implemented aggressively; additional action should be considered as necessary for a comprehensive approach.

  • Capital markets. The priority should be on orderly functioning of markets (which could include emergency liquidity provision by the central bank), not on intervention to influence valuation. Fundamentally, the solution to recurrent market excesses lies in addressing the underlying search for yield and curtailing excessive liquidity creation. A set of more immediate issues includes refraining from intervention during sell-offs and tightening underwriting and disclosure standards, in particular in the bond market where issuance of publicly traded products has surged over the past year with relatively limited dispersion in credit ratings. The resilience of securities firms and other regulated institutional investors should be strengthened through capping leverage and improving risk management practices.

  • Property. Residential investment is reviving again in several parts of the country, even as excess inventory remains high, and region-specific policies could be appropriate. Specifically, tighter macroprudential measures in Tier 1 cities seem warranted (for example reducing loan-to-value ratios on mortgages for second homes). For lower-tier cities, where multi-year excess inventory levels are particularly acute, restricting new starts seems warranted, for example by tightening prudential measures on credit to property developers.


    Tier III or IV City Real Estate Inventory Still High 1/

    (In years)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

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

  • Crisis preparedness. Given the rising vulnerabilities, the authorities should be prepared for potential idiosyncratic and systemic stress. Key actions include: (1) conducting stress tests and readying the emergency liquidity framework; (2) preparing a strategy, including a resolution framework, for distressed financial institutions, especially nonbanks; (3) instituting a clear public funding backstop for the deposit insurance scheme; (4) ensuring adequate data and analysis (e.g., on bank/shadow bank interlinkages and FX exposures); and (5) allocating coordination of crisis preparedness and management to a high-level forum with a clear implementation plan and communications strategy.

  • Regulatory structure. International experience does not speak clearly in favor of a particular structure. Nevertheless, a major upgrade in supervisory cooperation and coordination is necessary. The goals should be: (1) seamless information sharing, coordination and communication among agencies; (2) more proactive response to markets’ proven agility to expand into regulatory gaps and engage in regulatory arbitrage; and (3) stronger crisis management capabilities.


Current Regulatory Structure

Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

Authorities’ views

40. The banking regulator disagreed with staff’s assessment of corporate debt-at-risk. Their own internal exercise, taking into account the mitigating impact of loan collateral, had produced significantly lower estimates. They noted that unlisted companies—assumed the same as the listed universe in staff’s exercise—were healthier as a group than the listed universe. The regulator also argued that the classification of loans as nonperforming would need to consider other criteria besides payments overdue beyond 90 days, such as judgment about the borrowers’ long-term viability and whether they faced cyclical or structural cash flow problems. The regulator noted that bank exposures to nonstandard credit assets was a key concern and they had already instructed banks to conduct stringent asset quality classification, which would require them to set aside more reserves against these exposures than against loans. The banking regulator was also closely monitoring the growing reliance on wholesale funding, but viewed this as a needed adaptation in banks’ business models with the growing competition for deposits. The banking regulator argued that bank capital ratios were sufficient and stable, and viewed dynamic provisioning (introduced in 2011) as effectively playing a similar role to a countercyclical buffer.

41. The securities regulator concurred with staff that the regulatory focus should be on ensuring smooth functioning of capital markets. They emphasized they stood ready to provide liquidity to distressed securities firms and would avoid indiscriminate and large purchases of securities. Information requirements for bond issuers had been raised and onsite inspections increased.

42. The authorities questioned staff’s view on instituting a public backstop for the deposit insurance scheme. They argued that the deposit insurance system was a market-based framework to prevent moral hazard and should not be directly linked to public funding. The authorities further noted that international experience and standards suggested that premium contributions—not fiscal resources—should be the main source of financing deposit insurance. At the same time, the legal framework does not preclude public emergency liquidity funding for the deposit insurance system, though such public funding shall be repaid by bank premiums. More generally, the authorities agreed that closer cross-agency coordination was needed to bolster supervision, policymaking, and crisis preparedness. Steps were already being taken in this regard, for example through closer collaboration on issuing new liquidity guidelines for securities firms.

D. Progressing Toward an Effectively-Floating Exchange Rate Regime

43. FX regime. China has made progress over the past year in moving toward a more flexible, market-determined exchange rate system. The past year has also shown that the transition from many years of stability/gradual appreciation is difficult and potentially bumpy, particularly amid the challenging global and domestic context. Achieving a smooth, successful transition will need to combine a clear overarching drive toward progressively greater market determination and skillful, short-term management to avoid excessive volatility. In particular

  • Achieving an effective float within the next couple of years, ideally by 2018, remains a key goal. A more flexible, market-determined exchange rate is needed to allow the market to play a more decisive role in the economy, absorb shocks, and maintain an independent monetary policy as the capital account opens.

  • While staff assesses the current level of the RMB as broadly in line with fundamentals, the value of permitting market forces to help guide the exchange rate toward equilibrium levels should be recognized. Therefore, the effective exchange rate (relative to a basket) should over time be allowed to move in response to market conditions.

  • At the same time, the authorities should also ensure that such adjustment is not destabilizing by preventing overshooting, one-way expectations, and disorderly market conditions—the large buffer of reserves provides ample ammunition for such intervention, to be deployed, for example, in the event of a significant shock.

  • A possible framework for managing this transition could be to progressively widen a tolerance band around an equilibrium effective rate within which the spot rate could fluctuate. The band could be widened gradually or in discrete steps; spot rate fluctuations within the band could be smoothed by intervention; and the center of the band could be adjusted if the equilibrium effective exchange rate is assessed to have changed (influenced heavily by sustained market pressures in either direction).

44. A more market-based monetary framework. The move to a more flexible exchange rate should proceed in tandem with completing the transition toward a more market-based monetary framework. Key elements include:

  • Objectives. Although the PBC does not operate under an explicit inflation targeting regime, its official mandate includes maintaining “the stability of the currency value and thereby promote economic growth.” Formally, the PBC targets multiple objectives (inflation, balance of payments, growth, financial stability). As an important first step, the authorities should introduce an explicit medium-term inflation target or a range (set by the government/State Council) together with operational (instrument) independence for the PBC.

  • Instrument. The PBC should declare the seven-day repo rate its new intermediate policy target for monetary policy purposes and publish a new market rate (seven-day repo) representative of lending conditions for Tier 1 banks. The clearer the policy framework, the easier it will be for the market to establish a yield curve. Standing facilities should act as a backstop with unlimited access for banks against appropriate collateral.

  • Operational framework. While the volatility of short-term repo rates has decreased significantly since last summer, the PBC could further improve its operational framework to ensure the stability of the short-term market rates. For instance, reserve averaging (introduced in 2015) could be expanded to a 4–5-week period to allow easier liquidity management by banks.

  • Backstop. Clear standing facilities should be put in place as a backstop. The overnight standing credit facility may function as an important backstop for the payment system. In addition, eligibility and collateral requirements for the PBC’s liquidity facilities should be clear.

  • Transparency. Most central banks have found that policy operates more efficiently and effectively if it is clearly and simply communicated and implementation clearly supports the stated policy. For example, domestic monetary policy would be clearer if the PBC were explicitly to announce its monetary policy goals and use monetary policy instruments to achieve those goals in the most transparent manner possible.

45. Capital account. Enforcement of capital controls has been tightened since last summer and some additional measures, notably the 20 percent unremunerated reserve requirement on FX forwards, have been introduced to stem significant depreciation pressures. Such tightening has likely contributed to the restoration of stability in the capital account, but has come at some cost to the efficiency of individual corporate treasury management. While new controls should be avoided, further liberalization should be phased very cautiously. Indeed, capital account liberalization (and financial liberalization more broadly) can only succeed if supported by a strengthened financial system, enhanced corporate sector governance and greater exchange rate flexibility, suggesting that much further progress on the former (capital account liberalization) may need to await the latter (a strengthened financial system, enhanced corporate governance and greater exchange rate flexibility). Care should also be taken to ensure that enforcement of existing capital controls does not spillover to affect current account transactions.

Authorities’ views

46. The authorities noted that exchange market pressures had eased considerably in recent months and the move to a more market-based exchange rate was progressing. The approach was to continue maintaining broad stability against a currency basket while allowing market forces a greater role in determining the level. FX intervention had decreased in recent months and was used largely to smooth adjustments and curb overshooting. The authorities remain committed to gradually liberalizing the capital account over the medium term. They may complement such reforms (including the reserve requirement on FX forwards that the authorities consider macroprudential measures) to maintain stability and minimize disruptive short-term capital flows. The monetary framework was also being adapted to elevate the role of interest rates as a policy lever. Daily open market operations, open bid auctions for liquidity, and 10-day reserve averaging had contributed to increased stability and predictability in money market rates. The PBC did not see the need to extend the period over which reserve averaging is calculated, citing banks’ liquidity management had adapted well to the current system.

E. Enhancing Transparency and Communications

47. Contributing to the market turbulence in recent months is a lack of clarity about what is happening in the economy and the authorities’ policy intentions.

  • Data gaps. Lack of confidence in macroeconomic data prompts many investors to suspect the economy is much weaker than officially reported (Box 3). While progress has been made, for example, in monetary, financial and external statistics and by disseminating data via SDDS and CPIS, important gaps remain. Addressing these data gaps, especially in the national accounts (e.g., providing quarterly GDP by expenditure, high-frequency indicators on services and the “new” economy, and improving the deflation methodology), government finance statistics (e.g., tracking off-budget spending by local governments and providing an expenditure breakdown by economic type) and credit composition (e.g., by sector) would enable better monitoring of macro developments, identification of key risks, and design of the policy stance. Ensuring adequate data are available on bank/shadow bank linkages and FX exposures is also critical for financial stability analysis. While data are broadly adequate for surveillance, they are only barely so, and are not commensurate with China’s systemic importance.

  • Communications. Clear, authoritative, and consistent communications about policy objectives and how they are being achieved would reduce uncertainty and align expectations. This requires developing a communication strategy integrated closely with policy decisions; identifying key audiences (both domestic and foreign); using a range of user-friendly communication tools and channels; and learning from international experience. Recent efforts by key policymakers to convey their insights on the outlook and their policy intentions are encouraging, as is the initiative to increase the frequency of press conferences on data releases from quarterly to monthly.

Authorities’ views

48. The authorities noted that data collection and dissemination was being upgraded in three main areas: consistency between provincial and national GDP, national balance sheet, and natural resource balance sheet (accounting for environmental assets such as land, forests and water). They were exploring possibilities for publishing expenditure-based quarterly GDP in real terms and high-frequency indicators for services. From a financial regulatory perspective, the authorities did not see any major data gaps in bank/shadow bank linkages or credit allocation by sector. They intended to publish more detailed breakdowns of bank credit and increase the frequency of dissemination. The authorities acknowledged the importance of communications and pointed to recent press conferences and media interviews by key policymakers.

How Reliable is China’s Output Data?

There is some evidence pointing to possible overstatement of growth recently, but the overstatement is likely moderate and the official national accounts data—while there is much room for improvement—likely provide a broadly reliable picture.

China’s nominal GDP is probably larger than the official estimate. This could reflect flaws in measuring service consumption, including the inability to fully capture the switch from state-owned industrial firms to market-based (and often smaller) service firms. A study by the Rhodium Group, which duplicates the authorities’ statistical methodology, but addresses some key weaknesses, suggests nominal GDP is underestimated by, for example, 13–16 percent in 2008, and some other studies, while using different approaches, show similar results.

But growth may be smoothed since the smallest and most volatile firms may not be adequately captured in the statistical methodology. Indeed, skepticism that growth is overstated has grown recently, arising largely from the more pronounced weakening in some hard indicators compared to official growth data, including consumption of energy, industrial value added, and commodity imports. A few studies indicate that growth is not overstated over a long time horizon, but that the volatility is understated. Some further argue that the official nominal GDP data are reliable, but the weaknesses in deflators cause real growth to be smoothed. For example, the single deflation approach, which deflates input and output using the same deflator, tends to overstate growth when commodity prices decline sharply. But a counterargument is that the dynamism in the service sector is robust and not well reflected in the hard indicators mentioned above. For example, private consumption is buoyant, with retail sales growing by around 10 percent y/y in real terms.

“Underlying” growth may be weaker than officially reported, but only somewhat.

  • Correlation. A sudden decline in the correlation between overall growth data and individual hard indicators could signal that the official data might overstate growth. However, looking at 12-month rolling correlations for real GDP growth versus electricity production, cement, crude steel and freight, does not suggest a recent significant decline (though the series are noisy).


    GDP Growth: Official and Estimated

    (In perent, year-on-year growth)

    Citation: IMF Staff Country Reports 2016, 270; 10.5089/9781475524321.002.A001

    Sources: CEIC Data Company Ltd.; and IMF staff estimtes.

  • High frequency-based estimates. Out-of-sample estimates of growth from high-frequency PMIs and consumption/investment indicators are about ¼–½ percent lower than official growth data in 2015.

These results, however, are only indicative of possible slower underlying growth. While providing some cross checks, they are not based on comprehensive datasets and cannot substitute for national account statistics. These approaches focus on underlying growth by analyzing variables traditionally shaping economic fundamentals, while actual growth also includes transitory factors not captured (e.g., the current strength of financial services).

Staff Appraisal

49. Reform and rebalancing amid a bumpy transition. China continues its transition to a sustainable growth path. Rebalancing has progressed on many dimensions, particularly switching from industry to services and from investment to consumption, but less on reining in credit growth. Reforms have advanced impressively across a wide domain, but lagged in some critical areas, and the transition to sustainable growth is proving difficult, with sizable economic and financial volatility. Vulnerabilities are rising on a dangerous trajectory and buffers, while still adequate, are eroding.

50. Policy plans. Recognizing these challenges, the recently launched 13th Five Year Plan appropriately aims to boost consumption, expand the service sector, protect the environment, and reduce poverty. The government has put supply-side reforms at the center of its economic policy agenda, including the restructuring of SOEs, capacity reduction in the coal and steel sectors, and facilitating firm entry and worker resettlement to new growth areas.

51. Benign near-term outlook… Growth is expected at 6.6 percent this year, shored up by policy stimulus, falling to 6.2 percent in 2017. This assumes robust consumption and wage growth, and a slight pick-up in investment this year, but moderating next year. Net exports will likely continue to drag growth in the near term as external demand remains tepid. Inflation should gradually pick up as commodity prices recover.

52. …but increasingly uncertain medium-term prospects. More urgent action is needed to tackle vulnerabilities and improve resource allocation. Under staff’s baseline scenario, growth will decline below 6 percent over the medium term, the credit/GDP ratio will continue rising, and the risks of a disruptive adjustment will increase. Under an alternative, proactive scenario with decisive measures to tackle corporate debt and reform SOEs, near-term growth would dip below baseline but, critically, medium-term growth prospects would improve and the nonfinancial private credit/GDP ratio would stabilize at a significantly lower level than in the baseline.

53. Tackling the corporate debt problem. Corporate debt, though still manageable, needs to be decisively tackled to ensure it remains so. International experience, including China’s during the 1990s, suggests that addressing a systemic corporate debt problem requires a comprehensive approach and decisive implementation to: harden budget constraints; triage excessively indebted firms, restructure the viable and liquidate the nonviable; recognize and share financial losses among firms, banks, other creditors, and, if necessary, the government; absorb the social costs of layoffs through earmarked funds; and facilitate entry of dynamic private firms. Progress should be kick-started by piloting a few high-profile restructurings/liquidations of weak SOEs in the next few months.

54. Macro policies should be consistent with lowering vulnerabilities and the resulting moderately slower, near-term growth. Most importantly, credit growth and investment need to decline, partially offset by a further increase in on-budget measures that support rebalancing by boosting household consumption. Pro-rebalancing measures should include raising pensions, social assistance, education and health spending, providing restructuring funds, and cutting minimum social security contributions.

55. Further action is needed on multiple fronts to secure financial stability. This includes proactive recognition of losses in banks’ loan books; strengthening capital ratios; enhancing supervisory focus on liquidity risk management and funding stability risks; and addressing risks in shadow products. A major upgrade in supervisory coordination and cooperation is necessary to foster more seamless cross-agency information sharing and policy coordination, reduce the scope for regulatory arbitrage, and enhance crisis management capabilities.

56. Steady progress toward an effectively floating exchange rate regime should continue. Staff encourages the authorities to build on the progress made over the past year in moving toward a more flexible, market-determined exchange rate system. Achieving an effectively floating exchange rate regime, ideally by 2018, will need to combine a clear overarching drive toward progressively greater market-determination and skillful short-term management to avoid excessive volatility. The move to greater flexibility should be supported by progress to a more market-based monetary framework. Further capital account liberalization should be phased carefully, supported by a strengthened financial system, enhanced corporate governance and greater exchange rate flexibility.

57. Transparency in data and communications. Greater clarity about developments in the economy and the authorities’ policy intentions would reduce uncertainty, align expectations, and help contain market turbulence. This requires more comprehensive and timely dissemination of economic and financial data and a communication strategy integrated with policy decisions, conveyed via a range of user-friendly tools.

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

Table 1.

China: Selected Economic Indicators

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

Surveyed unemployment rate.

After adjusting local government debt swap, staff estimate that TSF stood at 203 percent of GDP in 2015.

Average selling prices estimated by IMF staff based on housing price data (Commodity Building Residential Price) of 70 large and mid-sized cities published by National Bureau of Statistics (NBS).

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.

Estimates of debt levels before 2015 include central government debt and explicit local government debt (identified by MoF and NPC in Sep 2015). The large increase in general government debt in 2014 reflects the authorities’ recognition of the off-budget local government debt borrowed previously. The estimation of debt levels after 2015 assumes zero off-budget borrowing from 2015 to 2021.

Expenditure side nominal GDP.

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.

Table 2.

China: Balance of Payments

(In percent of GDP, 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.

Includes foreign currency reserves and other reserve assets such as SDRs and gold.

Table 3.

China: External Vulnerability Indicators

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

Estimates of debt levels before 2015 include central government debt and explicit local government debt (identified by MoF and NPC in Sep 2015). The large increase in general government debt in 2014 reflects the authorities’ recognition of the off-budget local government debt borrowed previously. The estimation of debt level in 2015 assumes zero off-budget borrowing during 2015.

Shanghai Stock Exchange, A-share.

Includes foreign currency reserves and other reserve assets such as SDRs and gold.

Table 4.

China: Monetary and Credit Developments

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

After adjusting local government debt swap, staff estimate that TSF grew by 15.9 percent (y/y) and stood at 209.3 percent of GDP as of 2016Q1.