People’s Republic of China: Staff Report for the 2017 Article IV Consultation

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China


2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China

Context: Stimulus Keeps Growth Strong but Vulnerabilities Remain High

1. While growth has remained strong, vulnerabilities continue to accumulate, pointing to the need to accelerate reform efforts already in train. Growth has been bolstered by a supportive macro-policy mix, strengthening external demand as well as progress in domestic reforms. Strong growth and tighter enforcement of capital flow management measures (CFMs) have also helped stem external pressures. Reforms have advanced across a wide domain, including reducing overcapacity, strengthening local government borrowing frameworks, and addressing financial sector risks. However, reform progress needs to accelerate to secure medium-term stability and address the risk that the current trajectory of the economy could eventually lead to a sharp adjustment.

2. Though annual growth slowed in 2016, the momentum of the Chinese economy accelerated over the course of the year and into early 2017. GDP growth in 2016 reached 6.7 percent, down from 6.9 percent in 2015 and in line with the authorities’ target of 6.5-7 percent. However, after a largely constant deceleration in quarterly output since early 2010, underlying momentum stabilized in the second half of 2016.

  • On the demand side, consumption firmed amid a still-tight labor market and accounted for nearly two-thirds of total growth, the highest share since 2000. Investment also remained strong, supported by continued fast growth in public infrastructure and the first acceleration in real estate investment in five years.

  • On the supply side, the service sector remained the key driver, reflecting growth in the new economy (e.g. information technology) and a recovery in real estate services. But the change in momentum came from industry which stabilized after a 5-year deceleration, due in part to a sharp recovery in prices of key commodities.


    Real GDP Stabilizes While Nominal Accelerates

    (In percent, year-on-year)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Source: Haver Analytics.

Growth then accelerated into the first quarter of 2017 when real output rose 6.9 percent (yoy), faster than any quarter in 2016. While domestic demand remained strong and real import growth reached double digits, the contribution of net exports turned positive, largely reflecting the recovering global economy.

3. Stronger domestic demand helped further reduce China’s external imbalance, though it remains moderately stronger compared to the level consistent with medium-term fundamentals. In 2016, the current account surplus fell by almost 1 percentage point to 1.7 percent of GDP. The falling surplus was driven by a sharp recovery in goods imports and continued strength in tourism outflows (though due to data limitations, tourism imports may be overstated by roughly ½ percent of GDP since 2014, reflecting misclassified capital outflows). With this fall in the surplus, and taking into account potential overstatement of tourism and other data uncertainties, staff assesses that the 2016 current account was ½-2½ percent of GDP stronger than the level implied by medium-term fundamentals and desirable policies, versus 1–3 percent of GDP in 2015. The reduction of the current account gap reflects in part the effect of fiscal and credit easing.


Current Account Surplus Near 15 Year Lows

(In percent of GDP, four quarter rolling sum)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

4. Stronger domestic demand reflects a mixture of substantial policy easing and some progress in supply-side reforms.

  • Stimulus. First, between September 2014 and December 2015, the benchmark lending rate was reduced by 165 basis points. Second, the authorities eased real-estate macro-prudential policies in 2015 and early 2016 (e.g. lower down-payment requirements and higher discounts on mortgage rates) which helped lower inventories. Third, general government net borrowing widened by 2¾ percent of GDP between 2014 and 2016, driving a similar increase in the “augmented” deficit which reached an estimated 12¼ percent.


    Residential Real Estate Inventory Ratio Falls

    (In years)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Local Housing Administrative Bureau (Fangguanju), Wigram Capital Advisors, IMF staff estimates.

  • Supply-side reforms. The authorities initiated reforms to reduce overcapacity in the industrial sector, achieving capacity reduction targets for the coal and steel sectors, restructuring some weak state-owned enterprises (SOEs), and more tightly enforcing environmental regulations. While not complete, the measures, along with the above-mentioned stimulus, have helped reverse the deflationary trend and trigger a recovery in producer prices and industrial profits. Moreover, the supply-side reform effort extends beyond overcapacity: for example, a 2014 reform to facilitate business registration has helped increase the number of new businesses from 6,000 before the reform to 15,000 per day in 2016.


    PPI Drives Recovery in Industrial Revenues

    (In percent, year-on-year growth, 3mma)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

5. Amid strong growth, the authorities have pivoted toward tightening measures, reflecting a greater focus on containing financial sector risks:

  • In the second half of 2016, the authorities started tightening macro-prudential measures for the real estate sector, reversing much of the previous easing (See Selected Issues Papers (SIP)).

  • In early 2017, the PBC increased its 7-day repo rate twice by 10bps and clarified that the policy stance was now neutral.


    Tier I Cities’ Real Estate Price Growth Moderates

    (In percent, year-on-year growth, 3mma)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Local Housing Administrative Bureau for city-level prices, NBS, and IMF staff estimates.

  • Also in early 2017, the PBC extended the coverage of its “Macro-Prudential Assessment (MPA)” to off-balance sheet activity for the first time by including Wealth Management Products (WMPs).

  • The CBRC published several new documents aimed at stricter enforcement of existing regulations and reducing regulatory arbitrage across financial products.

Thus far, the key impact of these measures has been a tightening in financial conditions and a sharp fall in intra-financial sector credit. Interbank interest rates have risen sharply—since mid-2016, the three-month Shibor has risen 124 basis points, the one-year government bond yield has risen 107 basis points and AAA corporate bond yields have risen 124 basis points. Meanwhile, bank claims on non-bank financial institutions (NBFIs) and off-balance sheet WMPs have largely stopped growing on a month-to-month basis after booming in recent years. Total credit to the non-financial private sector has also started to moderate at the margin, but has thus far been relatively less affected.


Interest Rates Have Risen

(In percent)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

Intra-financial Claims No Longer Growing

(In RMB trillions)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: Haver Analytics.

6. In addition to tightening financial conditions, the authorities have taken several steps to stabilize exchange rate expectations.

  • Foreign exchange intervention. In late 2015 and early 2016, the RMB depreciated by 8 percent in effective terms (using the basket of currencies published by the China Foreign Exchange Trade System or CFETS), reversing most of the appreciation that had resulted from the previous tight link to the U.S. dollar. Then, since mid-2016, the RMB traded within a narrow range against the CFETS basket. This stability in the RMB effective rate required considerable sales of foreign exchange when the U.S. dollar was strengthening in the second half of 2016, but once that reversed and capital outflows moderated (see below), FX reserves stabilized.


    Previous Appreciation Almost Reversed

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Bloomberg LP; and IMF staff estimates.

  • Tighter enforcement of CFMs. Enforcement of existing measures was tightened substantially from late 2016.1 Together with a stronger near-term growth outlook and a weaker U.S. dollar, these steps helped reduce net capital outflows substantially.

  • Change in mechanism for setting daily fix. In May 2017, the CFETS revised the guidance to banks for calculating their quotes for the daily opening exchange rate to reduce what they viewed as “irrational” depreciation expectations that raised the risk of overshooting (Box 1).


    Capital Outflows Moderate Sharply

    (In US$ billion)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Institute of International Finance (IIF); and IMF staff estimates.

The RMB/USD Central Parity Fixing Mechanism

China officially maintains a managed floating exchange rate arrangement. After keeping the RMB closely linked to the U.S. dollar during the global financial crisis, the PBC in June 2010 returned to the managed floating exchange rate regime. In this regime, the RMB’s daily trading prices against the dollar were allowed to move up to ±0.5 percent from a central parity rate, the so-called “fix”, released daily by China’s Foreign Exchange Trading System (CFETS—a PBC subsidiary). To inform the fix, market-making banks were supposed to provide quotes for the RMB/USD rates based on their sense of market supply and demand in the morning, an opaque system that had allowed substantial discretion and, in practice, resulted in the central parity barely moving from day to day, even though the market rate had often closed at some distance from the previous day’s morning fix. The daily trading band was subsequently widened to ±1 percent in April 2012 and to ±2 percent in March 2014, to allow additional flexibility of the exchange rate.

In August 2015, the PBC announced a new “central parity exchange rate formation mechanism.” Under the new mechanism, banks were asked to submit quotes that took account of the closing spot rate of the previous day as well as market supply and demand. The PBC’s announcement explained that the change was designed to increase the role of market forces, in the context of the policy objective of gradually increasing exchange rate flexibility.

In December 2015, CFETS started publishing an RMB Effective Exchange Rate Index (“CFETS basket”). Subsequently, in February 2016, they formulated new guidance to banks for their daily quotes for the RMB/U.S. dollar central parity. Henceforth, the quotes would be based on the “previous closing rate plus overnight changes in a currency basket”, with the “changes in a currency basket” referring to the adjustment in the RMB/USD rate needed to offset the impact of changes in cross-rates among basket currencies.

In May 2017, CFETS adjusted its guidance to banks further. Banks were requested to include a “countercyclical adjustment factor” in their quotes with the objective of reducing “irrational” depreciation expectations and “pro-cyclical” herding behavior. The adjustment factor was not defined, with each bank calculating it using its own parameters to reflect their assessment of economic fundamentals, in addition to the previous closing rate and the RMB’s move relative to a currency basket. In the first week after the new factor was introduced, the RMB appreciated by almost 100 basis points relative to the CFETS basket and roughly 90 basis points against the U.S. dollar.

Outlook: Stronger Near-Term Prospects but Still Rising Medium-Term Tensions

7. Ahead of the fall Party Congress, the economy is well-positioned to meet the 2017 growth target amid continuing stability in the balance of payments.

  • Growth drivers. The government set the 2017 growth target at around 6½ percent but added “or higher if possible in practice” to convey an upside bias. Staff now project 6.7 percent (up from 6.2 percent in the last Article IV) reflecting the momentum from last year’s policy support and strengthening external demand. Nonetheless, over the course of the year, momentum will likely decline reflecting recent regulatory measures which have tightened financial conditions and contributed to a declining credit impulse. Indeed, high frequency indicators from Q2 suggest that activity likely peaked in Q1. These factors will likely keep core inflation broadly stable around 2 percent.


    Credit Impulse Starting to Weigh on Real Estate

    (In percent, year-on-year growth)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    1/ Credit impulse is the change in the flow of adjusted TSF over the last four quarters relative to GDP.Sources: Haver analytics and IMF staff estimates.

  • External. The current account surplus is projected to fall by 0.3 percentage points to 1.4 percent of GDP, due primarily to robust domestic demand and a projected 5-percent deterioration in terms of trade. However, that fall will be more than offset by a moderation in capital outflows relative to 2016 levels amid tighter enforcement of CFMs and more anchored exchange rate expectations.

8. In the baseline, staff projects that China will meet the authorities’ 2020 output target, but at the cost of further large increases in public and private debt.

  • Staff has revised up average GDP growth over 2018-20 to 6.4 percent, from 6.0 percent in the last Article IV. Given the extensive use of stimulus in recent years, there is a greater expectation that the authorities can and will maintain a sufficiently expansionary macroeconomic policy mix to meet their target of doubling 2010 real GDP by 2020.


    Upward Revision to Path of Real GDP Growth

    (In percent)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

  • To achieve this higher path, staff now assume that the authorities will broadly maintain current levels of public investment over the medium term and not substantially consolidate the “augmented” deficit (which includes staff’s estimate of off-budget investment). Therefore, “augmented” debt no longer stabilizes over the medium term, as projected in the 2016 Article IV, instead reaching 92 percent of GDP in 2022 on a rising path.


    Slower Consolidation in Augmented Deficit

    (In percent of GDP)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    1/ Definition of augmented deficit has been expanded to include government guided funds. This has also resulted in a revision to the historical path back to 2015.Sources: CEIC Data Company Ltd.; and IMF staff estimates and projections.

  • Private sector credit is projected to continue increasing over the medium term, largely unchanged from the last Article IV. Thus, total non-financial sector debt reached about 235 percent of GDP in 2016 and is projected to rise further to over 290 percent of GDP by 2022.


    Non-Financial Debt Rises Further

    (In percent of GDP)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Haver analytics and IMF staff estimates.

9. Downside risks around the baseline have increased. A key consequence of the new baseline is that it envisions China using up valuable fiscal space to support a growth path with slower rebalancing and a higher probability of a sharp adjustment. Thus, if a sharp adjustment were to materialize, China would have lower buffers with which to respond. Such a potential adjustment could be triggered by several risks, including:

  • Funding. A funding shock could come from at least two (related) pressure points. The first is the mostly short-term, “interbank” wholesale market (which includes banks’ claims on each other and on NBFIs). The second is a loss of confidence in short-term asset management products issued by NBFIs, or a run on the WMPs which fund them.


    Significant Reliance on Wholesale Borrowing 1/

    (In percent)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    1/ Wholesale borrowing includes liabilities to other banks, to non-bank financial institutions, to the PBC, and bond issuances.Sources: Haver analytics and IMF staff estimates.

  • Retreat from Cross-Border Integration. Should higher trade barriers be imposed by trading partners, the impact would depend on their coverage and magnitude, how exchange rates respond, and whether China retaliates. For example, an illustrative simulation in the IMF’s Global Integrated Monetary and Fiscal Model suggests that if the U.S. puts a 10-percent tariff on Chinese exports and China allowed its real exchange rate to adjust, real GDP in China would fall by about 1 percentage point in the first year. If China retaliated with similar tariffs on U.S. imports, its GDP would contract further. However, given the complexity of global trade relationships and uncertainty regarding how exchange rates would adjust, the effect could be larger and more disruptive.


    Tariff Retaliation Lowers GDP Further

    (In percent difference from baseline; impact on Chinese GDP of 10 percent tariff on Chinese imports to US)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Source: IMF staff estimates.

  • Capital Outflows. Pressure on the exchange rate could resume because of a faster-than-expected normalization of U.S. interest rates, much weaker growth in China, or some other shock to confidence. In an extreme scenario, the pressure could lead to renewed large reserve loss and eventually a potential disruptive exchange rate depreciation. However, this risk is likely small in the short run due to the stronger enforcement of CFMs, the prominence of state-owned banks in the foreign exchange market, and ample foreign exchange reserves.


    Record Capital Outflows

    (In US$ billion, four quarter rolling sum)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

10. Growth could also be lower than projected, but more sustainable, if the authorities de-emphasize quantitative growth targets. Staff’s baseline assumes that the authorities will do what it takes to attain the 2020 GDP target, adjusting macro and financial sector policies as necessary. However, the authorities’ public pronouncements, as well as their reactions to staff projections (see below), suggest they are putting increasing weight on the quality, rather than the quantity, of growth. While reducing nearer-term growth, such an outcome would be welcome as it would raise the longer-term sustainability of growth.

11. In a fast-reform “proactive” scenario, China could stabilize GDP growth above medium-term baseline projections if it implemented two key reforms.

  • The growth slowdown since the global financial crisis has largely been driven by slower productivity growth. To reverse this trend, greater progress on resolving weak firms and converging to the cross-country efficiency frontier is needed. Staff estimates that such efforts could increase the contribution of productivity to growth by about 1 percentage point over the long term. Such gains could allow China to reduce the currently excessive contribution of investment to GDP growth by 1 percentage point, keeping headline GDP growth broadly unchanged.


    Better Resource Allocation from Resolving Weak Firms Can Raise Growth Potential

    (In percent, per year)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Hsieh and Klenow (2009); IMF Fiscal Monitor (2017); NBS; and IMF staff estimates.

  • A change in the composition of fiscal policy to support rebalancing toward consumption and away from investment would allow faster consumption growth financed by a drawdown in household savings rather than higher debt.

12. In the short term, such reforms to resolve weak firms and reduce investment may have a negative impact on output and employment. While the size of this impact is uncertain, staff estimates that short-term growth in a proactive reform scenario could fall to about 5½ percent absent a policy response. However, China has some fiscal space to delay consolidation and could smooth the growth impact during a transitional period. Such stimulus should be on-budget and targeted at improving the social safety net. While these reforms would improve China’s trajectory relative to the baseline, total debt (public and private) would still increase by 35 percentage points of GDP over the medium term and stabilize at a high 270 percent of GDP (compared to 293 percent in the baseline). Overall, it should be emphasized that the growth path in a proactive reform scenario is uncertain, depending on many factors, including the depth, pace and sequence of reforms, cyclical fluctuations, and external conditions. The key policy imperative is to replace precise numerical growth targets with a commitment to reforms that achieve the fastest sustainable growth path.


Increasing Downside Risks in Growth Outlook

(In percent, year-on-year growth)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

13. The revised baseline scenario—with higher growth, slower rebalancing, and a tighter capital account than in the 2016 Article IV—has three primary near-term spillovers and one major medium-term global risk. First, the baseline implies ongoing support for global commodity exporters which benefit from strong public investment, real estate, and heavy industry (e.g. Brazil, Australia). Second, there are fewer global mergers and acquisitions and Chinese-financed real estate purchases because of residents’ more limited access to foreign exchange (e.g. Canada, U.K., Australia). And third, China will continue to gain upstream market share in the Asian supply chain (e.g. Japan, Korea, Malaysia,) but at a slower pace than if there were a better investment climate for the domestic private sector and FDI. But this scenario of high growth and high debt accumulation also raises the probability of a disruptive adjustment to Chinese demand which would result in a sharp contraction in imports and a contractionary impulse to the global economy. In this regard, it is in the global economy’s interest that China transitions now to a new model of economic growth, even if the transition may be bumpy.

Authorities’ Views

14. While agreeing on the growth outlook, the authorities disagreed about the associated risks. The authorities agreed that 2017 growth was likely to exceed marginally the 6.5 percent full-year target. This implied some deceleration during the course of the year and would result in inflationary pressure remaining contained and a broadly unchanged current account. For the medium term, though the authorities shared the view that their 2020 target of doubling 2010 real GDP would likely be reached, they viewed the debt build-up thus far as manageable and likely to slow further as their reforms take effect. They also explained that their “projected growth targets” were anticipatory and not binding. They underscored that reaching the desired quality of growth was a greater priority than the quantity of growth. The authorities viewed domestic concerns, such as high financial sector leverage, as manageable considering ongoing reforms and Chinese-specific strengths, such as high domestic savings. They saw the external environment as facing many uncertainties, such as an unexpected fall in global demand or a retreat from globalization.

Policies: Switching Growth Engines to Sustain Strong, Inclusive, and Green Growth

Decisive implementation of reforms could greatly improve the baseline outlook. This requires (1) switching faster from investment to consumption so growth is less reliant on debt, (2) increasing the role of market forces to improve resource allocation, and (3) further building the “soft infrastructure” of modern policy frameworks to enhance policymakers’ ability to manage the modern Chinese economy. China has buffers to boost growth if needed, but they should be used to support accelerated reforms.

A. Fueling Sustainable Growth by Improving Resource Allocation

Excess savings

15. Low consumption and high national savings translate into lower welfare for Chinese citizens and excessive investment and debt. Estimated at 46 percent of GDP, China’s national savings are 26 percentage points higher than the global average, largely due to the household sector (SIP). Structural characteristics of the Chinese economy are part of the explanation, but so are policy factors, especially a comparatively weak social safety net. Excessive savings are problematic for welfare and macroeconomic stability:

  • Allocating a low share of income to consumption reduces current welfare (e.g. via a lower standard of living).


    China is Major Outlier in Savings and Consumption

    (In percent of GDP, 155 countries)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

  • Given home bias, capital account restrictions, and high growth targets, such high savings translate into similarly large amounts of domestic investment, which are unlikely to be absorbed efficiently—the risk is that returns from such high investment do not commensurately support future growth and debt service obligations.

  • Amid such high savings, if investment were curtailed, the current account surplus would widen, worsening global imbalances, reducing China’s contribution to global demand, and undermining the multilateral trade system which has served the world, including China, well in recent decades.

16. While demographic change will gradually reduce savings over time, targeted structural reforms, particularly fiscal, can help further boost consumption and ameliorate income inequality. Given China’s rapid aging, the ratio of elderly to working age population is expected to rise from 15 percent in 2015 to 50 percent in 2050. Model simulations suggest that this aging will lower the 2030 household savings rate by about 6 percentage points of GDP. As this would be a very gradual process, still leave domestic savings at excessive levels, and do little to reduce inequality, further reforms are needed with the following priorities:

  • Make the tax system more progressive: Reduce the personal income tax (PIT) basic exemption (which results in about 80 percent of urban workers not paying the PIT) and remove imputed minimum earnings for social contributions which results in prohibitively high effective tax rates for the working poor.


    Highly Regressive Taxes on Labor Income

    (In percent of labor income, urban household, 2012)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Note: Labor income taxes include the Individual Income Tax on labor earnings and employee social security contributions for pensions, medical and unemployment insurance.Source: China Household Finance Survey; and IMF staff estimates.

  • Further increase social transfers to poor households. Lower-income households in China have a savings rate of plus 20–30 percent compared to minus 20 percent in many peers. A key driver of the difference is China’s lower public transfers. A move toward international norms on social assistance would help lower excessive precautionary savings and reduce income inequality, which (while moderating recently due to government efforts) is among the highest in the world (See SIP).


    High Chinese Savings at All Incomes

    (In percent)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Chinese Household Income Project (CHIP); and Luxembourg Income Study (LIS).

  • Continue to increase public spending on health, pensions, and education. Higher health and pension spending will increase government consumption directly and private consumption indirectly by reducing households’ need for precautionary savings. Intensified “hukou” (residency) reform and improved access to social services, particularly less-developed areas, is needed to ensure an adequate safety net for all Chinese citizens.


    Rising Social Spending But Well Below OECD

    (In percent of GDP)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: CEIC, IMF FAD Expenditure Assessment Tool and IMF staff estimates.

  • Increase SOE dividend payments to the budget. The share of aggregate SOE profits currently paid to the budget is estimated to be well below the government’s 30-percent target by 2020. Addressing this can help establish appropriate budget constraints for weaker SOEs, reduce wasteful investment, and finance needed social spending.


    Low Transfer of SOE Dividend to Fiscal Budget

    (In percent of aggregate SOEs’ profit)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Ministry of Finance; Unirule Institute of Economics; and IMF staff estimates.1/ SOEs were required to contribute their profits to the fiscal budget since 2007. Data for 2007 did not cover all SOEs. The third plenum reform required the transfer 30 percent of SOE profits to the fiscal budget by 2020.

Authorities’ Views

17. The authorities shared staff’s view that national savings remained high. They noted that demographic factors would help reduce savings going forward but agreed that policy initiatives such as strengthening the social safety would help further boost consumption and promote a more sustainable composition of growth. They noted that social spending had already risen materially in recent years and further discretionary increases would need to be balanced against underlying spending pressures, such as those due to aging.

Reform of State-Owned Enterprises and Promotion of Competition

18. SOEs have been structurally less efficient than the private sector, reducing economy-wide productivity. SOE profits have fallen and are significantly lower than those of the private sector (SIP). While partly due to higher exposure to overcapacity industries, SOE productivity is also a quarter lower on average than non-SOEs when controlling for the sector, partly driven by still-significant social responsibilities and weak corporate governance. The relatively lower profitability is especially striking given that SOEs receive substantial implicit support (e.g. credit, land), which are estimated at about 3 percent of GDP, even excluding other benefits such as operating in protected markets (Lam and Schipke 2017). Another way to illustrate the relatively lower efficiency is that in the industrial sector, SOEs account for more than half of corporate debt and 40 percent of industrial assets but less than 20 percent of industrial value added.


Weak SOE Return on Equity

(Net return on total owners’ equity; in percent)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: Statistical Yearbook (2015); Unirule Institute of Economics (2015); and IMF staff estimates.1/ Based on nominal profits of industrial SOEs net of fiscal subsidies, implicit support through the use of land and natural resources, and lower implicit financing cost.

19. Though SOE reform is considered a top priority of the government and progress has been made, reforms should be accelerated. The authorities have classified SOEs into two categories (commercial and social functions) to clarify the mandate for their managers, phased out some social responsibilities, and initiated governance and ownership reforms. This is important progress, but many concerns remain:

  • After many years of downsizing, SOEs started growing after the global financial crisis, accounting for three-quarters, or 60 percentage points, of the rise in corporate debt/GDP since then, and now have assets of over 200 percent of GDP. Under the current reform plans, SOEs would extend their size further, potentially crowding out private sector development.

  • “Mixed-ownership” reforms, in which private capital is allowed to invest in government-run enterprises, and other measures to strengthen SOE governance are still at initial stages. Actual increases in private sector participation in SOEs remain limited, political influence has been institutionalized, and it is still unclear whether the mixed-ownership model is sufficient to improve efficiency. In addition, while several troubled SOEs have announced restructuring plans, the focus appears more on mergers and consolidation, rather than operational restructuring.

  • Efforts to resolve unviable debt are underway but incomplete. While 20 percent of identified “zombie” (unviable) central SOEs were reportedly resolved, SOEs continue to account for 50 percent of zombie debt outstanding, suggesting that significant further progress is necessary.

  • Despite several high-level announcements (e.g. that the number of industries that are restricted for foreign investment would be reduced from 93 to 63), there seems as yet little effective progress in exposing SOEs to greater competition, due to the limited breath of the reforms and their slow implementation.

20. While privatization may not strictly be necessary to improve resource allocation, “competitive neutrality” is.

  • SOEs. The authorities should expedite implementation of their existing reform initiatives to foster competitive neutrality. This includes moving SOEs’ social functions to the budget to allow firms to focus on commercial objectives, raising the share of SOEs classified as “commercial-competitive”; opening additional protected sectors to greater competition from private and foreign investment; and faster restructuring of SOEs’ underperforming debt. The SOE reform agenda should also be broadened to include hardening budget constraints on SOEs by phasing out implicit subsidies on factor inputs and forcing non-viable firms to default and exit if market forces warrant, with fiscal support for the affected workers. As competitive neutrality under state ownership may prove elusive in practice, these reforms would usefully be complemented by transferring more state-owned assets to private ownership.

  • Investment climate and trade. Greater opportunities and a level playing field for the private sector, including foreign firms, would increase growth by promoting competition and attracting technology from abroad. There are two key priorities. The first is reducing barriers to entry. The OECD’s Product Market Regulations Index found services (financial, IT, transportation, logistics) highly closed relative to the OECD and other emerging markets—SOEs are particularly dominant in services. Second, a greater focus on giving the private sector (including foreign firms) equal access to resources (land, natural resources, credit and government subsidies) and ensuring equal treatment in regulations, taxation, government procurement and administrative approvals. Both can be fostered by following through on the government’s announced plans to expand private and foreign market access and local governments’ fair-competition review. China also has scope to gain from trade by reducing trade barriers, including tariffs which are still considerably higher than those of its main trading partners. Progress in these areas could help reduce trade tensions, foster positive outcomes (greater opening up and more trade), rather than negative ones (higher barriers and less trade) and encourage greater openness amongst trading partners by demonstrating China’s commitment to an open rules-based trading system.


    Product Market More Closed than Most OECD and EM Peers

    (OECD’s product market regulation (PMR) index)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Note: The PMR index assesses degree to which policies promote competition in the product market. Policies assessed include state control of business enterprises; legal and administrative barriers to entrepreneurship; and barriers to international trade and investment.Sources: OECD Product Market Regulation Statistics; and IMF staff estimates.

Authorities’ Views

21. The authorities argued that SOE productivity continued to improve as a result of the supply-side and mixed-ownership reforms. They also noted that SOEs’ commercial performance was comparable with that of private firms, particularly if one accounted for their significant social responsibilities. Citing significant progress in phasing out overcapacity, deleveraging, and SOE governance, they noted that SOE profits had risen 10 percent year-over-year while leverage ratios had declined. They also disagreed with staff’s assessment that SOEs received material state support, in particular, with staff’s estimate of 3 percent of GDP: SOEs were independent market entities and thus were treated the same as other market entities. To the extent that banks chose to extend preferential credit access to SOEs, this reflected the creditworthiness of these borrowers. Looking forward, the authorities emphasized that they had completed their classification of central SOEs into commercial or social functions and had accelerated mixed-ownership reforms which allowed SOEs to benefit from both public and private perspectives. In addition, they argued that institutionalizing the Communist Party’s leadership within SOEs would help increase efficiency.

22. The authorities underscored their commitment to opening up to the private and foreign sectors. The authorities emphasized the importance of recent announcements on reducing barriers to entry for private investment (e.g. in oil refining, electricity, natural gas, telecommunications, civil aviation, and certain financial services such as credit ratings), reducing the size of the negative list restricting foreign investment, and improving the business environment for foreign firms. They stressed their commitment to promoting global trade and investment liberalization, opposing all forms of protectionism, and seeking “win-win” cooperative solutions to trade tensions (noting recent progress in the dialogue with the U.S.).

Reduction in Overcapacity

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

The official targets announced were net changes relative to 2015 levels. These targets are staff estimates of the capacity target levels that those announcements implied.

The authorities intend to reduce 0.5 million employment in 2017 (or a total of 1.8 million workers over the medium term) for coal and steel sectors. Here assumes the reduction target for 2016 is one-fifth of the total target based on 2015 employment levels. Beyond 2016 are forecast numbers based on recent reports not targets.


23. While related to the role of SOEs, the overcapacity challenge straddles the public and private sectors and has domestic and international dimensions. Defined by low capacity utilization rates and a large share of firms incurring losses, overcapacity in China encompasses at least ten sectors including coal, steel, cement, plated glass, aluminum, chemicals, paper, solar power, ship building, and coal-fueled power. China’s protracted excess capacity has contributed to downward pressure on global prices, rising market share for Chinese firms, and tensions with key trading partners. But overcapacity is also damaging for China by weighing on medium-term growth, the environment, and financial stability.


Overcapacity: Deteriorating Utilization and Large Global Share

(In percent of total legal designated capacity (left-scale) and global output (right-scale))

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: European Chamber of Commerce, Goldman Sachs, and IMF staff estimates.1/ Coal capacity exceed 100 percent because coal mines produced over legal designed capacity level in earlier years. Coal capacity utilization in 2016 fell because coal production fell sharper than the cut in coal capacity relative to 2015.

24. Initial progress has been made in reducing overcapacity. The authorities outlined capacity and employment reduction targets for the coal and steel sectors for 2016-2020. They clarified that the targets were in net terms so any new capacity, aimed at improving efficiency, would require deeper cuts to existing facilities. According to official data, the capacity targets were over-achieved in 2016 and are on track to be met in 2017, in part due to tighter enforcement of environmental and regulatory standards. Total employment in the two sectors is also 25-30 percent (around 2 million) below 2013 levels. Key concerns are that, per some accounts, capacity reduction included the closure of already-idle plants, and there is still limited restructuring of overcapacity firms’ outstanding debt.

25. Going forward, the reform effort should be broadened and deepened with greater reliance on market forces. Efforts should focus on more ambitious net targets within coal and steel and a broadening of targets to other sectors. Enforcing targets should avoid excessive reliance on administrative measures such as cuts in work days, mergers, and window guidance on prices. Reform efforts also need to address the origin of overcapacity which is a combination of high GDP growth targets met through state-directed investment spending, soft budget constraints which allow loss-making firms to stay in business, and underpricing of long-term environmental damage. Indeed, until market forces more fully drive resource allocation, new overcapacity sectors are likely to emerge, possibly including in the high-technology sectors that the government is now making a priority in its industrial policy. In this regard, China’s participation in the OECD Global Forum on Steel Excess Capacity is welcome and staff encourages further efforts to strengthen multilateral cooperation in reducing overcapacity.

Authorities’ Views

26. The authorities felt that staff did not sufficiently appreciate the progress in reducing overcapacity in steel and coal. Due in large part to the government’s supply-side reforms, there had been substantial improvements in key operational indicators in these industries (capacity utilization, prices, firm profitability), which had in turn contributed to a reduction in global overcapacity. The authorities explained that this progress stemmed largely from optimizing corporate structure, upgrading product quality, strict enforcement of environmental regulations, a crackdown on illegal construction, and forceful elimination of inefficient production techniques. This progress had also provided useful experience for extending efforts to reduce over-capacity in other sectors.

B. Tackling Financial Stability Risks

27. China now has one of the largest banking sectors in the world. At 310 percent of GDP, China’s banking sector is above the advanced economy average and nearly three times the emerging market average. The sharp growth in recent years reflects both a rise in credit to the real economy and intra-financial sector claims. The increase in size, complexity and interconnectedness of these exposures have resulted in sharply rising risks.


Banking Sector Among Largest in the World

(In percent of GDP, 2015)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Note: Non-standardized report forms (non-SRFs) for Argentina, China, India, Saudi Arabia, and United Kingdom. All other countries report in SRF.Sources: Bank for International Settlements (BIS); and IMF staff estimates.

Nonfinancial private sector debt

28. The recent growth in non-financial sector debt raises concerns for medium-term macroeconomic stability. Lending to the private sector rose 16 percent in 2016, twice nominal GDP growth, pushing the credit gap to about 25 percent of GDP. Since 2008, private sector debt relative to GDP has risen by 80 percentage points to about 175 percent—such large increases have internationally been associated with sharp growth slowdowns and often financial crises. Staff estimates that, had credit growth been kept to a sustainable rate, ceteris paribus, real GDP growth would have been around 5½ percent between 2012 and 2016, rather than 7¼ percent (SIP). As recommended by staff in previous Article IV consultations, the growth-subtracting effect of credit restraint can be mitigated by pro-rebalancing, on-budget fiscal stimulus, and in the medium term, by productivity-enhancing structural reforms—which would ensure growth is both strong and sustainable.


China’s Large Credit Gap

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Note: Based on credit to private non-financial sector.Sources: Bank for International Settlements (BIS); and IMF staff estimates.

29. In the past year, the authorities have started to take important initial steps to facilitate private sector deleveraging. For example, guidelines were issued to broaden the number of tools that firms could use to restructure their debt. In addition, as explained in ¶5, a range of prudential and administrative measures were introduced to contain financial sector risks.

30. Given strong growth momentum, now is the time to intensify these deleveraging efforts.

  • Stock. The focus should be on greater recognition of the underlying stock of bad assets. This requires a reduction in implicit subsidies, especially for SOEs, and more decisive action by supervisors. The immediate focus could be the debt of zombie firms, overcapacity companies, and underperforming SOEs.


    Nonviable Zombie Firms are Rising Again 1/

    (In percent of total industrial firms, weighted by number of firms and total liabilities)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: NBS Industrial Firm Survey and staff estimates.1/ Data for 2010 are missing and based on average of 2009 and 2011. Estimates are average between two definitions of zombies (State Council and Fukurama and Nakamura (2001).

  • Flow. Ultimately, private sector deleveraging will require credit to grow more slowly than GDP. To achieve this, the overarching priority remains focusing more on the quality and sustainability of growth and less on quantitative targets. To reduce the drag on growth from slowing credit expansion, new credit needs to become more efficient. On the credit demand side, this includes imposing hard budget constraints on SOEs and macro-prudential measures to contain mortgages and broader risks to the real estate sector. On the credit supply side, micro-and macro-prudential regulations should be tightened further, by requiring additional buffers for the financial system and continuing recent efforts to eliminate regulatory arbitrage.

The Size and Complexity of Intra-Financial Sector Credit

31. The large stock of intra-financial sector credit continues to raise important risks for financial stability. Intra-financial sector credit is a way for institutions to boost leverage and profits while avoiding regulatory hurdles such as capital and provisioning requirements on bank loans. The key channels are (1) large banks lending to small banks and NBFIs in the largely short-term and collateralized wholesale market, (2) banks or NBFIs investing in other banks’ WMPs and negotiable certificates of deposit (NCDs), and (3) banks and NBFIs investing in shadow products issued by other NBFIs. These exposures raise several concerns:


Large Banks Fund Small Banks, NBFIs in Wholesale Market

(In RMB trillion)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: The People’s Bank of China.
  • Capital. When banks purchase investment products, the risk-weighting may be lower than that of regular loans even when the underlying assets are loan-like. In addition, losses on wealth management products may ultimately be absorbed by the issuing bank given the perceived guarantee.

  • Liquidity. Even though intra-financial sector credit is often short-term and collateralized, these products may prove less easy to redeem in practice, NBFIs do not have access to PBC funding, and the price of the underlying assets could gap lower in the event of large-scale liquidity stress, amplifying the shock.

  • Complexity. The numerous stages of leverage make “seeing-through” to the underlying asset more difficult for banks, regulators and investors.

32. Recent regulatory/supervisory tightening is thus critically important and should continue, even if it means some financial tension and slower growth. This tightening is welcome but, given the size of accumulated imbalances, it is bound to create difficulties, and defaults of overexposed firms and to dampen activity in related sectors. To prevent such tension from derailing the supervisory tightening and leading to another “stop-go” cycle, regulators should: (1) coordinate effectively to ensure that financial conditions do not tighten excessively, (2) ensure that all solvent banks have equal access to the PBC’s standing lending facilities provided they have the required collateral, and (3) allow insolvent financial institutions to exit.

33. The ongoing Financial Sector Assessment Program (FSAP) will provide staff’s comprehensive assessment of the financial sector framework, risks, and recommendations. While this Staff Report has been coordinated with the FSAP progress to date, the FSAP work is ongoing, with Executive Board consideration tentatively envisaged around November, and thus the above analysis and recommendations should be considered preliminary.

Authorities’ Views

34. The authorities disagreed that the stock of bad assets was underestimated. They argued that weak firms were already facing significantly harder budget constraints due to pressure on financial institutions to reduce financing to overcapacity and real estate sectors. More broadly, while the authorities underscored that deleveraging remained a top priority, they considered a more gradual pace of deleveraging than that recommended by staff as desirable and sustainable. They pointed out that lending to firms was already slowing and would stabilize as a share of GDP over the medium term.

35. The authorities recognized that the growth in the size and complexity of the financial sector raised risks but argued the problem was manageable. They pointed to the recent intensification of supervision and resulting slowdown in financial sector leverage as evidence of their commitment. The authorities recognized that the increase in market interest rates could create some tension, but underscored that they had recently stepped up efforts in policy coordination and the PBC would maintain sufficient liquidity to avoid disorderly adjustment and systemic risks. They emphasized that all banks had access to the PBC’s standing facility against required collateral, but disagreed with staff’s recommendation not to use penalty rates for banks with low MPA ratings. The authorities looked forward to the finalized FSAP recommendations.

C. A More Sustainable Macro-Policy Mix Should Play a Key Role in the Transition

Fiscal Stance

36. China has some fiscal space, but the extent depends on whether liabilities from off-budget investments are considered. China’s general government net borrowing and debt were 3¾ and 37 percent of GDP, respectively, in 2016. Given that the primary balance is projected to be broadly stable and China has a favorable growth-interest rate differential, official government debt is projected to rise gradually and stabilize over the long run. However, including debt of Local Government Financing Vehicles (LFGVs) and entities such as government-guided funds, “augmented” debt is estimated at 62 percent of GDP in 2016 and projected to rise to 92 percent in 2022. The argument for using the “augmented” concept is that these obligations financed spending that appeared to be mostly non-market based with uncertain returns and by entities that are largely government-controlled; it thus likely provides a more accurate estimate of the fiscal impulse and potential debt burden on public finances. Indeed, in 2014, two-thirds of LGFV debt (22 percent of GDP) was recognized as government obligations. On the other hand, given recent reforms, especially the 2014 Budget law and subsequent regulations that legally removed government responsibility for such debt, there is now somewhat larger uncertainty regarding the degree to which “augmented” debt will eventually become a burden on public finances (SIP). Further analysis of firm-level data is needed to assess the extent to which LGFVs operate on a fully commercial basis with sound earnings and debt outlook, or otherwise.


Rising Augmented Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Source: IMF staff estimates.1/ Data through 2015, 2016 estimated, 2017 projection. Large jump in 2014 reflects official recognition of 22 percent of GDP in LGFV debt.2/ Government guided funds (GGF) and special construction funds (SCF). Social capital portion only.

37. Fiscal policy going forward should aim to support rebalancing and ease the transition to a new growth model. China has some fiscal space given mitigating factors such as the relatively captive market provided by large national savings and the substantial stock of government assets. As a result, while consolidation is important, improving the composition of fiscal policy is more urgent. The preferred approach would involve:

  • Fiscal reform for faster rebalancing. The composition of fiscal policy should favor rebalancing by increasing spending on health, education, and social security and reducing infrastructure investment. Revenues should also be re-calibrated away from land sales and social security contributions in favor of higher personal, property, and environmental taxes as well as higher SOE dividends. Substantially raising taxes on fossil fuel and pollution (e.g., a carbon/coal tax) would not only raise revenue, but also curtail emissions, improve energy efficiency, and prevent almost 4 million premature deaths by 2030 (WP/16/148).

  • Gradual “augmented”-deficit reduction. The “augmented” deficit should gradually fall to its debt stabilizing level. A tightening of some ½ percent of GDP per year could balance the need to achieve sustainability while limiting the drag on growth. On-budget deficits can be maintained and even expanded if combined with faster off-budget consolidation.

  • Easing costs of transition in the short to medium term. If an accelerated reform agenda were to weigh on growth and risk an excessively sharp adjustment, China would still have some fiscal space which could be used to limit the transition cost, ideally via an enhanced social safety net for affected workers. Thus, if necessary, consolidation could be slowed or even temporarily reversed.

Authorities’ Views

38. The authorities continued to disagree with the “augmented” debt and deficit concepts used by staff. They argued that the 2014 budget law and subsequent regulations had clarified that Local Government Financing Vehicles (LGFVs) were standard firms and thus new borrowing was not part of the government sector. All obligations of local governments had now been explicitly recognized within official public debt statistics and local governments would not assume any legal repayment responsibility going forward for financing vehicles, government guided funds, or special construction funds. They argued that many LGFV projects were commercial and backed by real assets. The authorities also argued that staff should only use the general budget deficit and official debt numbers of roughly 3 and 37 percent of GDP (as of end-2016), respectively.

Monetary Stance

39. A gradual removal of monetary policy accommodation would be justified if core inflation continued to tick up. The current stance of monetary policy is still accommodative. At 4.35 percent, the benchmark lending rate is at its historical low and, at 2.45 percent, the PBC’s 7-day repo rate (a key policy instrument for the new interest rate corridor) is barely positive in real terms. In addition, GDP and credit growth are strong, the labor market is robust, and core inflation has risen from 1½ to 2 percent in the last year. Indeed, current rates are well below Taylor Rule-suggested levels. At the same time, recent regulatory and supervisory measures have significantly tightened financial conditions and, coupled with other factors, may contain core inflation pressures. Thus, while the PBC should expect to increase gradually the 7-day repo rate, the pace should be data dependent with a focus on near-term developments in core inflation and activity. Moderately higher interest rates could also help reduce excessive leverage and limit pressure on the exchange rate, but these considerations are secondary as interest rates should not be the primary tool for tackling financial stability concerns or stabilizing the exchange rate (SIP).


Current Rates Below Taylor Rule Suggested Levels

(In percent)

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Note: The Taylor rule assumes an inflation target of 3% and a neutral benchmark lending rate of 6%.Sources: CEIC Data Company Ltd.; and IMF staff estimates.

Authorities’ Views

40. The authorities disagreed with staff that the monetary stance was accommodative. After the recent adjustments in banking system liquidity and interest rates, they saw the current stance as neutral (they agreed that the stance had been accommodative in recent years) and preferred to have no bias regarding future interest rate moves. Though headline inflation had fallen sharply in recent months due to food prices, the authorities saw underlying inflation dynamics as broadly consistent with their desired range of 2-3 percent. They also viewed the current stance as appropriate for their exchange rate and financial sector stability objectives.

Exchange Rate Management

41. The authorities have taken several steps since 2015 that make China better prepared to increase exchange rate flexibility, even in the near term.

  • Established reference to a basket. Though the CFETS basket has not fully replaced the dollar as a reference, the authorities have made progress in reducing the dollar link and increasing market focus on the nominal effective exchange rate.

  • Reduced Intervention. Tighter enforcement of CFMs, a better growth outlook, and a weaker U.S. dollar have helped reduce FX intervention and the near-term risk of large outflows.

  • Exchange rate broadly in line. Staff assesses the real effective exchange rate to be broadly consistent with fundamentals, unchanged from the 2015 assessment.

  • Containing depreciation expectations. The authorities have helped stabilize expectations by explicitly countering, both in words and actions, market views that they were seeking depreciation as a way to boost growth and competitiveness.


    Still Strong Export Market Share

    (In percent)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Sources: Haver Analytics; and IMF staff estimates.

42. Nevertheless, administrative control over FX flows and the exchange rate has increased over the past year, and progress toward a more market-determined, flexible, exchange rate should resume. Besides the tighter enforcement of CFMs, the recently introduced “counter-cyclical” factor to guide banks in their fixing quotes reduces the role of market forces and FX intervention in day-to-day exchange rate management in favor of more administrative control. While this may still leave room for significant flexibility over time, the change could have been better explained and, as many market participants/observers perceived, it appears a step back toward a closer link to the U.S. dollar. It is also unlikely to reduce durably the need for foreign exchange intervention if underlying pressures are not addressed. Thus, there remains considerable scope to further improve exchange rate policy as well as the communication of it.

43. Against this background, the framework suggested in last year’s Article IV remains appropriate. The authorities should maintain an implicit and widening band around an equilibrium effective rate within which the spot rate could fluctuate with market forces. If the equilibrium rate is assessed to have changed, the center of the band could be adjusted. Such a framework would be implemented by foreign exchange intervention and public communication.

44. China’s foreign currency reserves, at US$ 3 trillion, are more than adequate to allow a continued gradual move to a floating exchange rate. There are two key considerations when applying the IMF’s composite metric for assessing reserve adequacy to China.

  • First, given that China has a neither fully open nor fully closed capital account and an exchange rate which is closer to, but not fully, fixed, it is not obvious which weights to apply. The US$ 1 trillion threshold implied by the composite metric for a floating exchange rate with capital controls is too low and the US$ 2.9 trillion threshold for a fixed but open regime is too high. On balance, the appropriate precautionary level lies in between.


    Reserves Well Above Relevant Adequacy Metrics

    (In US$ billion)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

    Source: IMF staff estimates.

  • Second, the composite metric is designed to guide the appropriate level of reserves to acquire in a normal period so they can serve as a buffer if a capital account crisis materializes. It is not meant to be a minimum to maintain at all stages of capital outflow pressure.

45. Further capital account opening, while desirable over the medium term, should be carefully sequenced. The recent tightening in CFMs was broadly consistent with the IMF’s institutional view on capital flows: the necessary supporting reforms (effective monetary policy framework, sound financial system, and exchange rate flexibility) had not kept pace with the de facto liberalization of capital flows (SIP). Nonetheless, there are several concerns to consider. First, tighter enforcement of CFMs is weighing on the business climate, in part because of the less-than-transparent way in which it has been implemented and its uneven enforcement over time and across provinces. Second, there is a risk that the use of CFMs allows for a delay in reforms and increases the risk of domestic asset bubbles. And third, the effectiveness of CFMs is likely to erode as investors find loopholes and portfolio flows increase. With these considerations in mind, there are two key priorities going forward:

  • Accelerated progress on the necessary supporting reforms is needed to support ongoing liberalization. In the near term, only carefully targeted liberalization—e.g. more FDI in services or reducing the reserve requirement for onshore hedging—should be considered.

  • Existing CFMs should be consistently and transparently enforced. They should also not restrict current international payments and transfers, in line with China’s IMF obligations.

46. The “Belt and Road” Initiative (BRI) could foster multinational cooperation in trade, investment and finance, bringing much needed infrastructure and connectivity to the region. Fully reaping the benefits of this initiative will require strong governance of projects to make sure that they are financially viable and that the recipient countries have sufficient institutional and macroeconomic capacity to manage them.

Authorities’ Views

47. The authorities believed that capital flow pressures had become more balanced since early 2017. However, they continued to see some irrational and self-reinforcing dynamics in market forces. For example, they saw the RMB’s stability against the dollar in the first quarter of 2017—a period of depreciation in the global dollar index, little official foreign exchange intervention, and improving fundamentals in China - as evidence of persistent irrational market behavior; in their view, the RMB should have strengthened during that period. To break these expectations, they considered policy steps to generate two-way expectations as appropriate, particularly before a period of dollar strength resumes. Such steps could at times be through intervention (selling FX to move the exchange rate against market expectations), and they were confident that the current level of FX reserves was adequate. Regarding the daily fixing, they explained that the previous mechanism had at times led to self-fulfilling market expectations with market pressures one day influencing directly the following day’s morning fix (which carries a policy flavor). Given the irrational and self-reinforcing pressures in the foreign exchange market, the authorities introduced a “counter-cyclical factor” to reflect better macroeconomic fundamentals and underlying market forces.

48. The authorities noted that the tighter enforcement of existing regulations had helped reduce excessive capital outflows. They underscored that legitimate transactions should not be delayed and intended to increase their administrative capacity to ensure smooth processing of these transactions in the future. They stressed that they remained committed to not restricting current international payments and transfers, in line with their obligations to the IMF. In addition, they remained committed to further gradual capital account liberalization and did not think that progress in key reform areas was insufficient for further opening of the capital account. Rather, they argued that such opening could support the reforms. They saw the BRI as an open and inclusive regional economic cooperation framework that benefited all countries involved.

D. Modernizing Policy Frameworks2

Fiscal Framework

49. Ongoing fiscal framework reforms should be deepened to support consumption, reduce inequality, and ensure medium-term debt sustainability. Important steps have been taken with formulating the new Guidelines for Local Government Debt and the blueprint for reforming inter-governmental fiscal relations (SIP). As these reforms move forward, a number of issues should be considered:

  • Targeted Amount of Revenues and Spending. The authorities should consider whether the level and structure of tax and spending is adequate for China’s development goals. China’s tax revenue is relatively low at 20 percent of GDP (versus OECD average of 34 percent) due primarily to low PIT and property receipts. In addition, the tax structure is regressive and China lags major emerging markets in public spending on education, health and other social assistance. This is reflected in one of the highest levels of income inequality in the world, which, while easing slightly recently, is projected to increase without policy action.

  • Allocation of responsibilities. Tax and spending responsibilities should be assigned to the level of government that can most efficiently execute them. For example, social insurance functions (e.g. pensions and employment insurance) should be centralized to take advantage of economies of scale, remove barriers to mobility and ensure benefits are equalized across regions. Currently, local governments in China have the highest share of national spending responsibility in the world yet very limited revenue autonomy. Introducing a recurrent property tax with rates set by local governments within a centrally-approved band is one option to help address this imbalance.


    Highly Decentralized Spending Responsibilities

    (In percent)

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

  • Intra-governmental transfers. Even after such reallocation of responsibilities, some “vertical imbalance” will likely remain. This imbalance should be reduced via central government transfers (i.e. non-revenue sharing) which are rules-based to improve predictability and reduce the pro-cyclicality of local government funding. Fiscal disparities across regions could be reduced further by increasing the size of equalization grants. Targeted transfers should be rationalized and simplified with stronger emphasis on outputs/quality of services rather than inputs.

  • Financing. A key advantage of this framework is that provided the debt authorization is adequate, it reduces pressure for off-budget borrowing or reliance on land sales. Together with developing comprehensive medium-term budgets and stronger coordination with the National Development and Reform Commission (NDRC) on investment projects, this framework would also support the Ministry of Finance’s recent intensive focus on eliminating potential government liabilities from LGFV borrowing, currently included in staff’s “augmented” debt/deficit concepts—staff will continue to review the size, coverage and appropriateness of this concept as these efforts gain traction.

Authorities’ Views

50. The authorities broadly shared staff’s view that direct taxes (including on personal income and property) should increase but argued that the process should be gradual and consistent with the broader tax reform strategy. They also agreed that more centralization of social insurance spending could be appropriate to take advantage of economies of scale. Key areas of difference with staff focused on whether the new budget law and recent steps to remove further government guarantees, increased reliance on PPPs and existing local government borrowing quotas were adequate to prevent further off-budget fiscal spending. Unlike staff, the authorities did not see a need for further increasing pollution tax rates or expanding the base, notably by adopting a carbon tax. The authorities also favored tax sharing as a means of financing spending of local governments, as opposed to given them more revenue autonomy through a property tax and personal income tax surcharge.

Monetary Policy Framework

51. China’s transition to a more market-based economy requires continued progress in modernizing the monetary policy framework:

  • Objective. The PBC’s mandate includes multiple goals, including stabilizing the level of the exchange rate and domestic prices while supporting growth and financial sector soundness. However, monetary instruments are unable to deliver on multiple objectives (if inconsistent) and are limited in their ability to affect real variables directly (e.g. output) in the long term. Thus, monetary policy effectiveness would be considerably improved if price stability was formally identified as its primary objective. In addition, the PBC should have clear accountability around the target (such as a medium-term inflation target set by the government) and the necessary operational independence to achieve it.

  • Key policy instruments. The conduct of monetary policy increasingly resembles a standard interest rate-based framework, based on the 7-day interbank reverse repo rate. This would be strengthened by (1) formally acknowledging this framework, (2) dropping monetary aggregate targets and the publication of benchmark lending rates, (3) gradually reducing the distortionary high reserve requirements (offset as needed by open-market operations), (4) basing pricing and access to the PBC’s lending facilities on clearly defined collateral rules and not supervisory criteria, and (5) aligning lending instruments more closely to the PBC’s monetary policy objectives.


    PBC Raises Short-Term Interest Rates

    Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

  • Communication. PBC communications have improved, but considerable scope remains to (1) clarify the objectives of monetary policy and how the policy instruments relate to those objectives, (2) communicate transparently with financial institutions, and (3) publish policy communications simultaneously in English, given the growing global importance of Chinese financial markets.

Authorities’ Views

52. The PBC articulated that price stability was the primary, but not the only, objective of monetary policy. The authorities explained that, per the PBC Law, the aim of monetary policy was to maintain the stability of the value of the currency and thereby promote economic growth. As China remained an economy in transition, this meant that price stability had the highest weight when making monetary policy decisions, but that other objectives had to be considered as well including employment, balance of payments, and financial sector stability. Regarding the implementation of monetary policy, the authorities agreed that they had made progress in moving to a market-based system where prices and interest rates played an increasingly important role relative to quantities. However, they felt it premature to drop monetary aggregate targets, did not consider current levels of reserve requirements as distortionary and feared that lowering them would inadvertently signal a looser monetary policy. They also thought it premature to refer explicitly to the 7-day repo as the policy rate and saw a continued need for benchmark rates to guide market pricing.

Data Frameworks

53. While some progress has been made, major data gaps remain, undermining policy making and credibility, IMF surveillance, and G20 commitments.

  • Coverage. Key data are still missing, including a full breakdown of real GDP by expenditure (e.g. quarterly levels of consumption, investment, exports, and imports) and by supply (e.g. a decomposition of “other services” and “industry”).

  • Integrity. Significant effort has been made to improve data integrity, including the newly introduced regulation on implementing the Statistics Law. Continued follow-through is critical.

  • Quasi-fiscal. Closer monitoring of all types of public investment (e.g. LGFVs, PPPs, government-guided funds) is necessary both to avoid potential sudden increases in public debt, as in 2014, and to assess the impact of public policy on aggregate demand.

  • Communication. More detailed communication alongside data releases would improve transparency and credibility.

Authorities’ Views

54. The authorities agreed with the need to broaden their publication of macroeconomic data. However, with respect to the specific gaps noted by staff, they considered that further technical work was needed and did not see imminent publication as realistic. The authorities argued that significantly increased monitoring of new debt incurred by LGFVs was not necessary given that recent reforms had largely eliminated the risk that such debt could migrate to the government balance sheet. They also emphasized several steps taken to improve data integrity, including more frequent provincial inspection visits and greater penalties for falsification.

Staff Appraisal

55. China continues to transition to a more sustainable growth path and reforms have advanced across a wide domain. Important supervisory and regulatory action has been taken to contain financial sector risks, corporate debt is growing more slowly, and local government borrowing frameworks are being improved.

56. The near-term growth outlook has firmed but at the cost of higher medium-term risks. Policy support, recovering external demand, and reform progress have helped keep growth strong. Amid strong momentum and an expectation that the authorities will do what it takes to achieve their medium-term growth target, staff have increased their medium-term baseline growth projections. However, risks around this baseline have also increased. The main cost of this stronger growth outlook is further large increases in public and private debt. Such large increases have internationally been associated with sharp growth slowdowns and often financial crises. Staff thus recommends replacing precise numerical growth targets with a commitment to reforms that deliver the fastest sustainable growth path.

57. China has the potential to sustain safely strong growth over the medium term. But as has been widely recognized, including in the government’s reform plans, this requires deep reforms to transition from the current growth model that relies on credit-fed investment and debt. It is critical to accelerate such reforms now while growth is strong and buffers sufficient to ease the transition.

58. China needs to boost consumption further to ensure sustainable and inclusive growth. Continued increases in public spending on health, pensions, education, and transfers to poor households would reduce excessive precautionary savings and, combined with making the tax system more progressive and greener, boost growth while further reducing China’s high income inequality and pollution.

59. To increase the role of market forces, the existing reform agenda for SOEs should be accelerated and broadened, and trade and investment further liberalized. SOEs should face harder budget constraints by having their implicit state support removed and by being forced to default and exit if market forces warrant. Building on recent announcements, barriers to entry should be removed, especially in the highly closed service sector. Efforts to reduce overcapacity should have more ambitious targets with greater reliance on market forces and more attention to underperforming debt. Gains from trade should also be increased by reducing trade barriers and achieving “win-win” cooperative solutions to trade tensions Such actions could also encourage greater openness amongst trading partners by demonstrating China’s commitment to an open, rules-based trading system.

60. A more sustainable macro-policy mix should include focusing more on the quality and sustainability of growth and less on quantitative targets. The fiscal stance should be gradually tightened and monetary policy accommodation reduced. To reduce nonfinancial sector debt, the focus should be on greater recognition of losses, especially of underperforming SOEs and zombie enterprises. Reducing the flow of new debt and increasing its efficiency require cutting off-budget public investment and imposing hard budget constraints on SOEs.

61. The critically important recent focus on tackling financial sector risks should continue, even if it entails some financial tensions and slower growth. The ongoing FSAP will provide staff’s comprehensive assessment of the financial sector framework, risks and recommendations.

62. The monetary policy framework should continue to be strengthened. This should include phasing out monetary targets, resuming progress towards a flexible exchange rate, and improving communications. While China’s external position remains moderately stronger compared to the level consistent with medium-term fundamentals, the renminbi is assessed as broadly in line with fundamentals. CFMs should be applied transparently and consistently. Further capital account liberalization should be carefully sequenced with the necessary supporting reforms, including an effective monetary policy framework, sound financial system, and exchange rate flexibility.

63. The government’s guidelines on reforming central-local fiscal relations are welcome. Some expenditure responsibilities, such as social insurance, should be centralized, while local governments should be given more revenue-raising authority, as well as sufficient debt quotas to reduce their incentive to rely on off-budget borrowing and land sales.

64. China also needs to address remaining data gaps to further improve policy making and meet G20 commitments.

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

Figure 1.
Figure 1.

Activity: High-Frequency Indicators Remain Firm

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

Rebalancing: Continued Gradual Progress

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: CEIC Data Company Ltd.; IEA; Haver Analytics; and IMF staff estimates.Note: Green indicates substantial progress, yellow indicates some progress, and red means lack of progress. For more details on the color coding, see IMF working paper 16/183.1/ IMF staff estimates.2/ Based on flow of funds data, available up to 2014.
Figure 3.
Figure 3.

Fiscal: Continued Loosening

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: CBONDS; CEIC Data Company Ltd.; IMF FAD Expenditure Assessment Tool; IFS; HKMA; Haver Analytics; WIND; and IMF staff estimates.
Figure 4.
Figure 4.

Monetary: Rising Price Pressure

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.
Figure 5.
Figure 5.

External: Outflows Begin to Ease

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

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

Banking: Ongoing Rapid Expansion

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: CEIC Data Company Ltd.; HKMA; Haver Analytics; WIND; IMF Global Financial Stability Report (GFSR); and IMF staff estimates.
Figure 7.
Figure 7.

Credit: Rising Household Borrowing

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: BIS; CEIC Data Company Ltd.; WIND database; Authorities’ websites; and IMF staff estimates.
Figure 8.
Figure 8.

Financial Markets: Bond Yields Rise

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: Bloomberg; CEIC Data Company Ltd.; TMA; WIND database; Authorities’ websites; and IMF staff estimates.
Figure 9.
Figure 9.

Corporate Sector: Vulnerabilities Remain High

Citation: IMF Staff Country Reports 2017, 247; 10.5089/9781484314654.002.A001

Sources: China Court; CEIC Data Company Ltd.; Credireform; Euler Hermes; European Chamber of Commerce; Goldman Sachs; NBS Industrial Firm Survey; Sinotrust; UK Insolvency Service; US Trust Offices; WIND database; Authorities’ websites; and IMF staff estimates.
Table 1.

China: Selected Economic Indicators

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

IMF staff estimates for 2015 and 2016.

Surveyed unemployment rate.

Not adjusted for local government debt swap.

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.

Official government debt (narrow definition). 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) i.e. with land sales treated as financing.

Table 2.

China: Balance of Payments

(In percent of GDP, unless otherwise noted)

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

Includes counterpart transaction to valuation changes.

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

Table 3.

China: External Vulnerability Indicators

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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.