China’s economic powerhouse continues to dazzle: growth is high, inflation remains low, and initial steps have been taken toward a more flexible exchange rate. But to keep growth strong and build a more effective financial sector, China will need to undertake ambitious and intertwined reforms. Top priorities, says Steven Dunaway, Deputy Director in the IMF’s Asian and Pacific Department, in an interview with Sheila Meehan of the IMF Survey, are developing a banking system that operates on a sound commercial basis and ensuring a strong fiscal position and a responsive transfer system that will allow the country to meet rising demands for pensions, health care, and education.

IMF Survey: Isn’t China now a key engine of world growth? And if so, doesn’t it bear a major responsibility in helping resolve global imbalances?

Dunaway: China certainly has become an engine of growth in a regional context. Over the past decade, manufacturing processing has shifted to China, with components coming from such countries as Japan, Korea, Malaysia, and Singapore. But it is harder to make the case that China is an engine of global growth. Ultimately, the key source of demand for China’s products remains the industrial countries, with the United States, of course, being the leading export recipient.

As for global imbalances, in our policy advice to China, we’ve consistently talked about why various changes in pol-icy—in particular, a change in the exchange rate regime—are in China’s best interest. At the same time, a change in China’s exchange rate could help deal with global imbalances. This is partly through a possible indirect effect—through potential changes in the exchange rate policies of other Asian countries as well. Many of these economies are China’s principal competitors, and they have tended to look at China’s previously fixed rate to the dollar in keeping fluctuations in their own currencies in narrow ranges.

IMF Survey: What do you say to critics who charge that China’s massive trade surpluses and rising foreign exchange reserves are evidence of exchange rate manipulation and that the IMF should be doing something about this?

Dunaway: It’s very difficult to establish manipulation. From the late 1990s into the early 2000s, the U.S. dollar appreciated, and the Chinese renminbi appreciated along with it. Since then, the dollar has depreciated, and the renminbi has come down with it. So China essentially played by the rules for a fixed currency, allowing it to move in both directions against non-dollar currencies.

But the critical question, and the one that the IMF asked over this period, was whether a fixed exchange rate was really in China’s best interest. Increasingly, it became clear that more exchange rate flexibility would be better for China. This was certainly the case over the past two to three years during which China has had a massive increase in reserves and has seen rising speculative pressures. The fixed rate also created problems for domestic monetary policy and constrained efforts to control liquidity in the banking system. The IMF welcomed China’s move in late July toward greater exchange rate flexibility and is encouraging the authorities to make full use of the flexibility that the new regime provides.

IMF Survey: To what extent has China now supplanted Japan as a convenient “bogeyman” for the West?

Dunaway: I guess that there has always been a “bogeyman” In the late 19^th and early 20^th centuries, it was low-cost U.S. goods that terrified English and other European competitors. In the 1960s and 1970s, there also were fears that the United States, through its foreign investments, would buy up the world. Over the past several decades, Japan and, to a lesser extent, Korea and the Southeast Asian economies have filled this role. Now, China is the chief source of low-cost production and the principal perceived threat.

The reality is that low-cost goods from China have brought the world tremendous benefits—an example of why the IMF pushes for trade liberalization and talks about globalization’s benefits. Of course, some people have suffered short-term adverse effects. Change involves adjustment, which entails short-term costs, which can create frictions and problems, and which call for effective and well-targeted social safety nets and other policies to help people adjust.

Much depends upon the overall economic environment. Protectionist pressures were relatively muted in the United States in the mid-1990s, when output and employment were rising faster. Adjustment costs tend to be lower in a rapidly growing economy; people can move between jobs more easily. But with slower output and job growth in the United States and even slower growth and higher unemployment in Europe, these frictions tend to play out in more protectionist pressures.

IMF Survey: China has had some success in slowing down investment growth, but is it truly under control? Aren’t there legitimate worries about overinvestment and excess capacity leading to deflationary pressures?

Dunaway: The Chinese authorities ask themselves these questions and one more: Even if investment growth is under control now—and the authorities have managed to slow investment growth—will it stay under control? One encouraging sign is a shift in composition away from sectors where overcapacity was developing (metals, automobile production, and real estate) toward sectors where bottlenecks appeared last year, notably electricity generation and various parts of the transportation network.

But liquidity in the banking system is still high. While banks have limited loan growth this year for a variety of reasons, the means to fuel a resurgence in lending and investment is sitting in the banks. So, we’ve advised the authorities to do more to drain that liquidity out of the system.

In terms of deflationary pressures, we do see overcapacity in some sectors—particularly automobiles and steel—but we don’t see this triggering more generalized deflation. Our chief concern is how overcapacity might adversely affect the profitability of the enterprises in these sectors and their ability to service their bank loans. A lot of government funds have already gone into taking the old nonperforming loans off the books of the major banks. The last thing we’d want is a buildup of new nonperforming loans.

IMF Survey: How critical is it for China to develop a healthy banking sector?

Dunaway: The banking sector plays a fundamental role in any economy, but particularly in China, where national saving is around 50 percent of GDP. In the past, the banking system hasn’t done a very good job of taking savings and translating them into profitable investments, as reflected in the large buildup in nonperforming loans, which was, in part, a product of directed lending or lending by fiat.

More recently, however, China has done a lot to restructure bank balance sheets and has begun to restructure bank operations, too. Over the past year and a half, there have been capital injections in three major banks. These capital injections have been linked to restructuring plans that set specific milestones for reducing nonperforming loans, boosting capital, and improving returns on equity and assets. The basic objective is to get China’s banks to operate on a sound commercial basis, and an important part of this is strengthening the banks’ ability to assess and price risk.

Up to now banks have lent primarily to large-scale, capital-intensive companies, most of which have a significant state presence. But with China’s excess labor estimated at 150-200 million people, capital-intensive development isn’t what you want. If banks can do a better job of pricing risk, the hope is that more credit will flow to small and medium-sized enterprises, because these play a major role in creating new jobs.

IMF Survey: The authorities have agreed, in principle, to an evaluation under the IMF-World Bank Financial Sector Assessment Program [FSAP]. Would it be better to do this sooner rather than later?

Dunaway: The authorities recognize that an early FSAP can help them formulate plans to restructure and develop the financial sector. The FSAP is not just a stock-taking exercise; it’s also a means of measuring where a country’s financial sector stands relative to various international standards. And it doesn’t cover just the banking system. It involves the whole financial system and can be useful in developing or strengthening stock and bond markets.

IMF Survey: Is China’s fiscal position—a deficit under 3 percent of GDP and falling—as good as it looks?

Dunaway: It’s good, and it’s appropriate at this point to have a steadily improving fiscal position. What you are really asking about, however, is the status of the so-called contingent liabilities that the Chinese government has. On the books, official government debt is relatively low, but the recapitalization of the banking system and the writing off of nonperforming loans represent a substantial contingent liability. There are also potentially large contingent liabilities arising from obligations of the pension system. Going forward, there are likely to be large demands for social services as state-owned enterprises unbundle services that they used to provide, particularly health care and education. This unbundling also creates an additional source of tension between the central and local governments, because local governments are responsible for delivering education and health care but may not have the resources to fulfill these functions.

A growing presence in the world economy

China continues to enjoy high growth while containing inflation.

Note: Data/projections as of August 29, 2005.

¹Excludes government-guaranteed debt.

²Includes gold, SDR holdings, and reserve position in the IMF.

³Central and local governments. The 2005 figures reflect official budget data.

Data: Chinese authorities and IMF staff estimates.

A growing presence in the world economy

China continues to enjoy high growth while containing inflation.

					Proj.1
	2001	2002	2003	2004	2005
		(percent change)
Real GDP	7.5	8.3	9.5	9.5	9.0
Consumer prices (period average)	0.7	-0.8	1.2	3.9	3.0
		(billion U.S. dollars)
Gross official reserves2	219	295	412	619	829
		(percent of GDP)
Current account balance	1.5	2.8	3.2	4.2	6.0
Overall budgetary balance3	-3.1	-3.3	-2.8	-1.7	-1.7

Note: Data/projections as of August 29, 2005.

¹Excludes government-guaranteed debt.

²Includes gold, SDR holdings, and reserve position in the IMF.

³Central and local governments. The 2005 figures reflect official budget data.

Data: Chinese authorities and IMF staff estimates.

View Table

A growing presence in the world economy

China continues to enjoy high growth while containing inflation.

					Proj.1
	2001	2002	2003	2004	2005
		(percent change)
Real GDP	7.5	8.3	9.5	9.5	9.0
Consumer prices (period average)	0.7	-0.8	1.2	3.9	3.0
		(billion U.S. dollars)
Gross official reserves2	219	295	412	619	829
		(percent of GDP)
Current account balance	1.5	2.8	3.2	4.2	6.0
Overall budgetary balance3	-3.1	-3.3	-2.8	-1.7	-1.7

Note: Data/projections as of August 29, 2005.

¹Excludes government-guaranteed debt.

²Includes gold, SDR holdings, and reserve position in the IMF.

³Central and local governments. The 2005 figures reflect official budget data.

Data: Chinese authorities and IMF staff estimates.

The situation can get even more complicated as you look ahead. China has a very large, underemployed rural population and is likely to experience continued and very large internal movement of population from rural to urban areas, especially migration from the western provinces to the coastal areas. Out-migration will make it difficult for rural governments to raise sufficient resources to fund basic government services, and this may encourage further out-migration. At the same time, in-migration to urban areas will place heavy burdens on local governments to provide needed infrastructure and meet demands for services, particularly education and health care. The central government will be faced with a tremendously complicated balancing act in trying to facilitate this adjustment and ease the burden of the transition. Frankly, there may be little in the experience of other countries that China can draw on. Internal migration on this possible scale hasn’t been experienced elsewhere in modern times.

IMF Survey: In the ongoing reform of state-owned enterprises, the IMF is urging the authorities to require profitable enterprises to pay dividends to the government. Is this a big issue?

Dunaway: It’s a very big issue in a couple of senses. First, the government owns these companies, and the benefit from them should accrue to the government, particularly as they’re restructured and potentially sold off. Thus far, in the stock issues of state-owned enterprises, the proceeds have been retained by the companies for capital investment.

Second, some companies, particularly resource-based ones, have been tremendously profitable in recent years. They have extensive retained earnings that they’ve used for investments, some of which haven’t been in their core businesses. It’s not clear that these investments will provide the government with the highest return on its capital, so you do want the government, as an owner, to have a say in the use of these funds.

IMF Survey: Most of these reforms are both complex and intertwined. Should China attempt to tackle all these at once?

Dunaway: You do have to make some choices, but these issues are interlinked. China’s traditional approach to reform has been to take small steps and use pilot projects. If something succeeds on a small scale, it’s then broadened. That worked well in the early days, but with these large, interlinked reforms, it’s more difficult to take small, discrete steps. For example, bank reform potentially has consequences for state-owned enterprises. Weaker enterprises that have managed to survive based on their access to credit may have little or no access to credit once banks start making decisions on strictly commercial terms.

Of course, if these enterprises are unable to continue, that has implications for employment and for the government, which will need to take up the services that the enterprises had been providing, as well as possibly fund social safety nets for unemployed workers. And that brings in the question of fiscal reforms and reforms in the transfer system between the central and local governments as well as the mix of taxation.

IMF Survey: Is a new paradigm for reform needed?

Dunaway: Not so much a new paradigm, perhaps, as a pickup in the tempo and scale of China’s reforms. In fact, if you look carefully at the recent past, some of this is already happening.