China's Macroeconomic Update: World Bank Report

2004-06-12 15:27

I. Overview
Over the past five years, external demand for China's output has been affected by the shocks of the Asian financial crisis (1997-98) and the global economic slowdown (2001). In addition, the increasing pace of corporate reform as well as weak rural income put downward pressure on domestic consumption and investment. In the face of weakened external and domestic demand, the government engaged in expansionary fiscal and monetary policies to sustain growth and job creation. Consequently, the economy managed to maintain an average growth rate of 7.8 percent over the period 1997-2001.

Expansionary fiscal policy, especially an increase in government infrastructure spending, continued in 2002. The government has also raised civil servants' pay from July 1, 2002, the fourth hike after those in 1999 and 2000 (twice). These stimulative measures have contributed to maintaining growth in domestic demand. Monetary policy has also been broadly stimulative throughout the past five years. Interest rates were reduced in successive steps in 1998 and 1999. In February 2002, the People's Bank of China (PBC) reduced interest rates by another 0.5 percentage points, and in May, it raised the target growth rate for M2 from 13 percent to 14 percent.

By August, it was clear that China's economy had regained its growth momentum. This was due to the combination of an increase in external demand resulting from the moderate recovery in the global economy and expanding foreign direct investment, as well as the effect of the domestic stimulative measures. However, deflation, which had re-emerged in September 2001, continued throughout 2002.

II. Trends

Output and Expenditure

GDP growth accelerated from 7.3 percent in 2001 to 7.6 percent and 8.0 percent in the first two quarters of 2002. Industry was the key engine of growth, with output increasing from 8.7 percent in 2001 to reach 9.3 percent and 9.9 percent in the first two quarters of 2002. Manufacturing output increased from 9.9 percent in 2001 to 11.7 percent in the first half of 2002. Indicative of the foreign direct investment (FDI) and export driven growth, output of foreign funded enterprises rose by 12.2 percent in first half of the year and accelerated to 14.1 percent in July. The services sector, which had slowed from 7.4 percent in 2001 to 6.2 percent in 2002 Q1, turned around to grow robustly by 7.0 percent in Q2. On the other hand, growth in agriculture, which had increased from 2.8 percent in 2001 to 3.3 percent in 2002 Q1, fell to 1.9 percent in Q2. This was due partly to the effect of the spring drought, which resulted in a 2.9 percent decline in summer grain production.

Reflecting the effect of stimulative fiscal policy, total fixed asset investment rose substantially from 12.1 percent in 2001 to 21.5 percent in the first-half of 2002. Investment by state owned enterprises and foreign funded enterprises were particularly strong. Overall, the bulk of public investment was contributed by the local authorities, rising by 30.9 percent compared to the 1.2 percent increase in central government investment. Moreover, in line with the government's focus on the less developed regions, investment growth in capital construction was particularly strong in Gansu, Guizhou, Shaanxi, Hunan, Jiangxi, Inner Mongolia and Shanxi, rising 25-50 percent, compared to the national average of 23.6 percent.

Property investment, which rose 33 percent in the first-half, accounted for about a quarter of total fixed asset investment. Property sales reached about 7.5 percent of GDP. There was an also significant linkage to the financial sector through loans to the construction sector, property developers and households. Housing mortgage loans had reached RMB 650 billion by June 2002, accounting for about 10 percent of the total stock of outstanding loans of all financial institutions. Property prices have been rising rapidly, with prices in Shanghai increasing by 30-50 percent over the past year. This was substantially boosted by speculative demand, which was estimated by the market to account for over 20 percent of the purchases. Indicative of the rapidly increasing supply, the ratio between newly commenced constructions area to area sold rose sharply during the first half of 2002, to 3.5 in Beijing and 1.9 in Shanghai. Concerned about risks of property market bubble, six government ministries jointly issued a circular in August 2002 to tighten the supply of land as well as to control new property projects by developers with poor financial standing. There is still little sign that the rural-urban income gap is narrowing. Urban incomes rose by 17.5 percent in the first half, compared to 8.5 percent in 2001. Over the past 30 months, income growth in the rural areas has strengthened too-rising from only 1.9 percent in 2000, to 4.2 percent in 2001, and again to 5.9 percent in the first-half of 2002-but lags behind urban income growth by a significant margin. Indicative of the weaknesses in net income and the weakening domestic terms of trade for farmers, rural retail sales continued to fall, declining from 8.3 percent in 2000 to 7.7 percent in 2001, and further to 6.7 percent in the first half of 2002. By contrast, nominal retail sales in urban areas registered an increase from 9.3 percent in 2001 to 10.1 percent in the first half.

Prices, Wages and Employment

Both consumer and producer prices continue to decline. After falling by 0.6 percent in the first quarter, the CPI fell by a larger 1.1 percent in the second quarter. However, the monthly trends indicated that deflation could be abating, with the decline moderating to 0.9 percent in July. Producer prices declined by a smaller 1.7 percent in August, compared to the 2.3 percent fall in July, and the 3.4 percent drop in the first six months of the year. A part of the decline in prices was likely the result of rising productivity in the industrial sector. However, a significant contributory factor was the effect of excess supply. Inefficient SOEs, facing soft budget constraints and with supporting loans from the state commercial banks, have continued to cut prices aggressively to clear inventories. In addition, the support of local governments to local enterprises was a contributing factor in excess production. Apart from excess supply, the sustained deflation was also partly due to the recent global commodity prices decline, as well as the WTO tariff reduction effect. In particular, import tariffs (weighted average) declined from 9.1 percent in 2001 to 6.4 percent in early 2002.

Employment continues to decline in the state owned units and urban collectives. Based on administrative records, the number of employees within state owned units fell from 81.0 million at end-2000 to 76.4 million at end-2001. In the first half of 2002, it fell by a further 1.2 million. Employment in urban collectives declined by 2.1 million in 2001 and a further 0.3 million in the first half of 2002. However, since late 2001, the rate of retrenchment in the state owned units and urban collectives appeared to have moderated, especially compared to the period 1997-2000. Jobs were created in the other non-state owned sectors. Based on administrative records, which are incomplete (as they exclude the smaller private and informal sector), employment in the non-state sector rose from 20.1 million at end-2000 to stabilize at 22.2 million at end-June 2002.

Job creation continues to be at the top of the national policy agenda. This was re-emphasized in September at a major national employment conference. An emphasis on job creation by private businesses, labour-intensive industries and the services sector was stressed. This urgency in job creation is likely to lead to policies facilitating greater access of the private sector (both local and foreign) into hitherto closed sectors like telecom, finance, power, transportation, media and tourism. Domestic private businesses are also likely to gain greater access to capital, both from the state commercial banking system as well as the stock market.

Fiscal

Fiscal policy has played the main role in priming the economy over the past five years. It continued to play an important role in the first half of 2002. Total revenue grew by 9.2 percent while expenditure increased by 17.8 percent. The slower increase in revenue, compared to the 23.1 percent recorded in 2001, resulted from sharply lower corporate income tax as well as a substantial decline in tariff revenue and stamp duty. The growth rate of corporate income taxes (14.6 percent of tax revenue in 2001) fell from 47.2 percent in 2001 to 11.7 percent in the first half of 2002, and of value added taxes (36 percent of tax revenue) from 19 percent to 11.5 percent. Tariff revenue (5.6 percent of tax revenue) fell by 26 percent and collections of stamp duty (1.9 percent of tax revenue) declined by 65 percent, resulting largely from the rate cut from 0.4 percent to 0.2 percent in November 2001 as well as the fall in the stock market.

Increased expenditure for capital construction (46.4 percent), culture, science, education and healthcare (27.4 percent), pension and social security funds (41.4 percent) as well as government administration (25.6 percent) accounted for the sharp rise in government spending. The government is issuing RMB 592.9 billion in Treasury bonds this year to fund spending as well as an additional RMB 150 billion in special bonds to finance public works. Preliminary estimates indicated that expenditure has increased beyond the estimated 11 percent in the budget, while revenue collection has also fallen short of the projected increase of 10 percent. Consequently, maintaining the fiscal deficit below the target of RMB 309 billion, or 3 percent of GDP for the year, represents a challenge.

In view of the slowing tax revenue collection and rising expenditure, there is increasing pressure to reduce tax evasion, especially by private firms, foreign funded enterprises, state owned enterprises in some key industries as well as high income individuals. The personal income tax amounted to only RMB 71.6 billion in 2001, or about 4.4 percent of total fiscal revenue, a comparatively low ratio by international standard. Over the past several months, the tax authority has launched a campaign against tax evasion by private firm owners and high-income individuals, particularly celebrities, entrepreneurs and high profile athletes. Some cases have been brought to court, resulting in major headlines in the local media.

At a recent fiscal policy conference, the government announced its intention to maintain the deficit target for this year; it is likely, however, to be breached if present trends continue. Spending on government administration, education, science and healthcare, pension and social security funds are difficult to cut in the short run. Consequently, for the second half of the year, state investment especially by SOEs and the public sector could bear the brunt of adjustment and the rapid growth of fixed asset investment could moderate.

As at end June 2002, external debt reached US$ 169 billion (13.5 percent of GDP) of which 31 percent was short-term debt. The debt service ratio was about 7.3 percent. Official data on the stock of explicit government debt (including bonds issued in 1998 to recapitalize the four state owned banks) was relatively low at 25 percent of GDP at end 2001. However, quasi-fiscal liabilities could increase the public debt to GDP ratio substantially. This would include contingent liabilities associated with potential loan losses in the banking sector as well as the potential cost of the pension system reform. Consequently, medium term fiscal sustainability continues to require judicious management of the trend in the fiscal deficit, accompanied by state asset sales, and SOE and banking reform, especially by reducing the potential for new non-performing loans.

Monetary

As a result of banking reform and strengthened financial risk control, the growth of credit continued to slow. Outstanding loans rose by 12.2 percent in the first half. On the other hand, outstanding deposits increased by 16.5 percent. In particular, outstanding deposits of the household sector increased by 17.4 percent. Consequently, the loan-deposit ratio continued to fall from 80.3 percent in 2000 (end period), to 78.2 percent in 2001 and further to 76.8 percent by end June 2002. State commercial banks (SCB) have been cautious about lending, preferring to place funds in deposits at PBC or buy government bonds, rather than extend credit to the corporate sector.

Concerned that the slowdown in SCB lending could aggravate the deflationary trend, PBC adopted several stimulative measures during the first half of the year. In February, the PBC cut interest rates, with the one year lending rate reduced by more than 0.5 percent point to 5.3 percent. This was the first reduction since mid 1999. In May, the target growth rate for M2 for 2002 was raised from 13 percent to 14 percent. In addition, the PBC issued directives to commercial banks, urging them to boost lending to consumers and the SME sector. However, in view of the turnaround in growth since the second quarter, particularly the rise in domestic and external demand, the third quarter meeting (in July) of the Monetary Policy Committee of the PBC has suggested keeping interest rates unchanged in the near term. The focus has been redirected towards tackling structural problems of the financial system.

The monetary base increased by 17.1 percent in the first half as a result of central bank intervention to stabilize the RMB. This was largely due to continued trade surplus coupled with the effect of robust inflow of FDI. Consequently, foreign reserves rose by US$30.6 billion in the first half, to reach US$242.8 billion by end June.

External

With moderate recovery in the US economy, as well as the significant increase in FDI over the past two years, exports expanded by 19.4 percent in the first nine months of the year. Imports also rose by a more modest 13.2 percent, and show signs of accelerating in tandem with strong FDI inflows. Actual FDI continued its upward trend, rising by 20.7 percent in the first seven months to reach US$30.6 billion. Contracted FDI also rose by 32.9 percent to reach US$55.4 billion. The trade balance registered a surplus of US$ 15.5 billion over January-July.

This appears to herald a new phase of export expansion. The key driver is the rising confidence of foreign investors resulting from WTO accession, as well as the relocation of manufacturing production from US, Japan, and EU to China. The price decline in manufactured products and margin-squeeze around the world has encouraged companies to shift their production base to low cost locations such as China. This structural factor accounts for the expansion of Chinese exports at double-digit rate while the global economy was slowing down. This is confirmed by econometric estimates which indicate that over and above the effect of output growth in the US, FDI inflows have a significant effect on China's export growth, particularly of exports to the industrial country markets, and exports to all destinations of electronics and telecom equipment.

In addition, export growth has been boosted by the increasing participation of the domestic private sector in direct exports, as well as the rising competitiveness from a weaker RMB on an effective exchange rate basis. The nominal effective exchange rate depreciated by 6.1 percent in 2002H1, while the real effective exchange rate fell by a larger 7.2 percent.

III. Outlook

Presently, the key engines of growth are public sector fixed asset investment and expanding external demand, driven by rising FDI and export. Private consumption spending and private investment have yet to become self-sustaining to take over as key independent engines of growth. In addition, as many SOEs consolidate or are increasingly facing harder budget constraints as state commercial banks restructure, easy bank loans would be curtailed. Hence, private investment (domestic or foreign) increasingly would need to fill the void. Consequently, the removal of all barriers to facilitate private sector development would be crucial for expanding private investment as well as creating new jobs and sustaining private consumption expenditure.

The support from external demand, particularly the structural increase in export growth driven by FDI relocation and global out-sourcing is likely to be sustained. However, the cyclical weakening of the US economy, the potential for instability in the Middle East, as well as surging oil price cast a cloud over export growth over the next 12 months. Presently, 56 percent of China's oil import are from the Middle East, especially Iran, Saudi Arabia, Oman and Yemen. Some estimates indicate that a sustained increase of US$5 in oil price would lead to a fall of 0.4 percentage point in China's GDP growth. More significantly, unsettled conditions in the Middle East could lead to rising uncertainty, with detrimental effects on private investment, consumption, and the financial market throughout the major OECD countries.

On present trends, the government might need to slow down spending on fixed asset investment due to budgetary considerations. While surging FDI and export can help to cushion the economy, international market conditions might compel the government to continue spending to sustain growth momentum. On balance, it is likely that the macroeconomic agenda for the new administration that is expected to be introduced following the 16th Party Congress in November and the National People's Congress meeting early next year will continue to reflect the need for balancing fiscal consolidation with the urgent need to support domestic consumption (especially in rural areas) and employment.

Corporate Sector

Profitability recovered around May, after a sharp decline in the first quarter. By end-August, the accumulated profit of all industrial enterprises was 10 percent higher than last year. However, the profit of state owned and controlled enterprises was still 4.1 percent lower than last year.

Social stability has become increasingly a binding constraint to the reform of the corporate sector. In early 2002, there was worker unrest in Daqing, Helongjiang province and other northeastern cities. This could have influenced policy making; for example, the proposed NPC reading of the new bankruptcy law was postponed to next year. Reflecting rising social pressure, government spending on social security has grown substantially in the past few years. Total expenditure on "minimum living allowance" rose from RMB0.2 billion in 1998 to RMB4.6 billion this year. Central government expenditure on social security had also risen from 1 percent of total budget expenditure in 1997 to an expected 6.3 percent in 2002. However, Despite mounting social pressure the general direction of reform has been maintained. In some cases, reform has even gained greater momentum. In particular, ownership transformation in the corporate sector continued; AMCs have been active in disposing NPLs and initiating corporate restructuring. By June 30, 2002, the four AMCs had disposed NPLs with face value of RMB 210.4bn and collected RMB45.4bn in cash. The cash recovery rate reached 21.6 percent.

With WTO accession, China is speeding up the process of opening its SOEs and financial institutions to foreign ownership. SETC has been working on a new regulation expected to facilitate the merger and acquisition of large SOEs by foreign multinationals. During the Central Financial Working Conference in February 2002, a decision was taken to "allow foreign and private investors to acquire debts, equities and physical assets held by AMCs in accordance with relevant regulations". In June, two CSRC regulations were released to allow the establishment of fund-management joint ventures between Chinese and foreign firms. BNP Paribas Peregrine set up China's second JV investment bank in late February. Its key partner was a Wuhan based securities company, with Haier as a key shareholder. In the meantime, a new version of "Instructive Directory for Foreign Investment" was published in February by SDPC, SETC and MOFTEC, and took effect from April 1. The directory was revised in line with China's WTO commitments. Among 371 items, the category of "encouraged" expanded from 186 to 262, while the category of "restricted" fell from 112 to 75.

Ownership transformation continued domestically, particularly at the local level. An official from Shenzhen municipal government confirmed that the government was going to sell up to 49 percent of the ownership of its urban transportation group. The sale would be open to foreign and domestic private investors. An SDPC document entitled "Opinions on Promoting and Guiding Private Investment", highlighted the determination of the authorities to promote private sector development. It spelled out the following policies: (i) encourage and allow entry of private investors to all areas that are open to foreign investors; (ii) private investors investing in areas where preferential policies are available are also entitled to the same set of preferential policies; (iii) securities regulatory agencies and state owned banks must treat private investors in an equal manner; (iii) certain kinds of tax holidays should apply to support private firms in their start-up stage.

Corporate governance reform in China is gaining momentum. With increasing awareness among policy makers, corporate governance reform has been high on the agenda of the government. CSRC and SETC have implemented corporate governance inspections on listed companies, with a special focus on the behavior of state owned controlling shareholders. The China Association of CPAs had also issued an "instructive opinion" on internal control of accounting firms, as part of its ongoing efforts to raise the quality of services of the accounting industry. In an attempt to speed up the development of the market for corporate control, CSRC published a draft regulation on merger and acquisition in the stock market for public comments and suggestions. In addition, Shenzhen Stock Exchange had set up rules for transactions involving more than 500,000 shares, to encourage the development of market for corporate control. In late March, CSRC set up a "Reorganization Review Committee" to check irregularities in the re-organization of listed company involving substantial acquisition, sales and swap of assets.

NPC vice chairman Cheng Siwei announced that the existing Securities Law would be amended in 2-3 years. The NPC Standing Committee reviewed the long delayed Investment Fund Law recently. The latest revision deleted many controversial parts of the draft to make it acceptable to all relevant parties. Amendment of the Company Law and the Insurance Law has also been put on NPC's agenda.

Financial Sector

Despite successive interest rate reductions and steady growth rates in monetary aggregates, the growth of domestic credit slowed during the past year. This has been viewed by many as insufficient to sustain economic growth at a desirable rate, and a debate was triggered on the effectiveness of monetary policy.

Reduced credit growth should come as no surprise as the authorities are strengthening regulatory rules, including those pushing commercial banks to reduce non-performing loans. All state commercial banks have reported NPL reduction by around 3 percentage points in the past year. This phenomenon is consistent with experience of most countries, which have gone through financial restructuring and transition from centrally planned to market economies. In such circumstances, money multipliers decline and become unstable and monetary policy becomes less effective and its impact less predictable. Even if monetary aggregates continue to grow, banks may be investing new funds mainly in government securities and other safe assets while cutting credit to firms. This was exactly what is happening with Chinese banks. In this process, SME are often the most severely affected. Without structural changes, the effect could become more pronounced. However, despite the near term impact on growth and access to credit by small firms, reduced credit growth is a signal that the banks might be changing their methods of credit risk management. This is a necessary and urgent reform in China. But experience suggests that getting through this phase can take many years.

Consistent with the stated sequencing strategy for interest rate liberalization, i.e., to liberalize interest rates in rural before urban areas, but also to curb continued flow of funds out of rural areas, rural credit cooperatives (RCCs) in 8 counties were selected for participation in a pilot project on further expansion of the margin of float above regulated interest rates. This pilot covered both deposit rates and lending rates. Deposit rates could go up 20 percent (in certain instances 50 percent) and lending rates could go up by 70 percent (in certain cases 100 percent) above regulated rates. It is believed that this experiment will be expanded further if the authorities are reassured that no disruptive financial activities are caused by the bigger freedom to set rates by RCCs.

On June 23, 2002, the State Council announced the termination of the state share reduction scheme, thus putting to an end the suspense of investors and temporarily shored up stock prices. The Provisional Measures on Downsizing State Shares for Social Security Funds, issued by the CSRC on June 12, 2001 was aimed at whittling down the state share while bolstering the social security budget. The Measures required the firms to sell state-owned shares equivalent to 10 percent of proceeds from IPO or additional share issues. The proceeds from sales would be used to fund the social pension system.

The state share makes up 70 percent of the value of China's stock markets, and an increase in the number of shares available to circulate on the markets would certainly cause the price of currently circulating stocks to decline. In part, this is simple supply and demand problem. But what is more important is that China's stock markets are "Policy Markets" to some degree. That is to say, investors hold stocks today because they believe that the government-as a majority stockholder-will implement policies that will keep the value of shares high. Thus, state share reduction may signal a reduced willingness by the government to prop up the market. After the issue of the Measures, the A-share index plunged 30 percent between June and October last year. During this period, the total market capitalization of A-shares had shrunk by more than RMB 1800 billion, with tradable market capitalization losing RMB 571.7 billion. On October 23, 2001, the provisional Measures were suspended by CSRC.

Social Sector

Although China today compares favorably in education and health accomplishments with most of the countries of similar income levels, substantial challenges exist due to remaining pockets of poverty, persistent structural weakness and widening disparity of income and inequality in sharing the benefits of growth. In the last two decades, income inequality within the rural and urban areas has widened, as did the gap between the rural and urban areas. Other social indicators also show significant difference by region; for example, in 1999 infant mortality in inland provinces was three times higher than the rate for coastal provinces.

China still faces serious problems in the social sector. In social security, the government faces problems related to pension and social safety net. A way to solve this problem is the pilot program of social security reform in Liaoning. Liaoning was chosen by the State Council as a sole national social security reform pilot in 2000. The pilot program was launched on July 8, 2001, and included the combination of 5 social insurance (pension, medical, unemployment, work injury and maternity, and the basic living standard allowance for the urban residence). The general objectives are to establish a social security system that is independent of multiple resources of fund, standardized security system and socialized public administration and service. The main tasks of improving the social security system are to adjust and improve the basic pension system for urban enterprises employees; to study and formulate pension schemes for staff of government organizations and institutions; to speed up the establishment of the basic health insurance system for urban enterprises employees; to shift from the system of guaranteeing the basic living standard of laid-off workers of SOEs to the unemployment insurance scheme; to strengthen and improve the system of minimum living security of the urban citizens; to socialize the administration and services delivery of social security; to strengthen financing and management of social security fund as well as to speed up the process of social security legislation.

So far, Liaoning has been implementing the program for a year. The information system at the provincial level has basically been built-up and put into operation. During the implementation, Liaoning has encountered some major problems, such as pension coverage expansion, contribution arrears, the weak linkage between hospitals and the medical insurance administration, overly expensive medicine prescribed by the designated hospitals as well as the lack of monitoring of labor market movement. The experience of this pilot may have significant policy and institutional implications for the overall social security reform agenda. However, whether or not the pilot program will be extended to the rest of the country will depend on the monitoring and evaluation of the pilot experience.

In the area of public health, a particular problem is the extent of HIV infection (see Table 1). In April 2002, the Ministry of Health estimated that HIV infection in 2001 was about 850,000. On the other hand, the estimate by the UNAIDS was over one million. HIV is gradually spreading from people of high-risk behavior to the general population. Far beyond a health problem, HIV epidemic could endanger China's economy, human resources, education and social stability.

(china.org.cn November 6, 2002)