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)