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Overview
Despite SARS, which lowered the second quarter GDP growth rate to 6.5 percent, China ended 2003 at full tilt, growing by 10.4 in the fourth quarter to give a whole year increase of 9.1 percent. Although growth is slowing, particularly in industry, in the first quarter of 2004 it was still a sizzling 9.7 percent. As in the recent past, China continues to be a preferred destination for the relocation of global manufacturing facilities. Its strength as an export platform contributed to incomes and jobs; urban employment rose by a buoyant 8.6 million jobs, although registered unemployment also increased. At the same time, imports rose by 40 percent, making China a locomotive for growth in the Asian region. While a significant portion of imports fed into exports and domestic consumption, the pace of domestic investment was the prime mover.
In 2003, the fixed asset investment-to-GDP ratio (admittedly an imperfect measure of investment in the Chinese economy) reached an unprecedented high of 47 percent. Price increases have accelerated as well. Despite a slight deceleration in the growth of the monetary base in recent months, the recent rate of growth of money supply (about 20 percent) is stoking the price rise. The relatively easy availability of credit is an additional element in this picture, although its effects are complex-facilitating persistent price-cutting, even by weak firms; permitting over-expansion of capacity in others; and undermining efforts to rein in the volume of non-performing assets in the banking system. As indicated in the Premier's work report that was presented to the National People's Congress on March 5, bringing the economy back on track is at the top of the Government's policy agenda. The speed and effectiveness of stabilization policy measures depends on the sometimes competing need to maintain the pace of job-creation and structural reform, and the ability to coordinate macroeconomic policies among various agencies.
The three underlying tendencies in the Chinese economy-modernization, urbanization and globalization, all of which contain forces for both the convergence and divergence of incomes-provide the context for the stronger policy emphasis on "growth with equity" that became evident over the past year. Rural development is a special focus, as rural poverty is high, rural-urban income and non-income disparities continue to widen, and the orderly management of out-migration from rural areas is seen as the key to managing the productivity and "livability" of China's growing urban areas. In addition, at long last the Government is able to tackle the problem of weak banks, where the ability to make headway depended on the progress of reforms in housing, social security and state enterprise performance. During 2003 and early 2004 the Government has also been able to articulate a clearer, although still partial, development strategy-one that gives equal importance to the use of physical/financial, human and natural resources in the generation of growth, rather than excessive focus on the first.
Output
China's economic growth rebounded strongly in the second half of 2003 after SARS was brought under control, despite the sharp contraction in the second quarter and the effect on project implementation (especially FDI) during the rest of the year. The industrial sector grew by 14.2 percent in the fourth quarter (12.5 percent for the whole year of 2003), and services were up by 9.6 percent (6.7 percent for 2003). The overall profitability (profit to equity ratio) of industrial firms rose to 5.8 percent, up from 5.2 percent in 2002 and 5.0 percent in 2001, reflecting demand conditions and stronger prices in some of the dominant industrial lines.
Thus, despite a drop in the growth of agriculture value added by 0.4 percentage points, to 2.5 percent in 2003, overall output growth during the year was 9.1 percent (10.4 percent in the fourth quarter), the highest since 1997 (See Figure 1).
A steady drop in farm acreages across the country (due to non-farming commercial use but also reforestation) and some weather-related events resulted in a 5.8 percent drop in grain output. In 2003 alone, total arable land shrank by 4.3 percent, providing a lightning rod for the Government's new announcements regarding the safeguarding of land for grain production. However, as we have stated before, agricultural diversification is likely to yield significant benefits to farmers. For example, horticulture and livestock propelled a 4.5 percent increase in agricultural output in the first quarter of 2004. As a result, overall GDP growth was maintained at a very high rate of 9.7 percent, despite a small decline in industrial growth from the two previous quarters.
Despite large increases in productivity, China's growth in 2003 was accompanied by strong increases in manufacturing and services employment-nearly 8.6 million urban jobs. However, structural job losses in rural areas and layoffs from state-owned enterprises constrained net job creation to 6.9 million. But, the robust economic growth has made a substantial contribution to reducing poverty during 2003. Using the US$1/day consumption poverty line, the number of poor is estimated to have dropped dramatically from about 360 million in 1990 to 223 million in 1999, and further to 151.9 million in 2003. Nevertheless, the income of rural residents still lags urban incomes, and is falling behind each year. Urban disposable income (per capita) rose 9 percent in 2003, but rural net income (per capita) by only 4.3 percent. According to our estimates the Gini measure of income inequality, calculated from the household income surveys, rose to 0.47.
Demand
As usual, judgments about the growth of total demand in the Chinese economy are subject to large uncertainty. Data on the various components of aggregate demand-consumption, investment and net external demand-are flawed, and related data series are inconsistent. According to official estimates, fixed capital investment in 2003 was up by 26.7 percent in nominal terms, 9.8 percentage points higher than during 2002. Not only is this the highest growth rate since 1995, the implied share of investment in total demand is 47.2 percent. (See Figure 2)
Subject to some corrections to the data, it is clear that the sharp increase in investment was across-the-board, so the current debate about "over-heating" in selected industries, while useful, is not germane to the issue of overall macroeconomic management. Capital construction by state-owned and collective firms grew very strongly, with manufacturing industry taking the lead. Massive additions were made to production capacity in some industries, despite unclear prospects for future domestic or international demand. And, while the slowdown in FDI from the big increases of 2001 and 2002 continued into the first quarter of 2004, there has been only a small letup in industrial production or investment. This debt-financed investment excess is occurring at the same time as the authorities have become more pro-active in restructuring the state-owned banks. The success of recent recapitalization efforts will depend critically on the quality of assets in bank portfolios, but the current inability to ensure this is a source of risk for the future.
More worrisome is the fact that, while the Central Government's budgetary contribution to infrastructure investment is small, but steady, sub-national Governments have become very aggressive. Local Government projects accounted for 86 percent of the total in 2003. The financial obligations of Local Governments pose increasing fiscal risks for the Government as a whole. Although not permitted to borrow directly, Local Governments have accumulated various, often implicit, contingent and, through investment intermediaries owned by them, direct financial liabilities. These obligations are in the form of bank credit, bonds issued through various municipal enterprises such as the urban development infrastructure companies, guarantee schemes and investment funds run by Local Government sponsored agencies, letters of comfort provided to local enterprises to facilitate their access to credit, concession contracts, and so on. Local Governments themselves sometimes admit to not knowing all their contingent liabilities. They have been known to arrange various forms of bailouts to meet their obligations from such liabilities. Sometimes, however, such bailouts directly affect the Local Government budget to such an extent as to force them to request financial intervention by the Central Government. While the Government is vigorously pursuing various administrative measures to monitor and limit the ability of sub-national Governments to acquire potentially unserviceable liabilities-for example, through stricter control of industrial park development or guidance to banks on lending priorities-it is evident that Local Government behaviors stem from deeper-rooted policy problems, chief among which is the weak intergovernmental fiscal system.
As with investment, the available statistics are sending confusing signals regarding the strength of consumption. The data on retail sales suggest that 2003 growth-at 9.1 percent-was the lowest since 1999; however, the volume data show an increase of above 12 percent. For 2004, first quarter retail sales growth figures show strength, but this includes the buoyant Spring Festival period. The household survey data point to strong consumption. Urban consumption spending rose by 7.1 percent in real terms, about the same as the average for the previous five years but up from 2002. It was driven by a sharp increase in disposable income (Table 3). Although less than that of urban households, rural consumption spending grew by 4.3 percent (cash spending by 5.9 percent), slightly above the rate of the previous five years.
External demand continued to expand strongly in 2003. Exports rose by 34.6 percent in US dollar terms to reach US$438.5 billion. Fourth quarter exports rose by 40.5 percent, and the first quarter of 2004 saw a 34 percent increase. Exports seem to have been boosted by the rush to complete transactions ahead of the change in the VAT rebate rate (from 15 percent to 11 percent) which took effect from January 2004. However, the trade surplus shrank to US$25.4 billion in 2003, from US$30.4 billion in 2002 and a peak of US$43.5 billion in 1998; the trade balance for the first quarter of 2004 was negative. This reflects the sharp increase that took place in imports-39.9 percent increase to US$413.1 billion in 2003, and 42 percent (y-y) increase in the first quarter of 2004.
Through such imports, China has become a locomotive for the growth of several East Asian economies. In 2003, it accounted for 18 percent of total Korean exports, 12 percent of Japanese exports, and about 6-7 percent of the exports of the ASEAN countries. More significantly, since early-2002, between 20 and 90 percent of the increase in exports in the East Asian countries is accounted for by sales that have occurred in the China market. The trade liberalization triggered by China's accession to the WTO has had a significant impact. Intra-industry and intra-firm trade in electronics, electrical machinery and equipment is reshaping trade patterns within the region and enhancing complementarities in trade relationships among the East Asian economies. Larger trade surpluses with the major markets of Europe and the United States are being generally offset by rising deficits with the Asian economies. For example, the "early harvest" program between China and ASEAN, which started this year as part of the broader discussions of a free trade agreement, has already raised ASEAN's trade surpluses with China to US$3.85 billion in January-February 2004, 65 percent higher than the same period last year. At the same time, while these economies continue to be vulnerable to downturns in the developed country markets, their increased dependence on the China market puts the spotlight on the management of domestic demand in China.
In the period following WTO accession, a major part of the changed pattern of regional trade could be accounted for by the relocation of manufacturing through FDI inflows into China. Although for the whole of 2003 utilized FDI rose by just 1.4 percent, to US$53.5 billion, reflecting the effect of the SARS-induced slowdown, by March 2004 it was rising at about an 8 percent rate. The manufacturing sector continued to receive the bulk of FDI, US$37.4 billion during 2003, but foreign investment in finance and insurance increased by 217.5 percent and that in education, culture and media rose by 53 percent. FDI in these sectors is small, less than one percent of the total, but the footprint of post-WTO services liberalization is clear. The effects of even this small-but rising-entry of foreign capital into the services sector can be expected to have profound effects on productivity and growth. One blemish on the recent record is that although FDI commitments have rebounded strongly since December 2003, massive inflows from tax havens have occurred, which cast some doubt on the motivation and sustainability of such investment flows. Furthermore, despite a smaller trade surplus, slower FDI disbursements, and a transfer of US$45 billion to recapitalize two state banks, China added US$117 billion to its foreign exchange reserves. Market analysts and commercial bankers attribute this to massive capital inflows of a speculative nature related to expectations that the RMB will appreciate. The authorities have taken several actions to raise the transactions costs of such speculative capital movements (for example, by setting limits on the size of daily conversions from foreign currencies into RMB).
Macro policy
As described in our last Update, both investment and asset prices have risen sharply since 2002. Prices are an imperfect indicator of "overheating", given administrative controls in key sectors (especially services and non-traded goods). Nevertheless, taken together with data on excess capacities, patterns of investment, and bank lending, visible and incipient price pressures explain recent Government statements regarding the need to ensure a soft landing for the Chinese economy. Land and rental prices, the producer price index (PPI) and CPI are all pointing in the same direction; the variance in price increases among different components of the core indices is very large, with some prices for raw materials and intermediate inputs showing increases as high as 25-35 percent.
Slowing investment has become a daunting policy task. So far, the Government has taken several measures to cope with current and prospective macro-stability concerns. They include a consolidation of Central Government spending, with the intention to squeeze the primary (that is, non-interest expenditure) budget deficit during 2004, administrative guidance coupled with changes in bank reserve policies to slow and redirect lending, borrowing operations to sterilize foreign currency inflows and measures to slow inflows while promoting outflows. In several statements in recent months the authorities have explicitly eliminated the use of either interest rates or the exchange rate as policy instruments; once the market believes these statements to be credible, they could slow or even reverse capital inflow. As of yet, however, the continuing inflows suggest that market expectations have not changed significantly.
Again, as in 1998, fiscal and administrative measures are seen to be the primary means of macroeconomic control. It is, therefore, important to examine the fiscal situation of the Central Government. Improved economic performance and tax administration yielded buoyant tax revenues during 2003, which rose by 15 percent (Central Government revenue rose 10.3 percent). For 2004, the Government expects a real increase of 7 percent in Central Government revenues, but a smaller increase in expenditures, which is expected to reduce the size of the deficit by nearly 0.5 percentage points below the 2003 level of 2.7 percent of GDP (IMF method). Fiscal consolidation of this kind is appropriate, given the strength of the economy, and under current and prospective conditions the sustainability of the fiscal position will improve. Less favorable macroeconomic conditions in 2004 and 2005, however, could generate painful fiscal pressures over the medium term. The more important challenge is to ensure that a combination of macroeconomic instruments is used to deliver a soft landing to the Chinese economy, as fiscal and administrative instruments tend to be blunt. In this respect, greater flexibility in the use of other instruments is desirable (for example, by further freeing bank loan interest rates). Needless to say, given the vast needs of the Chinese economy for stable and higher levels of funding for public services, structural reforms in public finance-especially in intergovernmental finance-need to be intensified. At the same time, pressures to broaden the use of tax expenditures to promote regional economic development or specific short term objectives need to be resisted strongly, while incentives for Local Governments to pursue off-budget spending could be addressed more forcefully than in recent years.
Rapid expansion of the monetary base is contributing to excess demand pressures as well as to the decline in credit quality at banks. The People's Bank of China (PBC) tightened the money supply by raising approval thresholds for real estate loans in June and increasing the required reserve ratios for commercial bank in September. Credit growth was contained at 21 percent and broad money growth at 19.6 percent during 2003; early 2004 developments reflect a basic continuation of these trends. A multiplicity of policy objectives during 2003 combined with uncertainties related to SARS and other economic factors, as a result of which there was high volatility in credit flows during the year. Perversely, a weak transmission mechanism caused by the segmented financial market and the relative profit and interest-rate insensitivity of many large firms nullified the effect of such volatility on economic activity. Nevertheless, if a hard landing is to be avoided in 2004 and 2005, closer attention to monetary policy and its coordination with fiscal, commercial/trade, and exchange rate policy is required. Moreover, the recent recapitalization of two state banks with foreign exchange reserves attracted equal measures of praise and concern in the financial markets, and in the events surrounding the recent National People's Congress Issues regarding the independence of monetary policy formulation by PBC are expected to rise to the forefront of discussions of macroeconomic stabilization in China.
Meanwhile, the Government is continuing to send signals about its macroeconomic concerns. The cement, aluminum, steel and vehicle production industries have been identified as those where overcapacity is a problem. As market-based policy instruments have either not been fully exploited or are expected to have uncertain outcomes, the authorities have resorted to administrative tools. Restrictions have been put on Local Government infrastructure investment, especially in showy projects and in industries considered to have excess capacity. CSRC has announced intentions to prohibit corporates in these industries from new listings in the stock exchanges. More recently, CBRC stipulated tighter borrowing ceilings on mortgage loans, which are a rapidly growing segment of the financial market. Given existing weaknesses in the domestic financial system, the use of such administrative tools is understandable, despite their tendency to slow the ability of borrowers and lenders to build risk management capacity. However, they reflect a perspective that attributes too much of the present problems to supply side management, thus downplaying the key role that demand management policies can play in engineering a soft landing in China. More important, perhaps, is the point that these are blunt instruments, and close coordination of their use with market-based macroeconomic instruments is needed in order to avoid a stop-go macroeconomic cycle.
Institutional Reform Agenda
While dealing with macroeconomic uncertainties and beginning the implementation of a more balanced, people-centered development strategy, China's broad program of transition to a modern, market-based is reaching a decisive phase. In this regard, the authorities have been giving greater attention to the management of state assets-in both the financial market as well as among state-owned non-financial enterprises (SOE)-given their central role in resource allocation in the economy. Over the longer-term, the development of China's financial market and greater reliance on equity financing should serve somewhat to dampen industrial over-investment fueled by cheaper debt financing.
Banking
In late December 2003 the Government announced that US$45 billion in foreign exchange reserves had been invested in the Bank of China and China Construction Bank, two of China's four state-owned commercial banks. Although the recapitalization has been interpreted as a precursor to attracting strategic investors and/or listing the banks, domestically and/or overseas, their importance should not be overstated. Commercialization involves a fundamental top-to-bottom change in the way the banks operate. Recapitalization is most effective when it is accompanied by improvements in corporate governance, which in turn must induce the efforts of senior managers during the commercialization process. New corporate governance structures need to be translated into substantially improved corporate governance practices, and the way in which the Government exercises its ownership function in the state financial institutions will be a key factor in the eventual success of current proposals. These parameters are known to the authorities and to the senior managements of the banks, but a practical plan and stronger evidence of implementation is awaited..
State-Owned Enterprises
Progress in the management of other state assets is noteworthy. State-owned Assets Supervision and Administration Commission (SASAC) has initiated some significant reforms-for example, recruiting SOE managers through an open process, establishing performance evaluation and compensation rules, strengthening the accounting system, setting up boards of directors, and privatizing through two new rules on "ownership transformation". Yet several challenges remain in attempts to de-fragment industrial sectors and to encourage market-based corporate governance. Consolidation in the manufacturing sector requires additional exits of non-viable SOE, mergers, and acquisitions. The role of SASAC in such consolidations needs to be clarified. It is not obvious that SASAC have the expertise to actively manage the merger and acquisition processes designed to create globally-competitive industrial clusters. It would seem more appropriate for the Government to create a conducive investment climate and for SASAC to rely on SOE boards and foreign/domestic investors to achieve the necessary market-based consolidations. SOE exits, mergers, and acquisitions may, however, have the side-effect of highlighting non-collectible loans and unfunded pension liabilities in distressed SOE. The recent moves to re-capitalize state-owned commercial banks were notable for the lack of linkage between the resolution of non-performing corporate/infrastructure loans and financial sector restructuring. Going forward, it will be important for the central and local authorities (for example, SASAC, bank regulators, pension funds) to coordinate closely on the sharing of reform costs and proceeds.
In addition, there is a need to strengthen corporate governance and capital market discipline. To date, China's emphasis has been on accessing capital market finance. A major problem is the large overhang of non-tradable State shares, representing about 70 percent of the shares in China's listed companies. These make it difficult, if not impossible, for the other shareholders to introduce the changes needed to correct poor corporate performance. Moreover, the dominance of publicly-listed subsidiaries by state-controlled groups permits related party transactions that may disadvantage public shareholders. The promotion of capital market development requires that the non-tradable share problem be addressed soon. Innovative corporate finance transactions to resolve parent-subsidiary conflicts-for example, by listing the parent, as in the case of the blue-chip TCL Group, or through a secondary offering to enable the public subsidiary to buy the parent-could be considered.
Rural Economy
A package of measures presented on February 8, 2004 is the latest evidence of the Government's determination to promote rural development. Actions have been proposed in three areas-increases in fiscal resources for rural areas, access to finance, and improvements in the provision of public goods and services.
The Central Government budget for rural development will rise from RMB30 billion to RMB150 billion, and includes direct subsidies to farmers in the main grain producing provinces, the promotion of high-quality grain seeds, and training to rural migrant workers to improve their access to remunerative off-farm employment.
The rural fee-to-tax reform, which was initiated in Anhui Province in 1999 and was then rolled out to all provinces in 2003, is also expected to play an important role in improving the condition of rural residents, especially farmers. The increase in grain imports in 2003 re-ignited dormant concerns within the Chinese Government about food security. The Government has announced an increase of 20 percent in the rice procurement price, and has given very specific signals regarding its intentions to maintain land in grain production. While this may result in short-term increases in rural incomes and may slow the growth of imports, the proposed policies clash with economic efficiency considerations in the same way as did the ultimately costly grain production policies introduced in the mid-1990s. Moreover, as the decline in farm incomes (and, by many measures, the increase in rural poverty) in 1997-2000 suggested, it is doubtful if the welfare of producers in China is served by slowing China's agricultural evolution along the lines of its comparative advantage. At WTO accession it seemed likely that China would be able to avoid the costly path adopted by many other countries in their support of inefficient domestic agriculture activity. It was also believed that China's high foreign exchange reserves would permit it to make a rapid exit from policies that burden consumers and producers of grain with high welfare costs. The newly-announced grain policy is likely to spark a new round of debates on this issue.
Convenient and reliable access to rural finance is key for farmers to increase their income by enabling them to engage in higher-return economic activities. A pilot program for reforming the rural credit cooperatives (RCC) was launched in July 2003. The objective is to make the RCC responsible for their own losses in the future, by giving them operational autonomy. Creating sound rural financial institutions out of the poorly functioning RCC is bound to be a massive challenge. The ultimate success of the pilot program hinges on two key factors-on effective governance within the new rural financial institutions and the elimination of lending interest rate ceilings. The available evidence in China, as in other countries, shows that farmers mostly consider convenient and reliable access to finance more important than the level of the borrowing rate. Moreover, continuing t
o subsidize agriculture through low interest rates runs counter to the goal of poverty reduction, as the concessionary loans are often captured by the rich and influential.
A broad range of public services is under-provided in rural areas, the problems stemming largely from a malfunctioning system of intergovernmental finance. Of these, the Government has lately stressed the development of the rural health sector-to provide financial protection for the poorest, and to improve quality and efficiency in the delivery of care.
Key challenges in improving the health of people in rural China include better institutional coordination among government departments, addressing the question of the affordability of government commitments to both urban and rural health insurance initiatives and unifying the dualistic structure of such health insurance arrangements. It is not clear that lower levels of Government-provinces, but in particular prefectures and counties-have the capacity to bear this burden. There are also uncertainties about the expenditure assignment and affordability of social protection programs in the health sector, such as di bao (Minimum Living Standard Scheme). Moreover, the scope for targeting within each of the insurance schemes, in particular the new Cooperative Medical Scheme, has not been adequately explored. The separation of urban and rural insurance institutions also hinders the transfer of management lessons and results in potential inefficiencies.
Similar challenges exist in the area of service delivery. China has seen rapid cost escalation in the hospital sector, with the costs of an inpatient day and an outpatient visit both growing at annual rates of 16 percent during the 1990s. It also has seen supplier-induced demand, an inefficient service mix, questionable quality of care, and a high degree of duplication. Providers have sometimes exploited their ability to raise additional revenues, on top of their supply-side subsidies, through the provision of services that yield a profit at the margin. Providers tend to prescribe drugs even if their "main business" lies elsewhere. They tend to over-prescribe drugs and to prescribe unduly costly-and possibly inappropriate-drugs. Facilities acquire equipment to compete with one another to perform revenue-generating tests, and to offer services they are not mandated-and perhaps not qualified-to deliver. The result is not only duplication of capacity and an over-provision of services with relatively low cost-effectiveness, but also the displacement of essential activities such as basic curative care, public health programs, outreach, and support and supervision. There also appears to be a lack of linkage between health finance and service delivery, despite the clear need to reform provider payment mechanisms (e.g. replacing the current system of bonuses, markups, etc., with a more rational system) and the pricing system of drugs and medical services.
The Government has recently made commitments to improve the public health infrastructure following SARS. These important initiatives in turn raise issues for policy consideration. They include the appropriate scale and growth of government health spending; the distribution and sharing of public resources between affluent and poor provinces and counties; and broader issues of the scope and content of the Government's public health strategy.
Note: This Update was produced by Min Zhao, based on contributions from Hana Brixi, Achim Fock, Sudarshan Gooptu, Xiaofan Liu,William Peter Mako, L. Richard Meyers, Kong-Yam Tan, Jun Wang and Mei Wang.
(China.org.cn April 20, 2004)
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