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p. 11 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia People's Republic of China Hong Kong, China Republic of Korea Mongolia Taipei,China Southeast Asia South Asia Central Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : East Asia

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People's Republic of China

With a strong performance in the trade sector after World Trade Organization accession, record inflows of foreign direct investment, and large fixed investment, the country continued its rapid economic expansion in 2002, recording one of its fastest rates in 5 years. Strong economic performance is expected to continue, though growth will slow slightly in 2003-2004. However, many challenges remain, including slow growth in rural incomes, the need to create jobs and an enabling environment for the private sector, growing disparities between the coastal and interior provinces, and financial sector weaknesses.

Macroeconomic Assessment

GDP growth in the People's Republic of China (PRC) accelerated to 8.0% in 2002 from 7.3% in 2001, moving higher than the 7.8% average of the previous 5 years. This higher than expected figure resulted from exports performing better than anticipated, surging foreign direct investment (FDI), and buoyant domestic demand. Expansionary fiscal and monetary policies also played a role.

Industry (including construction) was the key engine of economic growth, with value added accelerating to 9.9% in 2002 from 8.7% in 2001. Electronic equipment, transportation equipment, and chemical products all did well. A surge in FDI and export growth resulted in the value added of foreign-funded enterprises increasing by 13.3%. Supported mainly by growth in transportation, telecommunications, and real estate, the services sector expanded by 7.3% in 2002 (though because of weaknesses in the statistical system, growth in this sector is probably underestimated). Despite a spring drought, agriculture sector performance improved slightly compared with the previous 2 years. Grain output, which dropped by 2.1% in 2001, rose by 1%.

A surge in fixed asset investment, which grew by 16.1%, stimulated domestic demand (Figure 2.1). Private investment rose by 15.7% in the year, faster than in 2001. Across sectors, investment in real estate was particularly strong, registering a 21.9% increase in 2002, as housing reforms and more housing mortgage loans led to a buoyant property market. Supported by the Government's western region development strategy, investment in that region grew by 20.6%, faster than in the central (20.0%) and eastern (16.2%) regions.

Domestic consumption strengthened by 8.8%. The steady growth in domestic spending was mainly driven by urban households, which spent 10% more than in the previous year. Rural residents' spending registered a 6.8% increase, reflecting the continued widening of urban-rural income disparities. Per capita urban disposable income grew by 13.4% in real terms to exceed CNY7,700 ($928), while per capita real rural cash income increased by only 4.8% to reach CNY2,476 ($298). The rapid increase in urban incomes triggered a purchasing boom for private cars, telecommunications equipment, and houses. In 2002, car imports increased by 77% and sales of telecommunications equipment and houses grew by 69% and 39%, respectively.

As economic restructuring continued, employment in the state-owned sector and urban collectives continued decreasing. The number of employees in the state-owned sector fell by 4.6 million in 2001 and by the end of 2002 had fallen by a further 4.8 million. Excluding smaller private and informal sector activities, employment in the nonstate-owned sector increased by 3.0 million in 2002. Based on official statistics, which underestimate the problem, the urban registered unemployment rate rose from 3.6% in 2001 to 4.0% in 2002. If workers at state-owned enterprises (SOEs) who had not been reemployed were included, the adjusted unemployment rate would have been more than 7%. The development of an urban social safety net and reform of social security are needed to ameliorate the social costs of the economic reform program.

The Government maintained an expansionary fiscal policy in 2002 to support economic growth. The 2002 fiscal deficit is CNY310 billion, or equivalent to 3.0% of GDP, and 0.4 percentage points higher than recorded in the previous year. However, these official figures do not reflect the true fiscal position. If the Government's social security obligations and the costs associated with the nonperforming loans (NPLs) of the four state-owned commercial banks (SOCBs) were included, the fiscal deficit would be much higher.

Total fiscal revenues grew by 15.4% while expenditures increased by 16.4% in 2002. The slower increase in revenues from the 22.3% surge in 2001 resulted from lower corporate income tax and a substantial decline in tariff revenues and stamp duty. Tariff revenues fell in 2002 due to reductions in tariffs after World Trade Organization (WTO) accession. The rise in government spending resulted mainly from expenditures on capital construction, pension and social security funds, and government administration. Because of emerging urban poverty, expenditures on the minimum living allowance have risen 23-fold from CNY0.2 billion in 1998 to CNY4.6 billion in 2002. Central government expenditures on social security have increased from 1% of total budget expenditures in 1997 to 6% in 2002.

Because of the slowing revenues and rising expenditures, the Government took several measures to keep the budget deficit within target. These included reducing tax evasion by strengthening collection efforts and ensuring stricter compliance with audits of firms, foreign-funded enterprises, and high-income groups. On the expenditure side, measures focused on tightening supervision of extrabudgetary funds and unauthorized spending.

As a consequence of banking reform and strengthening financial risk control, banking credit grew moderately in 2002. Outstanding loans rose by 15.4% while outstanding deposits increased by 18.1%. To boost domestic demand, the People's Bank of China (PBC), the central bank, cut interest rates in February. The 1-year lending rate was lowered by 0.5 percentage points to 5.3%, in the first reduction since mid-1999.

Concerned about financial risks, SOCBs preferred to place funds in deposits at PBC or buy treasury bonds, rather than extend credit to the corporate sector. Broad money (M2) growth accelerated to 16.8% in 2002, from 14.4% in 2001. Due to its robust economic growth and strong balance-of-payments position, the Government maintained a stable exchange rate, allowing the currency to fluctuate in a narrow band of around CNY8.3 to the dollar.

Stock market indices increased slightly in the first half of the year and then fell in the second. As of 31 December 2002, the Shanghai and Shenzhen A-share indices gained only 0.2% and 4.8%, respectively, from their lows in 2002. The main reasons for the market weakness include poor corporate performance and a crackdown on market irregularities.

Consumer prices continued to decline in 2002. The consumer price index (CPI) was on average 0.8% lower in 2002 than in 2001, and its fall reflects three main factors: (i) as a result of tariff reductions and quota cancellations, cheaper imported products entered the domestic market, intensifying downward pressure on domestic prices; (ii) productivity in the industry sector has been improving, with statistics showing that the PRC's productivity grew by 6.9% annually in 1996-2001; and (iii) the relative excess supply of agricultural products.

Exports grew by 22.3% in 2002, rebounding from a disappointing performance (6.8% growth) in 2001 as more opening of the trade sector after WTO accession brought a significant increase in FDI, and a weaker dollar improved international competitiveness. A shift in exports toward high-tech products was also noticeable. The country's agricultural products achieved a trade surplus with double-digit export growth, contrary to expectations of the impact of WTO on the sector. Industrial exports of textiles, garments, and mechanical and electronic telecommunications equipment all grew rapidly. Automobile imports did not grow as rapidly as had been expected, while surging iron, steel, and fertilizer imports put pressure on domestic enterprises.

Contracted FDI grew by 19.6% to $82.8 billion, and actual FDI increased by 12.5% to $52.7 billion. In tandem with strong FDI inflows, imports rose significantly by an estimated 21.0% in 2002, compared with an 8.1% rise in 2001. As a result, the trade surplus reached an estimated $44.6 billion, equivalent to 4.0% of GDP.

With the FDI inflows and large trade surplus, foreign exchange reserves reached a record high of $286.4 billion by the end of 2002, up from $212.2 billion in 2001. Total external debt amounted to $169.1 billion by end-June 2002. Short-term debt accounted for 31% of total debt and the debt service ratio was comfortable at 7.3%.

Policy Developments

Fiscal policy has played a key role in stimulating the PRC's economic growth over the past 5 years. The Ministry of Finance estimated that four consecutive fiscal stimulus packages contributed 1.5, 2.0, 1.7, and 1.8 percentage points to GDP growth in the years 1998-2001, respectively. The Government issued CNY150 billion ($18.1 billion) in special bonds to finance the public deficit in 2002. These bonds were mainly used to finance public sector projects under construction, development projects in the western region, technological upgrading of key enterprises, projects to divert water from the south to the north, and rural infrastructure.

To promote the development of an integrated national market and fair competition between enterprises in different regions, the Government changed the methodology of income tax sharing between the central and local governments. From 1 January 2002, corporate income tax revenues were no longer divided according to the jurisdiction of the enterprise. Except for several special industries, most of the corporate income tax and all personal income tax revenue were shared between the central and local authorities at a fixed ratio. The central Government used the income tax increase resulting from the reform for transfer payments from the central budget to local authorities, especially those in the central and western regions. Government procurement procedures were also strengthened.

With WTO accession, the Government accelerated the pace of reforming the domestic economy. A series of adjustments in fiscal and tax policies was made in the first year after WTO accession including: (i) reducing tariffs on more than 5,300 commodities, resulting in the general tariff level dropping from 15.3% to 12.0% (and further to 11.0% in early 2003); (ii) eliminating different treatments between domestic and foreign enterprises, such as unifying accounting standards, by applying the same tax rate reduction on investment in encouraged sectors and in the western region; and (iii) raising the export rebate rates on cotton, rice, wheat, and corn exports from 5% to 13%.

On the monetary front, the Government adopted several measures to stimulate domestic demand and took substantial steps to fulfill its WTO commitments. Concerned that the decline in SOCB lending could aggravate deflationary pressure, PBC adopted the following measures: (i) it cut the 1-year lending rate by 0.5 percentage point to 5.3% in February; (ii) it raised the target growth rate for M2 from 13% to 14% in May; and (iii) it issued a directive in mid-2002 urging SOCBs to increase lending to consumers and small and medium enterprises (SMEs).

To strengthen financial support to SMEs, the Government passed the ADB-supported Law on the Promotion of Small and Medium-Sized Enterprises. The Law includes provision for an SME development fund, the regulations for which are being written. In October, PBC released a set of trial regulations governing automobile financing for both foreign and domestic nonbanking financial institutions. To fulfill its WTO commitments, the Government allowed foreign-funded financial institutions to conduct local currency business in five more cities. Previously, the Government had removed restrictions on the foreign exchange clients of foreign banks and allowed them to conduct local currency business in Shanghai, Shenzhen, Tianjin, and Dalian.

Facing growing competition from foreign-funded financial institutions, the domestic banking system accelerated its pace of reform. The first step was to disclose the financial position of commercial banks requested by PBC in May 2002. All commercial banks must make their annual reports available no later than 1 April each year. The reports should provide key figures, such as the capital-adequacy ratio, asset quality, and amount of profit or loss.

The NPL ratio in the SOCBs stood at 23.4% by the end of June 2002 compared with 25.4% at the end of 2001. The goal of the four banks is to reduce their NPL ratios to less than 15% by end-2004. Four asset management companies have disposed of NPLs and initiated corporate restructuring. By the end of June 2002, the general recovery ratio of the four companies reached 21.6%. At the end of 2002, the financial authority approved the first two joint-venture asset management companies to bring foreign capital and expertise into the domestic nonperforming asset market.

Apart from the policy changes in the fiscal and monetary sector, the PRC made progress in many other sectors toward meeting its WTO obligations in 2002 (Box 2.1).

In another area of domestic economic reform, the Government moved to reform monopoly industries. In May 2002, China Telecom was split into two and a number of telecom operators began to compete with one another. In October 2002, the aviation industry finished regrouping with six major groups becoming independent enterprises. Corporate governance reforms also gained momentum. The China Securities Regulatory Commission (CSRC) and the State Economic and Trade Commission implemented corporate governance inspections on listed companies, with a special focus on the behavior of state-owned controlling shareholders. The CSRC set up a committee to check irregularities in the reorganization of listed companies involving substantial acquisition, sale, and swap of assets. To strengthen the legal framework needed for SOE reform, a new draft of the bankruptcy law clarifies and streamlines bankruptcy procedures for state-owned and private enterprises.

As part of the SOE reforms, the Government made legal provision for more foreign ownership of SOEs in 2002. Work began on drafting the merger and acquisition regulations that are expected to be adopted in 2003. To comply with the PRC's commitments to WTO, a new FDI guidance catalogue puts FDI into four major categories: encouraged, permitted, restricted, and prohibited. According to the catalogue, more industries are open to foreign investors. The CSRC also released rules that allow the establishment of fund management joint ventures if the foreign companies investing in PRC fund management companies have actual paid-in capital of at least CNY300 million and fall under the Government's definition of a financial institution. The CSRC reiterated that foreign shareholders in fund management companies could hold no more than a 33% stake within 3 years of the PRC's entry into WTO, and not more than 49% after that period.

There was substantial progress in promoting regional cooperation with the PRC's neighbors. In November 2001, the Association of Southeast Asian Nations (ASEAN) and the PRC agreed to establish the world's largest free trade area with 1.7 billion people and $2 trillion in GDP. The Framework Agreement was signed in November 2002 to establish the free trade area by 2010. The PRC granted most favored nation status and will also consider debt relief to less developed non-WTO member countries such as Cambodia, Lao People's Democratic Republic, and Viet Nam.

The Declaration on the Conduct of Parties in the South China Sea and the Facilitation of Cross-Border Transport of Goods and People in the Greater Mekong Subregion were signed in 2002. The Government adopted the Joint Declaration of ASEAN and PRC on Cooperation in the Field of Non-Traditional Security Issues and initiated a feasibility study on a free trade area among ASEAN members, plus Japan, Republic of Korea, and PRC.

According to an assessment by the ADB Institute, the PRC's economic development and membership of WTO will present many opportunities for East and Southeast Asia. The PRC will be those subregions' largest trading partner in the long term. While the country will be developing Asia's largest exporter by 2010, it will become the largest importer 5 years earlier, by 2005. The PRC is likely to develop, by 2020, a structural trade surplus with Organisation for Economic Co-operation and Development (OECD) countries and a trade deficit of about the same magnitude with East and Southeast Asia. The spillover effects from the PRC's growth and trade expansion will outweigh trade diversion effects on East and Southeast Asia.

The accuracy of PRC statistics has sometimes been questioned. The traditional comprehensive statistical reporting system is not suited to a market economy, and the Government is trying to establish a new statistical survey system. To improve statistical accuracy, the Government agreed to participate in the General Data Dissemination System of the International Monetary Fund (IMF) in April 2002. ADB, together with other international institutions (e.g., IMF, World Bank, OECD, and the Canadian International Development Agency), is assisting in strengthening the PRC's statistical capacity.

Outlook for 2003–2004

The economy will face downward pressure over the next 2 years. With a less expansionary fiscal policy, low growth in the rural sector, and the impact of severe acute respiratory syndrome (SARS), economic growth is forecast at 7.3% for 2003.

After record trade levels and government spending in 2002, exports and investment growth will slow in 2003. First, exports will not match 2002's rate of expansion as growth in import demand in its biggest markets, the US and Japan, is expected to be modest and growth of imports will exceed that of exports, resulting in a smaller trade surplus. Second, the Government's growing budget deficit will limit the continued use of fiscal stimulus packages. Worries about rising debt are expected to constrain government bond sales to finance more infrastructure and construction projects. There is a growing need to reduce debts in other sectors of the economy as the Government contemplates another huge bank bailout and ways to fund its fledging pension system. As the effectiveness of fiscal stimulus tapers off in 2003, growth of investment in fixed assets will rely more heavily on the private sector and FDI.

Although consumption will be robust, the consumption pattern may change with more money being spent on housing, cars, and tourism. However, services will suffer from the spread of SARS. Due to large excess capacity in many industries and cheap imports related to WTO trade liberalization, deflationary pressure will remain in 2003. CPI inflation is forecast at 0.5%. Substantial FDI inflows will partly offset the decline in the current account surplus resulting from the deteriorating trade balance. The current account surplus will be 1.6% of GDP in 2003.

If the world economy experiences a modest recovery, domestic private sector investment gathers momentum, and rural incomes rise moderately, then the economy will maintain its high growth in 2004, projected at 7.6%. With the deepening of economic reforms and industrial restructuring, excess capacity and supply should be gradually absorbed or transferred to emerging industries or sectors. Inflation will likely be moderate at 1.0%. The current account is forecast at 1.5% of GDP.

Although the 16th National Congress of the Communist Party of China outlined the Government's ambitious agenda for economic development and reform in the next two decades, such as quadrupling GDP by 2020 (Box 2.2), there are several important issues that could adversely affect economic prospects in the short and medium term.

In the next 5 years or so, the most important challenge for the PRC's policy makers is job creation, because, as the country continues its economic restructuring and reform of SOEs, more workers will be laid off. These workers will join about 8 million new labor market entrants and rural migrants in their search for jobs each year. It will not be possible for the country to reduce poverty and maintain social stability unless economic growth becomes more employment intensive, implying that the economy will need to shift from resource-extensive to labor-intensive growth.

The private sector is playing the key role in job creation, generating almost all new jobs between 1996 and 2002. To create a better enabling environment for the private sector, the Government needs to emphasize improving the legal framework and judicial system; honoring contracts; eliminating fake products and protecting intellectual property rights; converting legitimate fees and charges into taxes and abolishing illegal and arbitrary fees; reducing administrative bureaucracy; removing local protectionism, barriers to interprovincial trade, and other factors preventing fair competition; and setting better accounting and auditing standards and improving disclosure and enforcement.

Income inequality within regions, the gap between rural and urban areas, as well as disparities between the eastern region and western region (where most of the poor live) have all widened. Addressing the issues of poverty and inequality is essential to maintain broad-based public support for the country's reform program. More jobs need to be created for the poor and economic growth promoted in rural areas and in the interior provinces. This calls for strengthening policies and institutions, developing infrastructure, addressing land degradation, and supporting human resources development. Other measures required include strengthening social safety nets and the social security system, initially in urban areas and gradually in rural areas; improving poverty reduction programs with better targeting; encouraging poor people to participate in decisions that affect them; and undertaking pro-poor fiscal reform, particularly at the provincial and subprovincial levels.

Although the economic growth rate has been impressive, the efficiency of resource use can still be improved. The financial sector does not allocate capital efficiently. A large volume of NPLs and a poorly performing banking system have hindered the development of an efficient nationwide financial system and imposed large costs on the economy, and represent a potential systemic risk. WTO entry and short-term challenges associated with trade and financial liberalization will exacerbate vulnerabilities in the financial system.

To counter these risks, the Government needs to institute regulatory reform and information disclosure mechanisms in the financial sector conforming to international standards. Other measures required in a sequenced approach to liberalizing the financial sector include resolving NPLs; diversifying ownership of financial institutions; giving more autonomy to PBC and financial regulatory agencies; liberalizing interest rates; allowing foreign participation and the development of private banks; opening the capital account in phases after strengthening domestic institutions; and establishing a sound, flexible, and resilient exchange rate regime.

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