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p. 16 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : East Asia

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People's Republic of China

The rapid economic growth seen in 2003 will slow in 2004, but still probably outpace the Government‘s target. Concerned at patches of economic overheating and unbalanced socioeconomic development, the Government has taken steps to control credit expansion and is emphasizing a more balanced approach, with help for rural areas. But the country faces many challenges, including a weak banking system, state enterprise reform, job creation, and poverty reduction.

Economic Assessment

Economic growth accelerated from 8.0% in 2002 to 9.1% in 2003, with quarterly figures showing a V-shaped pattern (Figure 2.1). Fueled by strong domestic demand and buoyant foreign trade, gross domestic product (GDP) grew rapidly in the first quarter of 2003. However, with the outbreak of severe acute respiratory syndrome (SARS), GDP expansion slowed in the second quarter, particularly in services and especially tourism. With SARS brought under control in June, GDP growth accelerated in the second half of the year. While the robust economy reflects substantial reforms associated with World Trade Organization (WTO) accession and the accumulated impact of the proactive fiscal policy of the past 6 years, some signs of economic overheating are causing concern.

On the demand side, investment was the main driver, contributing 6.3 percentage points to growth. (Consumption contributed 3.9 percentage points but net exports subtracted 1.1 percentage points from the total growth figure.) Fixed asset investment soared by 26.7% in 2003, 9.8 percentage points higher than the previous year. Public sector investment, which accounted for 72.1% of total investment, surged by 28.2%, driven largely by local government investment decisions. A rapid expansion of bank lending, continual foreign direct investment (FDI) inflows, and a property market boom were major factors contributing to the investment surge. Supported by a greater volume of housing mortgage loans from commercial banks, investment in real estate grew by 29.7%.

Signs of economic overheating included the extraordinary investment growth rate, rising prices of raw materials, and shortages in some sectors (e.g., oil, electricity, and coal). Power consumption increased rapidly, and 21 out of 31 provinces suffered blackouts in 2003. The State Grid Corporation predicted that power consumption in 2004 would rise to 2,091 billion kilowatt-hours (kWh)-an increase of 207 billion kWh over the 2003 level-and that more provinces would experience power blackouts.

Concerns focused on the possible overinvestment in industries such as steel, automobile manufacturing, aluminum, and cement as well as the rapid rise in bank lending, particularly in real estate. In the fourth quarter, some steps were taken to address these concerns. For instance, the People’s Bank of China (PBC) increased the reserve requirement of commercial banks and prohibited them from providing mortgage loans for unfinished properties. The Government also sent several supervision teams to monitor the implementation of these measures at the provincial level.

Domestic consumption was hit by the SARS outbreak in the first half of 2003, but still expanded by 8.0% over the year. The growth rate of retail sales dropped in the second quarter but then rebounded in the second half of the year. Sales of private cars and home appliances rose sharply, fueled by higher urban incomes, a rising number of consumer loans, and lower import prices after WTO-related tariff reductions.

On the supply side, GDP growth came mainly from industry (including construction). Growth in value added in the sector accelerated to 12.5% in 2003, from 9.8% in 2002. Both production and sales of automobiles, electronic equipment, and construction materials increased rapidly.

The agriculture sector expanded by 2.5%. Because of a reduction in planted areas (partly due to lower profitability of grain compared with other crops), and natural disasters in some locations, total grain output at 430.6 million tons fell below the 2002 level.

While the SARS outbreak marginally affected industry and agriculture, it had a more serious impact on services, where growth slowed in the second quarter but recovered in the third and fourth. The services sector grew by 6.7% in 2003, 0.8 percentage point less than in 2002, with the value added of wholesale and retail sales, finance and insurance, and real estate rising by 6.6%, 6.9%, and 5.3%, respectively.

The living standards of both urban and rural households improved, but the rural-urban income gap continued to widen: real per capita income grew by 9.0% in urban areas, but only by 4.3% in rural areas.

According to official statistics, which significantly underestimate the problem, the registered urban unemployment rate rose from 4.0% in 2002 to 4.3% in 2003. If laid-off state-owned enterprise (SOE) workers who had not been reemployed were included, the adjusted unemployment rate would have been about 8%. Given that about 10 million young urban residents enter the labor market each year and that tens of millions of underemployed farmers have migrated to the cities in search of work, the actual employment situation is much worse than the official data indicate. (Since the “floating” population is not included in current statistics, the National Bureau of Statistics, together with other relevant government agencies, has decided to develop a more appropriate system for measuring employment.)

To ease unemployment pressures, the Government has prioritized job creation in the private sector, strengthened the social safety net, and accelerated employment reforms. Measures were implemented to promote small and medium enterprises to create jobs, and social security reforms have begun. In spite of the Government’s efforts, the reduction in rural poverty has slowed in recent years. The characteristics of the remaining absolute poor suggest that a different approach is needed (Box 2.1).

Fiscal revenues increased by 14.7% in 2003, slightly lower than the 15.4% rise seen in 2002. Fiscal expenditures rose by 11.6%. While spending on capital construction declined, expenditures on health care, social security, and government administration grew rapidly, partly because of the efforts to contain SARS.

Given the better than expected revenue growth, the fiscal deficit was about 2.7% of GDP, below the budgeted target of 2.9%. However, if off-budget obligations such as the implicit pension debt and costs related to nonperforming loans (NPLs) in the banking sector are included, the fiscal deficit comes out as much higher than the official estimate. There are, indeed, many more fiscal challenges than is suggested by the official estimate of the deficit.

Money supply growth accelerated in 2003. M2 increased by 19.6%, or 2.7 percentage points faster than in 2002. Factors included strong domestic investment demand, which prompted banks to expand credit, and large inflows of foreign capital, which the authorities attempted to sterilize. Total bank deposits grew by 21.7% to CNY20.8 trillion ($2.5 trillion) and total commercial bank loans amounted to CNY15.9 trillion ($1.9 trillion), a rise of 21.1% from 2002. There are concerns that the rapid expansion of M2 and bank credit might further fuel the overheating in some areas and cause a deterioration in loan quality, which could worsen the future NPL position.

The deflationary trend in consumer prices in 2002 was reversed. Driven mainly by rising prices of food and services, the consumer price index (CPI) rose by 1.2% in 2003. Grain price increases in the fourth quarter were in part caused by floods and drought, and by the continuing decrease in grain output of the past few years. Price rises in services reflected strong demand for education, health care, and housing.

Prices of other consumer goods (apart from food and services) continued to fall because of oversupply, tariff reductions, and greater market competition. As a consequence of the investment boom, producer prices rose significantly. While industrial producer prices increased by 2.5% on average, some raw material prices such as steel, iron, aluminum, and cement rose at double-digit rates. If this trend continues, the higher producer prices will be passed on, pushing up consumer prices.

Exports surged by 34.6% in 2003-after strong growth of 22.4% in 2002-pushed higher by increased production capacity and a favorable competitive position. Exports of foreign-funded enterprises rose by about 40% from the 2002 level, lifting their share in total exports to about 55% from 48%. Imports soared by 41.0%, nearly double the rate of 2002, due to strong domestic demand, higher oil prices, and lower tariffs. This caused a decline in the trade surplus to $41.4 billion from $44.2 billion in 2002. The country has a large trade surplus with the United States (US) but its trade deficit with East and Southeast Asia has widened in recent years. The PRC is the world’s biggest consumer of copper, tin, zinc, platinum, steel, and iron ore; second biggest of aluminum and lead; third largest of nickel; and fourth largest of gold. It is now the world’s second-largest oil consumer, and accounted for 35% of the global rise in oil demand in 2003.

The reduced trade surplus, together with a fall in receipts from services (in particular tourism), led to a decline in the current account surplus to an estimated $31.0 billion from $35.4 billion in 2002. The current account surplus is modest at 2.2% of GDP.

Actual FDI inflows rose by 1.4% to $53.5 bil­lion, slowing from growth rates of 15.1% and 12.5% in 2001 and 2002, respectively. The SARS outbreak and the weak world economy during the first half of 2003 hurt FDI. The figures might overstate FDI because they include some “round tripping,” i.e., PRC capital that is taken offshore and then returned to the country as FDI to take advantage of favorable policies designed to attract capital inflows.

About two thirds of foreign joint ventures in the PRC made a profit over the past 2 years and their profitability was frequently better than that of joint ventures elsewhere.

The FDI climate in the eastern part of the country is better than in the central and western regions. During the 1990s, over 90% of all FDI went to the east coast. Making the central and western regions more attractive for FDI would help reduce poverty but, according to the 2003 Private Sector Assessment Report (PRC) of the Asian Development Bank (ADB), about 40% of foreign firms already operating in east coast provinces are not currently considering expanding their operations to the central and western regions, mainly because of poor infrastructure and lack of markets. Improving the environment for FDI in the poorer interior provinces therefore requires the Government to take action to (i) lower fees and charges for their operations, transport, and land costs; (ii) improve infrastructure; (iii) open more sectors to foreign investment beyond what is available in east coast provinces; and (iv) liberalize the general rules of business, increase transparency, reduce restrictions, and simplify approval procedures for foreign investors.

Making progress in these areas is important, as many studies have shown that tax breaks and financial incentives alone are not the most important factors influencing investors’ decisions about whether or not to invest in a new location.

The FDI inflows, high domestic interest rates relative to international rates, and rising market expectations of a yuan appreciation led to a surge in foreign exchange reserves, which reached $403.3 billion by end-2003, 40.8% higher than at end-2002. Short-term foreign debt also increased sharply. Total external debt is estimated at $171.9 billion, equivalent to 12.3% of GDP, with short-term debt accounting for about 35% of this, which is 5 percentage points higher than in 2002. The exchange rate remained stable at CNY8.28/$1.

Policy Developments

While fiscal stimulus remains a key component of the Government’s measures to bolster domestic demand and generate employment, the quick recovery from SARS and robust economic performance have lessened the need for such stimulus. In March 2003, the Government budgeted for both revenues and expenditures to rise by 8.0% in 2003. However, revenues actually grew by 14.7% as a result of the strong economy. At the annual National People’s Congress (NPC) in March 2004, the Government targeted a 2004 deficit of CNY319.8 billion, the same as in 2003. This will lower the deficit-to-GDP ratio from 2.7% in 2003 to 2.5%. The 6-year expansionary fiscal policy is expected to be phased out. Related to this move, the Ministry of Finance announced that funds raised by treasury bond issues in 2004 will be used mainly for economic restructuring and social development rather than promoting economic growth.

The March 2004 NPC outlined the Government’s priorities. Major themes included increasing rural incomes, creating jobs, developing the private sector, strengthening the rule of law, developing more mechanisms for citizen participation, financial sector reform, and SOE reform. Although rapid economic growth will continue to be a priority, there was a recognition that economic growth by itself is not enough to achieve sustained socioeconomic progress.

A more balanced development agenda is being adopted, which will provide more people with the opportunity to benefit from economic growth and reduce poverty. Balance is being sought in five areas: (i) rural-urban disparities (increasing rural incomes, reducing rural taxes, protecting the land use rights of farmers); (ii) humankind and nature (environmentally sustainable development); (iii) economic growth and social development (more emphasis on health, education, social security reform, and protecting urban migrants); (iv) regional disparities (fostering development in the west and northeast); and (v) domestic and international concerns (trade, investment, WTO, and competition). To support this agenda, the constitution was amended to protect lawful private property rights, pay compensation for expropriated land and private property according to the law, establish a sound social security system, and respect human rights.

As part of this agenda, the Government plans to allocate CNY95.5 billion from the 2004 budget, up by CNY10.0 billion from 2003, for spending on education, health, science and technology, and culture and sport, with priority given to rural areas.

Farmers are benefiting from several policy changes, including a tax reform called the “fees-for-tax” plan, initially introduced in 2000, to reduce their financial burden. In the past 4 years, the number of provinces adopting the policy has risen to 20. About 620 million farmers gain from this reform, which reduced their financial burden by at least 30%. A nationwide inspection of the progress of rural tax reforms was launched in 2003, in an effort to standardize rural taxes. The NPC in March lowered taxes on many agricultural products. Furthermore, the agricultural tax rate will be reduced by more than 1 percentage point a year on average from 2004, and agricultural taxes will be removed in 5 years. Since urban incomes are three times as high as rural incomes and the majority of the country’s poor live in rural areas, these measures to reduce rural taxes should help reduce poverty.

Also on the tax front, the Government changed its export tax rebate system by (i) lowering the average export tax rebate rate from 15% to 12%, (ii) using all the increased revenues from imported products’ VAT and consumption taxes to refund export tax rebates, (iii) allocating all delayed tax rebates accumulated until end-2003 to itself, and (iv) establishing a mechanism for central and local governments to share the tax rebates (75% for central and 25% for local governments).

Concerned that the rapid rise in bank lending and liquidity could lead to a deterioration in loan quality and an increase in inflation, PBC took several steps to control money supply growth. In April 2003, it began issuing short-term central bank bills to sterilize the influx of foreign capital. In June, it issued prudential regulations to control property loans, particularly in high-end housing projects. And in September, it raised banks’ reserve requirement ratio from 6% to 7%. As a result of these measures, credit expansion slowed somewhat. Between August and end-2003, lending growth decelerated from 23.9% to 21.1% and M2 growth slowed from 21.6% to 19.6%. PBC tightened monetary policy again effective 25 April 2004, when it raised the reserve requirement ratio to 7.5% for most banks and to 8.0% for banks considered to be inadequately capitalized. It had already raised the rediscount rate on commercial bills in March.

However, the incomplete nature of economic reforms has dampened the impact of monetary policy instruments. The authorities might have to consider complementing the monetary steps with fiscal measures, such as deferring treasury bond issues, delaying disbursements from bond issues and treasury payments for capital projects, taking administrative action to defer or postpone capital investment projects, and increasing the contract tax on buying and selling real estate. Taking administrative measures to slow the conversion of agricultural land to other uses and ensuring that people whose land and houses are expropriated are fully compensated according to law would also help reduce capital investment in the longer term. Clearly, though, there will be time lags before the economy responds to any monetary, fiscal, and administrative changes.

To accelerate bank restructuring and financial reform, the Government established the China Banking Regulatory Commission (CBRC) in April 2003 to take over the functions of regulating and supervising banks from PBC. A priority of CBRC is to improve management of the country’s four major state-owned commercial banks (SOCBs). The new agency formulated supervisory rules and regulations to oversee bank operations; set up a branch in each province; and began spot checks of commercial banks and nonbank financial institutions to ensure that they were taking the appropriate measures to reduce their NPLs.

Subsequently, the Standing Committee of the NPC, in December 2003, approved the Law on the Supervision of the Banking Industry, which stipulates CBRC’s powers and functions. It also amended the Law on the People’s Bank of China, highlighting PBC’s role in the economy, especially in currency policy. Other amendments made to the Law on Commercial Banks free SOCBs from granting policy-oriented loans and loosen the limits on investment by commercial banks.

Reforms in the banking sector accelerated as the PRC entered its third year in WTO. The Government adopted long-awaited reforms of the four SOCBs. It injected $45 billion of foreign reserves to recapitalize the Bank of China and the China Construction Bank (the third capital injection to SOCBs since 1998). A similar package was announced for the Industrial and Commercial Bank of China in January 2004, while the Agricultural Bank of China will receive additional funding later in the year.

PBC widened the lending interest rate bands for financial institutions from 1 January 2004. The upper limit on lending rates for commercial banks and city credit cooperatives is now 1.7 times the benchmark rate and 2 times for rural credit cooperatives.

The capitalization requirements for foreign banks were relaxed a little, although they remain high by international standards. The Government allowed foreign banks to provide yuan services to domestic businesses in 13 key cities beginning in mid-December 2003. In 2004, the PRC is expected to open three more cities to foreign banks. Eighty-four of the 191 foreign banks operating in the country now hold a local currency license. As required by the WTO accession agreement, regulations for automobile financing were issued and the first three foreign licenses were approved.

Although the exchange rate of the yuan remained within a narrow band around CNY8.28/$1, there were calls from some of the PRC’s trading partners for a more flexible exchange rate policy and an effective appreciation of the yuan. The Government stated that it had no immediate plans to change its exchange rate policy, and that a flexible exchange rate regime would be a long-term goal, in conjunction with substantial financial reform and interest rate liberalization. It believes that one of the lessons of the Asian financial crisis is the importance of strengthening the domestic financial sector before adopting a convertible capital account and a flexible exchange rate.

The authorities did, though, take steps in 2003 to ease the pressure brought by high foreign exchange reserves: (i) the State Administration of Foreign Exchange allowed foreign trading companies to retain their foreign exchange incomes in full in their foreign exchange accounts from September 2003; (ii) the limit on individual foreign exchange purchases for overseas travel was raised; and (iii) a group of 40 banking institutions in Hong Kong, China began accepting yuan deposits on 26 February 2004, marking the first “offshore” convertibility of the PRC’s currency. The banks, including major players HSBC and Bank of East Asia, will change Hong Kong dollars into yuan up to CNY20,000 per day per account for funds on deposit, and up to CNY6,000 per day for cash transactions.

Accepting yuan deposits in Hong Kong, China is part of the Closer Economic Partnership Arrangement (CEPA) signed in 2003. As the deposits offer a medium for households to bet on yuan appreciation, their level will be watched as an indicator of such expectations. More important, the development signifies the Government’s efforts to bestow greater economic benefits on a Hong Kong, China populace uneasy over closer economic integration with the mainland.

The State Administration of Foreign Exchange also granted qualified foreign institutional investor status to several international investment banks, and the Government encouraged more domestic companies to invest abroad, including allowing qualified domestic institutional investors to invest in foreign capital markets.

To accelerate SOE reform, the State-owned Assets Supervision and Administration Commission (SASAC) was established in April 2003. It acts to supervise the 196 central SOEs that had CNY6.9 trillion ($833.3 billion) in state assets at end-2002. SASAC appoints or removes senior SOE executives and has a say in the transfer of state holdings, corporate mergers, closures, or other major changes in SOEs. A major focus of SASAC will be to improve corporate governance such that it can exert its powers through well-functioning boards of directors. SASAC also intends that foreign companies will be able to participate in SOE reform through mergers and acquisitions.

In other policy developments, the Government took steps to promote private sector development, including introducing a mergers and acquisitions mechanism, allowing the private sector to invest in infrastructure and public utilities, and developing a modern property rights system. The Government intends to reform its investment regulatory system in 2004, which would mean that most nongovernment investment projects will no longer require government approval. Domestic investors will be allowed to make their own decisions and only notify the Government about the projects for record purposes.

Improvements are also planned for the PRC’s statistics, which should provide a better basis for macroeconomic management and business decision making by the private sector. Some measures already taken include revising upward the GDP series to better reflect the contribution of services; participating in the General Data Dissemination System of the International Monetary Fund (IMF); producing quarterly national accounts by industry; revising and releasing estimates to reflect data that become available following initial publication; and conducting periodic economic censuses from 2004.

As the effect of these measures will be gradually felt over the long term, weaknesses are still evident in the country’s statistics, including those related to data coverage and methodological issues. This has led some observers to question the accuracy and reliability of the figures. For instance, after examining indicators from the real sectors, they have concluded that the economy actually grew faster in 2003 than the official statistics indicated. The major reason is that, as a legacy of the centrally planned system, the statistical system does not fully capture data on the rapidly growing private sector, particularly services.

Looking to the longer term, a new generation of leaders was confirmed at the NPC held in March 2003. They pledged an overall continuity of policy and put a priority on balanced, sustainable socioeconomic development. In October, the Third Plenum of the 16th Communist Party of China Central Committee approved the Decision on Improving the Socialist Market Economic System, which outlines the main tasks for development and structural reforms and indicates that more emphasis will be placed on income equality, job creation, and private sector development.

Outlook for 2004-2005

Although the Government set an economic growth target of 7.0% for 2004, GDP looks more likely to grow by around 8.3%, and by 8.2% in 2005. In the first quarter of 2004, GDP expanded by 9.7% on the back of 17.7% growth in industrial output. Investment in fixed assets rose by 43.0%, nearly double the rate in 2003. The PRC’s growth in 2004 will account for 15% of the expected expansion in the world economy, even though the PRC has only about 4% of global GDP. The country’s strong performance will stimulate growth in the rest of the region. However, over the medium term, the Government will need to tackle several issues to ensure sustainable socioeconomic development (Box 2.2).

Investment growth will likely fall by nearly half to around 16% annually in 2004-2005 because (i) high housing prices and a tightening of bank lending for real estate will cool property investment; (ii) the Government will limit investment in automobiles, iron and steel, aluminum, and cement; (iii) FDI inflows will grow only moderately; (iv) the rapid increase in bank credit will be brought under control; and (v) the gradual phaseout of the expansionary fiscal policy will slow government-dependent investment.

Economic growth will be unsustainable in the long run if one of its major drivers continues to be such government-dependent investment. Ways must be found to harness the rapidly increasing incomes of urban residents such that consumer expenditures play a greater role in stimulating growth. This will require the development of new financial products and new economic management tools. A beginning has, in fact, been made. Housing markets have been created and financial institutions have introduced new services, such as credit cards, consumer credit, and mortgages. However, other institutions need to be developed (e.g., consumer credit bureaus) and greater support must be given to financial institutions when they repossess assets on which consumers default.

Consumption growth will accelerate slightly to around 9% in 2004-2005, underpinned by several factors. First, rapid urbanization and changing consumption patterns support consumption growth. Second, income expectations and consumer confidence have been improving as urban wages rise and rural incomes increase following a rise in grain prices, rural taxation reforms, and fiscal support for agricultural development. Third, tourism and catering will grow significantly because of the lower base resulting from the impact of SARS in 2003.

Exports in 2004-2005 will continue to rise, but at a slower rate of around 15% a year. The lower export tax rebates will play a part in this. Also, after the revaluation demands of some of the PRC’s major partners in 2003, trade friction, especially with the US and the European Union (EU), could intensify in 2004-2005, which would hamper export growth. On the other hand, some positive factors will contribute to exports. The global economic recovery will stimulate trade volumes worldwide, including trade with the PRC. Some components of the PRC-ASEAN Free Trade Area (AFTA) Agreement and the CEPA between the mainland and Hong Kong, China will become effective, and that will also stimulate trade.

Strong domestic demand, especially for oil, steel, grain, and raw materials, will be the major engine of import growth. Capital imports will continue to grow strongly due to rapid economic development. Import growth rates, while somewhat lower than in 2003, will be in the order of 16-20% and will exceed the increase in exports in 2004-2005, resulting in a lower trade surplus. As this surplus shrinks in the coming years, the current account-to-GDP ratio will narrow to 1.0-1.3% in 2004-2005. In the first quarter of 2004, exports rose by 34.1% and imports increased even faster, by 42.3%, resulting in a trade deficit of $8.4 billion.

The rise in the CPI will likely accelerate moderately to 2.7-3.0% in 2004-2005, on the assumption that (i) the current grain price increase will remain in place at least until the harvest in 2004; (ii) prices of electricity, coal, and construction materials will continue to move higher; and (iii) the price of services will rise somewhat based on the 2003 level of 2.2%. However, overcapacity in many industry subsectors will offset part of the inflationary pressure, as will the more open international trade regime, which will result in international markets responding to some of the shortages in bottleneck sectors.

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