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p. 20 of 77 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : East Asia

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People's Republic of China

Despite macroeconomic tightening measures that cooled overheated sectors in 2004, economic growth was stronger than forecast. A more balanced development strategy and continued macroeconomic controls are expected to slow growth by about 1 percentage point in 2005. There are challenges to achieving this soft landing from both sides--investment could surge again and spark overheating, or growth could slow more abruptly than planned if potential problem areas are not addressed.

Macroeconomic assessment of 2004

Gross domestic product (GDP) growth in the People's Republic of China (PRC) accelerated from 9.3% in 2003 to 9.5% in 2004, the highest level since 1997, even though the Government took several steps to damp sectors that it considered overheated. On the supply side, the growth rate of industry fell to 11.1% in 2004 from 12.7% in 2003. Supply shortages were still experienced in coal, electricity, petroleum, and transport. For example, 26 out of 31 provinces suffered power outages. The growth rate of agriculture more than doubled to 6.3%, supported by subsidies to grain growers and a cut in agricultural taxes. Grain production recovered from a 4-year decline to increase by 9% to 469.5 million tons. The services sector grew by 8.3%, a percentage point faster than in 2003, when services were hurt for a while by the outbreak of SARS.

In the breakdown of demand, fixed asset investment grew by 25.8% in 2004, which was marginally slower than 2003's rate of 27.7% because of the macroeconomic controls. Investment grew faster in manufacturing than in agriculture, services, and small and medium enterprises (SMEs). When the growth rate of fixed asset investment shot up to 43% in the first quarter of 2004, the Government implemented a combination of monetary, fiscal, and administrative measures to cool it, especially in the overheated steel, cement, aluminum, automobile, and real estate subsectors. As a result, growth of investment in manufacturing eased for the full year to 38.3% from 46.3% in 2003. Investment in agriculture rose by 20.3%, a turnaround from 2003 when investment fell.

Total consumption increased faster in 2004 than in 2003, driven by improving rural and urban incomes. Due to rising grain prices and subsidies to farmers, real rural incomes grew by 6.8% in 2004, the highest rate since 1997. Urban incomes increased by 7.7%, helping push up retail sales by a fast 10.2% in 2004, though retail sales growth in rural areas still lagged that in urban areas.

In spite of the stronger growth in total consumption, private consumption has declined as a share of GDP in recent years (Figure 2.1). In the past 3 years, private consumption has expanded at a slower rate than government consumption and fixed asset investment. Also, growth of consumption in rural areas has been slower than in urban areas. Private consumption as a share of GDP in the PRC is below the 60% average seen in other countries with a per capita GDP of around $1,000. An increase in the share of private consumption to GDP would help smoothen fluctuations in economic growth caused by swings in investment and would reduce the imbalance between supply and demand in some industries.

External trade maintained its robust uptrend on strong domestic and external demand, with the result that the PRC overtook Japan to become the world's third-largest merchandise trader, after the United States (US) and Germany. Merchandise exports rose by 35.4%, with production at foreign-funded enterprises estimated at about 58% of exports. Merchandise imports grew by 36.0%. Most of the increase came from energy products and raw materials. Factors behind the import surge were booming investment-led domestic demand, rising international oil prices, and the reduction in import tariffs and removal of nontariff barriers following the PRC's accession to the World Trade Organization (WTO) in 2001. The PRC played a more important role in interregional trade; bilateral trade between the PRC and countries in the Association of Southeast Asian Nations (ASEAN), for instance, grew by 36% to over $100 billion in 2004. Overall, the trade surplus on goods increased from $45 billion in 2003 to about $58 billion in 2004, and the current account maintained a surplus of about 3.3% of GDP.

The PRC continued to be a favored destination for foreign investment. Actual foreign direct investment (FDI) rose by 13.3% to $60.6 billion in 2004. Investors come partly for unskilled labor, which is about 4% of the cost in the US and one third of the cost in, for example, Malaysia. Moreover, the country's infrastructure continues to strengthen, and its business environment has improved significantly since it joined WTO. Multinational enterprises have accelerated their relocation of labor-intensive and export-oriented industries to the PRC. WTO membership has prompted an opening of services to more foreign participation, so that FDI in services during 2002-2004 on average grew slightly faster than in agriculture and manufacturing. FDI in steel and cement slowed significantly in the second half of 2004 as those industries faced government curbs. A combination of strong FDI inflows, the trade surplus, and fund inflows pushed higher by speculation that the yuan would appreciate led to a 51% surge in foreign exchange reserves, to $610 billion by year-end. Total external debt amounted to $229 billion, equivalent to 14% of GDP. The yuan was kept steady at CNY8.28/$1.

Fiscal revenues expanded considerably in 2004, rising by 21.4%, driven by high levels of economic and trade activity and strengthened tax collection. Fiscal expenditures rose by 15.1%. Priorities in public spending shifted from infrastructure to agriculture, social security, and health care as part of government efforts to better balance economic growth and social development. The fiscal deficit narrowed to an estimated 1.5% of GDP from 2.5% in 2003. However, if off-budget obligations, including the implicit pension debt and costs related to nonperforming loans (NPLs) in the banking sector were considered, the fiscal deficit would be much higher.

The growth of broad money (M2) moderated to 14.6% at end-2004 from 19.6% in 2003. Growth of total bank deposits slowed in the third quarter due to negative real deposit rates. Deposit growth picked up, though, after the People's Bank of China (PBC), the central bank, raised interest rates in October. The macroeconomic controls were expected to curb medium- and long-term lending to state-owned enterprises (SOEs) and to major investment projects. Instead, much of the impact fell on SMEs, when banks pulled back on short-term lending that SMEs use mainly as working capital, which affected their operations.

Inflation measured by the consumer price index (CPI) picked up to 3.9% in 2004 from 1.2% in 2003. During June-September, inflation exceeded 5%, prompting the October interest rate rise. Food, which accounts for around one third of the CPI basket, was the main cause of higher inflation. A better than expected grain harvest helped bring down inflation to 2-3% late in the year. However, ex-factory industrial prices, regarded as comparable to a producer price index, rose by 6.1% in 2004, the fastest rate in 8 years. Rising prices for oil and raw materials were the main reason. There were also signs that labor shortages in coastal manufacturing regions, such as the Pearl River delta, were causing factory managers to increase wages and benefits to attract workers, thereby stoking inflationary pressure.

Unemployment edged down to 4.2% of the urban workforce from 4.3% in 2003. However, this does not include laid-off SOE workers or those who migrate to cities looking for work. The number of urban employees went up by 9.8 million, 800,000 more than the Government's target. In addition to the labor shortages in some manufacturing regions, many college graduates are finding it difficult to get work in their professions. The number of rural poor with per capita incomes below CNY668 (the official poverty line) decreased from 29 million to 26 million as rural incomes increased and more budget resources were applied to poverty reduction.

Macroeconomic policy developments

The long-term goal of the Government is to raise per capita GDP to $3,000 by 2020, from $840 in 2000, and to quadruple GDP in this period, which requires growth of at least 7.2% annually. Although continued rapid expansion looks achievable, challenges need to be overcome. Rapid growth and structural changes, while resolving many problems, have created new ones: increasing income inequalities, weaknesses in the social security system, rising regional disparities, and environmental pressures. At the National People's Congress (NPC) in March 2004 the Government affirmed that sustaining strong economic growth would remain a priority, but it also started to address some of these problems to achieve more balanced and equitable development.

The latest NPC, in March 2005, set out the following targets for 2005: GDP growth of around 8%; 9 million new jobs for urban residents and keeping the registered urban unemployment rate under 4.6%; inflation held to 4% or less; and a sound balance of payments.

Fiscal policy will be tightened further, now that pump priming is not needed to maintain economic growth. The issuance of long-term government bonds was limited to CNY110 billion in 2004, a reduction from the budgeted amount of CNY130 billion, partly so that there would be less available for capital construction. Issuance will be reduced further this year, to CNY80 billion. The budget deficit target for 2005 is CNY300 billion, narrower than CNY319.8 billion in 2004.

Expenditure priorities were shifted in 2004 from infrastructure construction to agriculture, education, health care, and social security. Poorer central and western regions received greater attention, as did rundown industrial locations, and areas where ethnic minority groups live. The Government speeded up a trial of a change in the value-added tax (VAT) for some enterprises, to allow those in Jilin, Liaoning, and Heilongjiang provinces to claim tax deductions when buying new machinery. The trial will be expanded to more provinces. To assist farmers, the Government decided in March 2004 to abolish agricultural tax within 5 years. By end-January 2005, 23 out of 31 provinces and municipalities had done this. The aim now is to end the tax throughout the country in 2006.

Administrative measures taken in 2004 to rein in investment in sectors considered to be overheated included an order to curb credit expansion and investment in the overheated subsectors; restrictions on the transfer of arable land to nonagricultural use; and addition of industries to the restricted-investment list. The Government is expected to adopt more market-oriented pricing measures to control and direct investment from this year.

Since the second half of 2003, PBC has taken steps to tighten monetary policy, including: curbing real estate lending by raising the proportion of capital that developers must contribute to a project to 30%, and raising the cost of loans for investment in second houses; raising commercial banks' reserve requirement ratio from 6% to 7.5%; removing the ceiling on most commercial lending rates; and increasing the benchmark interest rate on 1-year loans from 5.31% to 5.58% and the rate on 1-year deposits from 1.98% to 2.25%. As the first rate rise since 1995, this October 2004 move signaled that the monetary authorities will use interest rates to cool the economy when necessary. During its annual meeting in January 2005, PBC announced that it would maintain its tighter stance, pointing to continuing inflationary pressures and a risk that growth in investment might surge again. PBC set its 2005 M2 growth target at 15%, slightly higher than the actual increase of 14.6% in 2004, and committed to using monetary levers such as interest rates to achieve the macroeconomic goals.

Speculation that the yuan may be allowed to appreciate was triggered in 2004 by the weakening US dollar, surging exports to the US and euro zone, and rising foreign exchange reserves. The International Monetary Fund called for greater exchange rate flexibility through a widening of the narrow band in which the yuan can move, and the G7 group of industrial countries said that it also favors more flexible exchange rates for Asian nations. While the Government stated its commitment to a long-term goal for a more flexible system, the current official stance is for a gradual transition to a more flexible exchange rate regime that does not put at risk macroeconomic stability and the financial system.

The PRC's stock markets performed weakly in 2004, even as stock prices rebounded in most other Asian markets. An overhang of nontradable state-owned shares and a relatively opaque stock-pricing system hurt the domestic stock market. In an effort to revive new share issues, the China Securities Regulatory Commission introduced a new pricing system for initial public offerings from January 2005. It also will promote better corporate governance and information disclosure by listed companies.

Progress was made in SOE reform in 2004. The State-owned Assets Supervision and Administration Commission continued its efforts to strengthen its supervision over 178 major central SOE groups and improve the management of SOEs nationwide. The commission tightened policies on management buyouts and stated that privatizations should be carried out through open and competitive bidding. Efforts to repair state-owned commercial banks continued when the Government injected $45 billion of its foreign exchange reserves into the Bank of China and the China Construction Bank to strengthen their balance sheets and prepare them for stock market listings.

For the private sector, the Government issued guidelines to improve the legal, policy, and market environment. More industries and sectors were opened to nonstate capital, and financing channels were widened for private enterprises.

Three years after WTO accession, the PRC has reached its goal in terms of cutting trade tariffs, with the general tariff level lowered from 15.6% in 2001 to 10.1% in early 2005. Nontariff barriers have also come down, with the number of quota-administered commodities reduced to 52 on the export side (from more than 100 in 2001) and eight on the import side (from 26). In services such as banking, insurance, and securities, the PRC has met its WTO commitments on time (Box 2.1). Over the past 3 years, the country has revised more than 2,300 national laws and regulations that ran counter to WTO rules. A series of laws and related regulations on the protection of intellectual property rights, including legislation on trademarks, patents, copyright, and protection of computer software, has been passed or revised. However, enforcement remains difficult.

Outlook for 2005-2007 and medium-term trends

The economy is likely to achieve its targeted soft landing, with GDP expected to grow by 8.5% in 2005, 8.7% in 2006, and 8.9% in 2007. Manufacturing and construction, hampered by bottlenecks in energy and transportation, land constraints, and reduced levels of investment, will slow. The growth rate of industry overall is forecast at 9.3-10.1% over the 3 years. Agriculture will expand by 4.1-4.6%, reflecting government efforts to support rural production and farmers' incomes. The opening of more services to external competition should ensure continued growth of around 8% for this sector. More emphasis on developing agriculture and services will benefit job creation and poverty reduction.

Investment in fixed assets is expected to grow by about 18% in 2005, slowing from 2004's rapid 25.8% expansion, and by about 13% in 2006-2007. Overheated subsectors face the biggest cutbacks. However, curbing investment growth will be difficult in some industries, such as construction, where substantial work is in progress. Also, private sector investment is likely to grow rapidly and foreign investment looks set to remain strong. Rising labor costs and labor shortages in coastal areas may persuade some investors to move factories to inland provinces.

Consumption will maintain double-digit growth rates, but these will be significantly lower than the rates for investment. Surging investment in the past 2 years has raised the proportion of capital formation to GDP to about 45%, the highest since 1994, while the proportion of total consumption in 2004 fell to 55%, the lowest since 1978. Over the past 25 years, periods of extraordinarily high investment, without support from high levels of consumption growth, have resulted in excess production capacity and have been followed by sharp declines in economic growth. This time, the authorities are reducing investment growth and taking steps that should stimulate private consumption--raising rural incomes is an example.

The growth rate of exports is forecast to fall to 12-20% in 2005-2007 from over 30% in 2004, largely for the following reasons: growth in industrial nations will slow; major trade partners may well take more protectionist and antidumping action against PRC exporters; and rising labor costs and high oil prices will raise costs for exporters. Import growth is expected to outpace that of exports as more sectors are opened to foreign competitors and as domestic demand remains strong. Consequently, the trade surplus will decrease over the forecast period. The current account will maintain a small surplus of 0.4-1.2% of GDP in 2005-2006, but move to a 0.2% deficit in 2007.

Inflation is forecast to step down to 3.6% in 2005, 3.3% in 2006, and 3.2% in 2007. Prices of electricity and coal will rise. Production costs have been pushed up by higher prices of energy and raw materials, and some of this will flow through to prices of final products. Labor costs, too, will edge up as the economy maintains rapid growth. These upward price pressures will be eased in part by overcapacity in many industrial subsectors and by smaller price rises for grains.

Risks to the outlook include a possible return to extraordinarily high growth rates of investment. A relaxation of the macroeconomic controls could spark a rebound in investment growth and overheating in some subsectors. Capital buildups add to the risk of overheating. Commercial banks, with their deposits growing, are under pressure to expand lending, and people with substantial private wealth are seeking investment outlets.

Conversely, the soft-landing scenario could be disrupted by potential problems that cause growth to slow more sharply than planned. In rural regions, the rapid increase in farmers' incomes may be unsustainable if prices of agricultural products turn down, which would reduce consumption spending. Among SMEs, the contraction in their working capital loans during the macroeconomic tightening period seems to have curtailed their development. Finally, the financial sector may lose resources as it is opened to more competition from foreign banks to meet the country's commitments under WTO.

The expansion of SMEs is important because they create much of the employment and can assist in reducing income inequalities. However, they are one of the most vulnerable economic groups in the PRC, with limited access to financing. Strengthening the SME credit guarantee system would help by reducing risks to lenders, as would developing private banks, which are more inclined to lend to SMEs. PBC should consider allowing banks to increase short-term lending to SMEs for working capital purposes. The Government could consider encouraging private investment companies to mobilize equity finance for SMEs, perhaps with some initial government funding. On the subject of competition for domestic banks, the critical time will be 2006, when all geographic and customer restrictions on foreign banks will be removed. If the state-owned commercial banks cannot improve their service, increase their capital, and reduce their NPLs, there is a risk that much of their deposit base could be moved to their competitors, putting further strain on them.

Energy bottlenecks are being addressed, but are unlikely to be eliminated soon, particularly as car ownership is rising rapidly. However, there is considerable potential to improve energy efficiency. The PRC uses 0.78 tons of oil equivalent to produce $1,000 of GDP, about twice the average for Organisation for Economic Co-operation and Development member countries. Steps taken so far in power reform include dismantling the State Power Corporation, separating policy and regulatory functions from production, and unbundling generation from transmission and distribution. Other measures that policy makers could consider are: encouraging the use of cleaner fuels and energy-saving technologies; imposing a consumption tax on fuel; removing constraints to private sector participation in the power industry; improving access to electricity supplies and the pricing structure for the poor; and strengthening interregional power transmission capacity to improve power system efficiency.

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