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p. 2 of 7 BACK | NEXT Executive Summary I. Current Development Trends and Issues II. The Government's Development Strategy and Development Issues III. ADB’s Development Experience IV. ADB’s Operational Strategy V. ADB’s Assistance Program VI. Risks, Performance Monitoring and Evaluation

Country Strategy and Program Update 2004-2006: People's Republic of China

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I. Current Development Trends and Issues

A. Introduction

1. When the economic history of the last two decades of the 20th century is written, the People’s Republic of China (PRC) will be recognized as one of the world’s great development success stories. Sustained, rapid economic growth has improved the living standards of the vast majority of the population and reduced poverty.

2. However, the successes of the past two decades do not guarantee that future reforms will be successful. Addressing remaining reforms and development issues will be a major challenge, complicated by the PRC’s enormous population and geographic size, wide divergence in natural resource endowments and human capital, and incomplete legal framework and governance systems needed for a market economy. The overriding development challenge is to complete the transition from a centrally planned to a market economy while maintaining both rapid economic growth and social stability. Reducing inequalities and creating jobs are necessary prerequisites for increasing productivity and winning the war against poverty.

3. This document sets out the PRC Country Strategy and Program (CSP) (2004–2006) of the Asian Development Bank (ADB). The CSP draws on extensive ADB analysis including a poverty profile,¹ an assessment of governance,² a private sector assessment,³ an assessment of the Government’s Western Development Strategy,⁴ an agriculture and natural resources strategy study,⁵ ADB’s first country assistance program evaluation,⁶ and the work of the Asian Development Bank Institute and other development partners. During the CSP preparation, consultations took place with many stakeholders, including the urban and rural poor, central and local government officials, and representatives of civil society, the private sector, and development partners⁷ (Appendix 1).

B. Economic Growth

1. Reforms Contribute to Social and Economic Development

4. Since the 1997 PRC Country Operational Strategy (COS) was prepared, PRC’s macroeconomic performance has been exceptionally good. Five consecutive years of pro-active fiscal and prudent monetary policies, continued integration with the global economy, and market reforms enabled the country to contain the adverse effects of the Asian crisis and the 2001/2002 global slowdown (Appendix 2, Table A2.2). Gross domestic product (GDP) grew by 8.1% per annum and per capita GDP increased by 44% from $671 in 1996 to $964 in 2002. Despite this exceptional economic progress, the PRC is not a wealthy country.

5. The following examples illustrate the ambitious and wide-ranging reforms in the past five years. In financial sector, the central bank was made more autonomous, the China Banking Regulatory Commission (CBRC) was established, and new indirect instruments of monetary policy were introduced. Banks were partially recapitalized and encouraged to lend on the basis of commercially oriented risk assessments. Some nonperforming loans (NPLs) were transferred to four asset management companies. Progress was made in strengthening capital and insurance market regulation. Fiscal reforms included strengthening public finances by distributing tax categories among central, provincial, and local governments, introducing new procedures for budget preparation, and initiating a new treasury management system. The 2002 Government Procurement Law and 1999 Tendering and Bidding Laws provide a framework for improving transparency through competitive bidding and reducing opportunities for corruption. Government was downsized and progress was made separating it from commercial operations. Thousands of state-owned small and medium enterprises (SMEs) were sold, merged, or closed. Social security and unemployment insurance reforms were initiated.

6. External sector trade increased 29-fold from 1978 to 2002.⁸ The PRC is the world’s sixth largest trading nation and became the world’s largest recipient of foreign direct investment (FDI) in 2002. It became the 143rd member of the World Trade Organization (WTO) in 2001⁹ (Box 1). Implementing WTO commitments will further liberalize the trade regime and provide a more transparent and predictable environment for trade and foreign investment. WTO accession will increase the PRC’s participation in the global economy in a rules-based manner and will help deepen a wide range of structural reforms.

7. Because of sustained, rapid, economic growth and targeted government programs, by 2002 PRC was ahead of schedule in achieving many Millennium Development Goals (MDGs). The PRC has already achieved the target of halving poverty from the 1990 level. The proportion of the rural population with incomes below $1 per day fell from 31.3% in 1990 to 11.5% in 2000. Other development goals that have been achieved or nearly achieved include access to primary and secondary education and maternal mortality. Goals where more progress is needed related to providing safe drinking water to the rural population, reducing child mortality, controlling HIV/AIDS, and improving some environmental indicators. Also, more attention should be put on addressing regional disparities since the poor interior provinces are lagging behind in achieving
the MDGs (Appendix 2, Table 2.1).

2. Future Challenges

8. The November 2002 16th National Congress of the Communist Party of China and the 10th National Congress in March 2003 confirmed that the PRC would continue its transition to a market economy. GDP is targeted to quadruple by 2020 and per capita GDP to reach $3,000. While many forecasts indicate that continued rapid growth over next two decades is achievable (Table 1), many challenges will need to be overcome to make these forecasts a reality.¹⁰ Rapid growth and structural changes, while resolving many problems, have created new challenges: increasing income inequalities, rising urban unemployment and rural underemployment, weaknesses in the social security system, slow growth of rural incomes, growing regional disparities in economic and social development, mounting environmental pressures, and potential for macroeconomic instability stemming from incomplete reforms including a weak financial system and inefficient state-owned enterprises (SOEs).

9. Looking ahead, the complexities of reform will increase. Many of the remaining problems cannot be solved by growth alone. Without appropriate policy responses, market forces could result in a further deterioration of income distribution and a widening of the rural-urban and the coastal-interior gaps. Making markets work better requires restructuring the financial sector, promoting private sector development, and fully integrating the PRC into the global economy. The economic growth must also be environmentally sustainable. These development challenges are discussed in more detail below.

C. Promoting Equitable and Inclusive Growth

10. Growth must be equitable and inclusive to benefit most of the population, particularly the poor, to be socially sustainable. Almost all major economic and social indicators have improved during the past two decades except that for income distribution. The PRC’s Gini coefficient¹¹ increased from 0.288 in 1981 to 0.397 in 2000.¹² While some deterioration in income distribution is inevitable as the PRC moves from a centrally planned to a market economy, the speed of the growing inequality is worrying. In the early 1980s, the Gini coefficient was below the world average. However, the PRC’s income inequality is now above the average of most regions except Latin America and Sub-Saharan Africa. There are three dimensions to rising inequality: (i) the growing gap between the wealthy coastal provinces and the poorer interior provinces, (ii) urban incomes have grown faster than rural incomes, and (iii) increasing inequality in both rural and urban populations.

11. Addressing Regional Disparities. The poor interior regions have not benefited as much from economic growth and reforms as has the east coast. Per capita GDP in the interior regions is only about 46% of that along the east coast. The poor interior provinces score lower on the Human Development Index of the United Nations Development Programme (UNDP) and on health and education indicators. There are also wide regional gaps in the development of physical infrastructure including roads, railways, power, telecommunications, and water supply (Figure 1). Land degradation is severe in the western region. A 2002 ADB business climate survey found that about 39% of foreign companies operating in the PRC would not consider expanding their operations into the interior provinces, mainly because of a lack of markets and poor infrastructure. To address these challenges, the Government launched its Western Region Development Strategy in 1999. The current focus is on improving infrastructure, protecting the environment, and encouraging private sector investment (Box 2).

Source: ADB Staff Estimates.

12. Reducing Urban-Rural Inequalities. The PRC's rural-urban income gap is large by international standards. Urban incomes are rarely more than twice rural incomes in other countries but they are more than three times as large in the PRC. If the data are adjusted for direct and indirect subsidies, the disparities are greater. The magnitude of the gap reflects both differences between economic growth in rural and urban areas and restrictions on labor mobility.

13. As about 62% of the population is engaged in the agriculture sector, improving the performance of agriculture is the direct way to reduce urban-rural inequalities. Given the arable land available (currently 0.1 hectare [ha] per capita) and water constraints, the development of agriculture should focus on increasing farm productivity, diversifying crop production, and adopting integrated approaches to farming that are friendly to the environment. Investment in rural infrastructure is needed to provide a framework within which farmers’ incomes can be improved. The rural financial system should be rebuilt as the lack of financial services constrains farmers’ investment options. The Government needs to allocate more resources in education, health, and other social services in rural areas so that rural residents and their children have the skills necessary to participate in the market economy.

14. Rural-urban income inequalities cannot be addressed unless a portion of the 150 million surplus rural laborers find off-farm incomes or move to urban areas. Currently, only 38% of the total population lives in urban areas.¹⁴ Sufficient job opportunities must be created in cities and towns if the PRC is to avoid the urban poverty and slums that are evident in many of the world’s mega cities. Issues that need to be addressed include: (i) creating the necessary jobs in the private sector, (ii) addressing urban environment problems (air and water pollution, solid waste), (iii) strengthening local governments and municipal finances, (iv) providing skills training, (v) providing the necessary housing and infrastructure to cope with rapidly increasing urban populations, and (vi) developing an urban social safety net.

15. Fighting Poverty. The PRC’s success in reducing poverty reflects sustained rapid economic growth, the mainstreaming of poverty reduction efforts, and significant budget allocations for poverty reduction initiatives in the past decade.¹⁵ In May 2001, the PRC adopted a 10-year poverty strategy identifying key counties for poverty reduction and development to assist 30 million rural people with annual incomes under the Government’s official poverty line of CNY625 per capita. Another 60 million rural people with per capita annual incomes below CNY865 are vulnerable to falling into absolute poverty. Using the most common measures for international comparisons of poverty,¹⁶ $1 per day income (the MDG measurement of poverty) and $1 day expenditure, 97 million people (10.5% of the rural population) and 235 million (25.5% of the rural population), respectively, would be classified as poor in 1999 (Figure 2). The speed of poverty reduction has declined partly due to slow growth in rural income and partly to declining prices of agricultural commodities.

16. The Government’s new poverty reduction strategies and targets are contained in the Tenth Five-Year Plan (2001–2005) and the Outline for Poverty Alleviation and Development of China's Rural Areas (2001–2010). The PRC’s approach is area- and group-focused, with an emphasis on providing social and economic infrastructure and creating opportunities for the poor to increase their incomes. To improve the targeting of poverty reduction programs, participatory processes are being used to identify poor villages.¹⁷ The Government now encourages broad social participation, including a positive role of NGOs. With ADB assistance, a legal/regulatory framework for private charities and foundations is being developed which, in the longer term, will help mobilize private sector resources for the war on poverty.

Figure 2: Trends in Poverty in Rural Areas

Source: World Bank. 2003. Country Assistance Strategy for the PRC. January.

17. Infrastructure and Poverty Reduction. Several studies and feedback from consultation with the poor have found that adequate infrastructure is a prerequisite for reducing poverty. Benefits for poor rural areas include lower transport costs, lower cost of inputs, expanded agricultural support services and therefore improved farming practices, greater access to employment opportunities in urban areas, and better access to health, education, or social services.¹⁸ Preliminary findings of an ongoing TA have also confirmed that targeting interventions to local conditions and involving the participation of local communities increase the likelihood of success of road projects.¹⁹ A detailed case study in Shaanxi also found that improved roads, railways, and electricity were correlated with poverty reduction.²⁰ A prominent feature of the PRC’s poverty reduction strategy since the mid-1980s has been to accelerate investment in rural infrastructure. Investment in rural roads, for example, grew by 23% annually in the 1990s—more than double the annual growth in the 1980s. ²¹

18. In the late 1990s, SOEs began shedding redundant labor and no longer provided social security for their employees. Urban unemployment and poverty began to emerge. Urban poverty is associated mainly with a lack of employment and poor health. Urban migrants are more prone to poverty than permanent city residents.²² The most effective ways to address these problems are to create more jobs for the unemployed and to establish a sound social security system.

19. Social Dimensions of Poverty. Rapid economic growth must be accompanied by social development. The success in reducing income-poverty has not fully captured all of the dimensions of human poverty, which reflects deprivation in other dimensions of the quality of life. Education, health, social security, and gender inequalities have widened among some segments of society. These problems have been aggravated by the transition away from a centrally planned system, which has placed additional stress on employment and the social safety net.

20. Compared to other developing economies, the PRC has shown impressive progress toward eliminating illiteracy and achieving the goal of universalizing 9-year compulsory education. It adopted a target of universal secondary education in 2002. The Ninth Five-Year Plan period (1996–2000) witnessed a sharp rise in gross enrollment rates in senior secondary and tertiary education. Despite this progress, there are disparities in education access, quality, and outcomes across regional, urban-rural, and gender dimensions. Net enrollment rates in one third of the provinces remain considerably below the national average. Overemphasis on the "user pays" principle in compulsory education threatens education access for children in poor households.

21. Following declines during the 1980s, public access to health services improved in the 1990s. However, access to affordable and high-quality medical care and key preventive services remains challenging. The recent outbreak of severe acute respiratory syndrome (SARS) exposed long-standing problems in the PRC's public health sector, including (i) a large gap in the quality of health services between rural and urban areas; (ii) inadequate disease prevention, control, and treatment systems; (iii) weak health insurance systems and exclusion of rural residents and migrant workers; and (iv) inequitable and inefficient distribution of public health resources.

22. Equality for women is official government policy. There is a commendable policy/legal framework in place to promote and protect the rights of women. A comparison of gender indicators shows that women are more likely to participate in economic activities in the PRC than in many other countries. While the transition to a market economy has had clear benefits for women, some market-oriented reforms have had adverse impacts on gender equality. Women workers are likely to be the first to be laid off during SOE restructuring. Also, women are more vulnerable than men to weakness in the health care system. Analysis of male/female wage differentials found that there is an unexplained wage gap, after accounting for differences in education and experience.²³ Some obstacles remain that have prevented the full realization of equal rights for women with respect to their participation in public affairs, employment, education, and family situations.

D. Making Markets Work Better

23. Despite two decades of reforms, the state and market remain intertwined. The Government should leave more room for markets to operate and shift away from direct involvement in production to promoting the rule of law, macroeconomic management, creating an enabling framework for the private sector, and the provision of public goods and support for vulnerable groups.

24. Building an Enabling Environment for the Private Sector. Between 2003 and 2007, the PRC needs to create about 15–20 million nonfarm jobs each year to absorb new labor market entrants, re-employ redundant SOE workers, and allow some of the 150 million surplus rural laborers to exit from the agriculture sector. The private sector will create most of these job opportunities. The potential for development is particularly large in the services sector, which accounts for only 34% of the PRC economy compared to about 50% in many developing countries.

25. Although the emergence of the private sector is one of the most significant features of the reform period, entrepreneurs continue to face many constraints.²⁴ ADB surveys of foreign and domestic private firms identified five major impediments: (i) weaknesses in the policy environment including lack of transparency, restrictions of market entry, and problems in the legal environment; (ii) lack of financing options; (iii) infrastructure constraints; (iv) human resources constraints; and (v) lack of access to reliable information and professional services.

26. Policy biases against market entry take many forms, including restrictions on private sector participation in banking, insurance, and investment banking, as well as listing requirements that favor SOEs. Local protectionism at the sub national level makes it difficult for companies to enter new markets and increases opportunities for corruption. The PRC needs to develop an integrated domestic market with fewer restrictions on factor mobility from both domestic and international sources. The private sector also needs better physical infrastructure to operate efficiently and increase productivity (Figure 3).

Figure 3: Infrastructure Constraints Faced by the Domestic Private Sector

Source: ADB-financed Survey in 2001.

27. Maintaining Macroeconomic Stability. Macroeconomic stability is essential for markets to work efficiently and to reduce risk and uncertainty faced by businesses and investors. Weaknesses in the financial sector, including large volumes of NPLs, are a major financial risk. The increasing competition associated with the phased opening of the financial sector after WTO entry will expose the vulnerabilities in the financial system. Problems in the financial sector also limit the impact of monetary policy. To address these problems, a sevenpoint phased financial reform program is suggested: (i) resolving the NPL problem; (ii) diversifying ownership of financial institutions to improve corporate governance; (iii) providing greater autonomy for the central bank and financial regulators; (iv) deepening the equity and bond markets, (v) sequencing interest rate liberalization starting from lending to deposit rates and from long-term to short-term rates; (vi) improving governance and marketbased risk management; (vi)i phasing in a cautious capital-account opening after strengthening domestic institutions; and (viii) at an appropriate time adopting a more flexible exchange rate regime.²⁵

28. The financial performance of many SOEs has been weak due to poor management, soft budget constraints, overemployment, and social welfare responsibilities. Restructuring SOEs resulted in thousands of smaller SOEs being sold, closed, or merged and about 26 million SOE workers being laid off since middle of the 1990s. The State-owned Assets Supervision and Administration Commission will help push SOE reforms forward. About 1,000 SOEs have been listed on the Shanghai and Shenzhen stock exchanges, but few private companies are listed. The debt side of the capital market is underdeveloped. Other capital market constraints include a lack of authority of regulators; weaknesses in corporate governance and legislation for accounting, bankruptcy, and the securities market; impediments to effective enforcement of laws and regulations; a lack of rating agencies; and a lack of institutional investors.

29. Fiscal reform is an essential part of the redefinition of government.²⁶ Official data suggest a reasonably comfortable fiscal situation with an annual deficit of about 3% of GDP in recent years. However, the official figures do not fully reflect fiscal risks. Large contingent fiscal liabilities exist outside the formal budget framework, including NPLs of state-owned banks and unfunded liabilities of the social security system. Key fiscal management issues include: (i) making the budget comprehensive to include extrabudgetary funds²⁷; (ii) accounting for contingent liabilities; (iii) reassigning expenditure responsibilities to be consistent with revenue sources at the provincial and subprovincial levels; (iv) rationalizing intergovernment fiscal transfers to put more emphasis on health, education, poverty reduction, and the environment; and (v) improving coordination among agencies involved in formulating fiscal and monetary policies.

30. Developing a Good Governance System. The transition from a centrally planned to a market economy is a fundamental change in the system of governance. The Government is committed to further improving transparency, accountability, predictability, and participation.²⁸ Thousands of new rules and regulations have been promulgated and new regulatory agencies have been established. However, there are problems of clarity, consistency, lack of transparency, and noncompliance. Redress mechanisms exist but their scope is limited and effective access is uneven. Strengthening the rule of law requires strengthening human resources, better enforcement, and consistency between local and national legislation, and between administrative regulations and national laws.

31. Corruption is the enemy of legitimate business, disrupts the efficient functioning of markets, undermines public support for governments, and produces significant economic losses. Estimates of economic losses from corruption range from 13% to 17% of GDP, half of which involves tax fraud.²⁹ The Government has launched an attack on corruption and adopting many policies aimed at improving transparency and containing corruption. While the Government’s resolve to tackle corruption is not in doubt, additional steps need to be taken, such as including sanctions against bribery in legislation, promoting corporate responsibility, strengthening accounting and auditing, and mobilizing public involvement against corruption.

32. Access to accurate information is needed for markets to function efficiently, and for entrepreneurs to make informed investment and marketing decisions. Despite the progress that has been achieved in reforming the statistical system, there is still room for improvement. Since 2002, the PRC has been participating in the General Data Dissemination System of the International Monetary Fund (IMF) that sets standards to guide member countries in publicly disseminating economic and financial data and to improve data accuracy. Efforts to strengthen the statistical system and to improve the accuracy of official statistics need to be continued.

33. Sustainable social and economic development requires the Government to partner with civil society. In the 1990s, the Government took a number of steps to increase public participation (e.g., requiring public hearings for price/utility tariff increases, requiring disclosure and consultation for resettlement plans, and releasing increasing amounts of information to the public). There was an increase in the number of NGOs operating in such areas as the environment, poverty reduction, education, gender, health, rural development, and social services. However, NGOs’ capacity to participate in the development process should be strengthened and an NGO law adopted to improve the transparency of NGO regulation.

34. Integrating the PRC into Global Markets. The PRC is becoming increasingly integrated into the world economy. This integration provides a market for the PRC’s products, as well as a source of capital, technology, expertise, resources, and products that can be more competitively produced in other countries. More liberalized trade and capital account management, including encouraging selected enterprises to invest abroad, and following WTOmandated rules would improve the efficiency of resource utilization.

35. Regional cooperation can help the PRC and other Asian countries to capture the full benefits of the PRC’s integration into the world economy and its global emergence as a major trading partner and manufacturer. Regional cooperation will also help address poverty since the poor are disproportionately represented in border areas. There are substantial economic benefits for East and Southeast Asian neighbors to increase their regional cooperation with the PRC. ³⁰The Asian financial crisis and the SARS epidemic reinforce the importance of regional cooperation for countries to prosper together. The Association of Southeast Asian Nations (ASEAN) + PRC free trade agreement has the potential to contribute significantly to the PRC’s economic cooperation in the region. The PRC is actively participating in many regional cooperation arrangements in Asia including Asia-Pacific Economic Cooperation (APEC) forum, ASEAN+3, Manila Framework Group, Boao Forum and many subregional cooperation initiatives (Box 3).

E. Making Growth Environmentally Sustainable

36. The PRC faces many environmental challenges—air pollution, water pollution, solid waste pollution, and land degradation.³¹ Although the rate of environmental degradation slowed in the 1990s, it was not reversed and some problems such as land degradation and desertification worsened. Continued economic growth, which will exert increasing pressures on the environment and natural resources, must be made environmentally sustainable. As in many other countries, poverty reduction, environmental protection, and economic development are inextricably linked. The poor are vulnerable to environmental degradation³² and find it difficult to get adequate medical attention for the respiratory illnesses associated with breathing polluted air and the digestive track ailments associated with polluted water. Improving the environment is a pro-poor initiative, although some environmental investments are more pro-poor than others.

37. Land degradation, which is increasing,³³ affects nearly 40% of the PRC’s land area. Land degradation is associated with rural poverty. Almost 90% of the rural poor eke out a living on degraded land. Economic losses due to land degradation are estimated at CNY64 billion annually ($7.3 billion) and indirect economic losses are over four times as much as direct economic losses.³⁴ Most land degradation is found in the western region, which contains about 31% of the forested land and over 90% of the country’s grassland. The Government recognizes that it needs to make a concerted effort to address land degradation. ADB helped develop a $1.5 billion 10-year PRC-Global Environment Facility (GEF) Partnership to address policy, institutional, technical, and financing issues related to land degradation (Box 4).³⁵

38. There are serious water shortages in northern PRC where per capita water availability ranges from 360 to 750 m3, much lower than the internationally accepted water scarcity of 1,000 m3/person/year. The major river basins do not meet the Class III national water quality standards and the major lakes are polluted. Wastewater reuse and treatment rates are low. Inadequate surface water leads to overextraction of groundwater and falling water tables.

39. Although emission of major air pollutants peaked in 1995,³⁶ air pollution remains a problem. Over half of the major cities fail to meet the Grade II national air quality standards. About one third of the territory is affected by acid rain caused by SO2 emissions. The situation could deteriorate given the PRC’s continuing dependence on coal as the major source of energy, unless clean coal technologies are used.

40. During the past 15 years, the PRC has put more resources in environmental protection and has developed better legal and institutional systems for environmental management. This trend will continue with environmental investments reaching 1.3% of GDP during 2001–2005.³⁷ A number of key environmental laws have been enacted, including those on environmental impact assessment; air, water, and solid waste pollution; desertification; and grasslands.³⁸ Apart from laws, the Government has issued a series of regulations on the use of natural resources and has instituted a system of monitoring, recording, and reporting the discharge of pollutants. Despite the progress that has been made, more needs to be done to strengthen the environmental policy/ legal/ regulatory system, improve enforcement, and make greater use of market-based instruments. Enhanced public awareness and consumer participation in environmental management can be powerful tools to promote environmentally friendly behavior and to develop markets that internalize environmental considerations.

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