IMF Concludes 2004 Article IV Consultation with the
People's Republic of China

On July 28, 2004, the International Monetary Fund's (IMF) Executive Board concluded the Article IV consultation with China.¹

Background

China has continued its rapid economic growth and integration into the global economy. Real GDP grew by 9.1 percent in 2003, underpinned by strong fixed investment and exports, which registered growth rates of 20 percent and 29 percent in real terms, respectively. Consumption growth declined somewhat from 2002, reflecting the impact of the SARS epidemic in the second quarter. In the first half of 2004, GDP grew by 9.7 percent (year-on-year), with indications that economic activity was beginning to slow down in response to measures taken to reduce investment growth. External trade continued to expand rapidly, and consumption growth has also picked up momentum. Inflationary pressures have emerged. After rising by 1.2 percent in 2003, consumer prices increased by 4.4 percent in the first half of 2004, largely due to food price increases. Despite the strong GDP growth, unemployment continues to rise; registered unemployment in the urban areas increased to 4.3 percent in 2003, up 0.3 percentage points from 2002. The level of surplus labor in the agricultural sector is estimated to be large, and rural-urban income disparities have continued to widen.

China's overall external position has strengthened further. The current account surplus rose from 2¾ percent in 2002 to 3¼ percent in 2003, mainly as a result of an increase in private transfers and a decline in the deficit on investment income. The capital and financial account posted another large surplus in 2003, as net foreign direct investment (FDI) inflows amounted to $47 billion and net porfolio investment turned positive. Official reserves increased by $117 billion in 2003 (excluding the $45 billion used for bank recapitalization). In the first half of 2004, the trade account registered a deficit of $7 billion, as imports surged by 43 percent, while exports grew by 36 percent. Nevertheless, foreign exchange reserves rose by $67 billion, reaching 471 billion by end-June (equivalent to around 9½ months of imports), as current transfers and capital inflows continued at a rapid pace.

Real GDP growth is projected to average around 9 percent in 2004. As the effects of recent macroeconomic tightening continue into 2005, economic activity should maintain a more sustainable pace, with real GDP growing at about 7½ percent. The CPI is expected to rise by about 3-4 percent over the next year and a half, with inflationary pressures dissipating towards the end of 2004 as food price increases ease and demand pressures diminish. The external current account surplus would decline by about ¾ percent of GDP in 2004, as import growth continues to outpace export growth, with the latter slowing down from the very high rates recorded over the last year. Sizable net capital inflows, including FDI, are likely to continue in 2005, and the external position is expected to remain strong.

Significant progress has been made in structural reforms. In the banking sector, restructuring plans are being put in place for the two state banks that were recently recapitalized, stricter prudential regulations have been adopted, improved lending practices have contributed to a decline in the reported ratio of nonperforming loans to total loans, and asset management companies have made progress in recovering distressed assets. In the state-owned enterprise (SOE) sector, the government has taken a number of new initiatives to improve management of the SOEs, including new laws and regulations related to the supervision, restructuring, and sale of state assets. Shareholding systems are being introduced into large SOEs, while more than 28 million workers have been laid off since 1998 as a result of closures of loss-making SOEs and reduction of redundant employees. To mitigate the social impact of reforms, the authorities have taken steps to strengthen the social safety net, including by increasing pension coverage and payments, widening the coverage of unemployment insurance and urban minimum living allowance assurance schemes, and providing assistance to laid-off workers for finding new employment.

Executive Board Assessment

Executive Directors commended the Chinese authorities for their skillful economic management, which has reduced the risk of overheating and further strengthened the Chinese economy. Efforts to rein in credit and slow investment appear to have started to bear fruit, as evidenced by the recent signs of moderating economic expansion. The key challenge going forward will be how to harness the strong potential for sustained economic expansion in China, while maintaining macroeconomic balance and ensuring sound, broadly-based economic development.

A crucial short-term concern is that despite the recent indications of moderation in the fast pace of investment and economic growth, a soft landing of the economy is not yet assured. Addressing this challenge, while at the same time maintaining the stability of the financial system and further integrating China into the global economy, will require the authorities to pursue prudent macroeconomic policies and accelerated structural reforms in key areas, including the banking sector, state enterprises, and labor markets. The scope and timing of actions by the Chinese authorities on all these fronts will have a decisive influence on China's medium-term prospects.

Directors noted that in view of the state of development of China's economy and the observed overinvestment in certain sectors, the authorities have relied on macroeconomic policies, legal measures, and some administrative means to deal with the current macroeconomic and sectoral pressures. Most Directors considered that, as the effects of the various measures already taken may not yet have been fully realized, additional time may be warranted before deciding whether further monetary tightening is needed. A number of Directors, however, felt that the administrative measures taken so far may not be sufficiently effective in reducing the risk of overheating and credit growth, and were of the view that a further tightening of the monetary policy stance would facilitate a soft landing. Going forward, Directors agreed on the need for continued vigilance, and cautioned against a premature relaxation of policy, noting in particular that significant excess liquidity remains in the banking system. They encouraged the authorities to further develop indirect monetary policy tools and improve the effectiveness of market-based instruments, which will allow a gradual phasing out of administrative measures that are not prudential in nature.

Directors carefully considered China's exchange rate regime in the context of the Fund's obligation to exercise firm surveillance over members' exchange rate policies. They reiterated that greater exchange rate flexibility remains in China's best interest, as it will improve the effectiveness of monetary policy in containing domestic demand and price pressures, and enhance the economy's ability to adjust to shocks. Several Directors stressed that greater exchange rate flexibility should also be helpful in contributing to an orderly resolution of global imbalances. Directors accordingly welcomed the Chinese authorities' aim to introduce, in a phased manner, greater exchange rate flexibility, with several Directors recognizing that the exact timing of such a change should be left to the authorities to decide. Directors suggested that greater exchange rate flexibility is best introduced from a position of strength, as this would help limit any adverse effects on growth and employment. Many Directors therefore considered that, in view of the present favorable circumstances, it would be advantageous for China to make an initial move toward greater exchange rate flexibility without undue delay, with some Directors preferring that this move be made soon. At the same time, many Directors also emphasized the importance of carefully sequencing such a move in relation to measures being taken to develop the capital and foreign exchange markets, liberalize the capital account, and reform the financial sector to ensure a successful exit from the current exchange rate regime.

Directors supported the authorities' gradual approach in moving to capital account liberalization, observing that a key pre-requisite for liberalization is a well-capitalized and sound banking system. Several Directors observed that many countries had found it advantageous to increase exchange rate flexibility prior to liberalization of their capital accounts in order to allow exchange market and hedging instruments to develop more fully. They accordingly agreed with the view that maintenance of capital controls should not deter a movement toward greater exchange rate flexibility.

Directors stressed that fiscal policy should play a supportive role in achieving a soft landing of the economy, and urged the authorities to save part of this year's expected revenue overperformance, to reduce public investment, and to lower the deficit below the level targeted in the 2004 budget. Directors noted that fiscal consolidation will also have medium-term benefits, in view of the likely sharp increase in fiscal pressures associated with the large contingent liabilities in the financial sector, the pension system, and local government obligations, as well as rising demand for social expenditures, including on health and education. They therefore welcomed the authorities' intention to keep the level of the fiscal deficit roughly unchanged in nominal terms over the next few years, which should imply a reduction in the deficit by ¼ to ½ percent of GDP per year over the medium term.

Directors stressed that both expenditure reprioritization and revenue measures will facilitate fiscal consolidation and promote economic efficiency. They emphasized the importance of timely adoption of a revised budget classification system and chart of accounts, full introduction of the treasury single account, and improved cash management to enhance the effectiveness of spending. Directors encouraged the authorities to continue to bring extra-budgetary funds, especially at the local government level, onto the budget. They stressed also that priority should be given to considering an extension of the VAT to services, shifting the VAT from a production to a consumption-based tax, unifying income tax rates for domestic and foreign companies, reducing the tax burden on the financial sector, and continuing to strengthen tax administration. Noting the growing fiscal risks at the local government level, Directors emphasized that local governments' accountability and transparency need to be significantly enhanced, and center-local fiscal relations revamped, including by reforming tax assignments, expenditure mandates, and transfers of revenue between levels of government.

Directors emphasized that structural reforms in a number of key areas will be crucial for China to achieve continued strong growth over the medium term. Of particular importance is banking sector reform to ensure future financial stability and sound, competitive domestic banks. Directors considered the recent recapitalization of two state-owned commercial banks at end-2003 as an important initiative aimed at stepping up the pace of reform. In this regard, they stressed the need to carefully monitor the implementation of the time-bound action plans for these banks and to ensure that all banks fully meet capital adequacy requirements with full provisioning by 2007, as required by existing guidelines.

Directors underscored the need for rigorous efforts to strengthen balance sheets throughout the banking system, improve corporate governance, and enhance the ability of banks to manage risks. They noted that diversification of bank ownership and further liberalization of lending rates will facilitate the restructuring process and increase the commercial orientation of the banks. Directors welcomed the progress made so far in reducing nonperforming loans, and encouraged the authorities to tighten lending standards and further improve overall, consolidated supervision, including through greater coordination among financial sector supervisors. To create a more favorable environment for the orderly resolution of existing nonperforming loans, Directors called for additional actions to strengthen the legal framework for creditor rights, foreclosure, and bankruptcy, and to allow full tax deductibility for specific loan loss provisions. The development of domestic equity and debt markets to reduce domestic dependence on bank financing and mitigate risks also remains a priority.

Directors commended the authorities for undertaking a self-assessment of the financial sector, and encouraged China to participate in the Financial Sector Assessment Program in the near future. They welcomed the steps recently taken by the authorities to improve the framework for anti-money laundering and combating terrorism financing (AML/CFT), and looked forward to the finalization of work on comprehensive AML/CFT legislation that matches international standards.

Directors welcomed the initiatives taken to improve the management of state-owned enterprises (SOEs). Continued reforms are needed to ensure that SOEs are subject to hard budget constraints, operate independently, and pay dividends to the government. Directors urged the authorities to close nonviable firms or, if deemed socially important, support them directly from the budget.

Directors cautioned that, even with a high rate of GDP growth, labor market pressures will continue with projected increases in the working-age population and the restructuring of the SOE and agricultural sectors. To cope with these pressures, Directors emphasized that the functioning of labor markets should be further enhanced, including by facilitating better information flow on job opportunities, improving education and training, and strengthening the social safety net for both rural and urban workers. Further reforms of the household registration (hukou) system to allow freer movement of labor will help mitigate underemployment in rural areas and reduce income disparities.

Directors encouraged the authorities to continue to implement WTO commitments as scheduled, and welcomed China's ongoing support for the completion of the Doha Development Round. Directors expressed appreciation for China's provision of debt relief in line with the HIPC Initiative.

Directors welcomed the continued improvement in the quality of economic statistics and the authorities' commitment to make further improvements in line with the General Data Dissemination System. They noted that further efforts are particularly needed to improve the provision of annual and quarterly estimates of real GDP on an expenditure basis, to bring the compilation of fiscal and labor statistics in line with international standards, and to report data on the international investment position as soon as feasible. Directors welcomed China's intention to join the Special Data Dissemination Standard in the future.

People's Republic of China: Selected Economic and Financial Indicators 1/

2000

2001

2002

2003

2004
IMF Staff
Projections

(Change in percent)

Domestic economy

Real GDP

8.0

7.5

8.3

9.1

9.0

Consumer prices (period Average)

0.4

0.7

-0.8

1.2

3.5

(In billions of U.S. dollars)

External economy

Exports

249

266

326

438

543

Imports

-215

-232

-281

-394

-512

Current account balance

21

17

35

46

40

Capital and financial account
    balance 2/

2

35

32

53

110

    Of which: Direct investment, net

37

37

47

47

48

Gross official reserves 3/

169

219

295

412

562

Current account balance (in percent
    of GDP)

1.9

1.5

2.8

3.2

2.5

(In percent of GDP)

Public finance4/

Overall budgetary balance

-3.6

-3.1

-3.3

-2.8

-2.2

Revenue

15.3

17.0

18.2

18.7

19.0

Expenditures

18.9

20.1

21.5

21.6

21.2

(Change in percent)

Money and interest rates

Broad money (M2) 5/

12.3

14.4

16.8

19.6

...

Interest rate 6/

2.3

2.3

2.0

2.0

...

Sources: Chinese authorities; and IMF staff estimates.

1/ As of August 25, 2004.
2/ Excluding errors and omissions.
3/ Includes gold, SDR holdings, and reserve position in the Fund.
4/ Central and local governments. Data include all expenditure financed by official external borrowing, interest payments on government debt, and unbudgeted expenditures in 2000 related to the fiscal stimulus program.
5/ Banking survey.
6/ One-year time deposits, year-end.