Speech

Growth and Stability in China: Prospects and Challenges, Remarks by Eswar Prasad, Division Chief, Asia and Pacific Department, IMF

April 17, 2004

This is a time of great hope and promise for China. Its transformation into a dynamic private sector-led economy and its rapid integration with the world economy, through both trade and financial linkages, are likely to prove landmark events in global economic history. China has become a major force in the world economy, reflecting a number of major accomplishments over the last two decades. Per capita income has risen almost three-fold to about $1000 at present and millions of people have been lifted out of poverty. China now ranks as the sixth largest economy in the world at market exchange rates. And it stands at the threshold of even greater achievements. With its vast human resources, high domestic saving rate and increasing outward orientation, China has the potential for maintaining rapid growth well into the future.

But there are many storm clouds on the horizon. A number of difficult structural problems in the Chinese economy will need to be dealt with in order for growth to be sustainable and for China to achieve its potential. Reforms of the banking and state enterprise sectors will have to be combined with measures to tackle rising unemployment, poverty that still remains widespread, and widening regional disparities in income.

Furthermore, as is typical, the present good times may be providing fertile ground for the germination of seeds of danger for the future. The rapid growth of credit that has taken place over the last two years has resulted in a remarkable rate of investment growth, particularly in some key sectors such as steel, cement and autos. This is helping to fuel inflationary pressures in the short run and, if current expectations about future demand growth should prove overoptimistic, could lead to a buildup of excess capacity and a further accumulation of nonperforming loans in the banking system. In the absence of adequate and rapid tightening of policies, the probability of a soft landing of the economy may diminish and that of a hard landing, with all of its attendant problems, will rise.

China's growing prominence in the world economy means that its success or failure will have broader ripple effects. At one level, China's importance should not be overstated. Despite the image of China as having taken over most of the world's export markets, it still accounts for only about 6 percent of world trade. From a different perspective, however, its trade does indeed have far-reaching implications for global growth. For instance, on a purchasing power parity basis, China accounted for almost a quarter of total world growth during the global slowdown over the last 2 years. China's voracious appetite for imports, both for its processing trade and domestic consumption, has kept the regional economies growing despite the slowdown in world demand. Thus, there is a great deal at stake in China's ability to successfully manage its vulnerabilities.

The Reform Challenges

Let me turn first to what I see as the major structural challenges that China faces. In China, financial intermediation takes place mainly through the banking system, as the equity and bond markets are relatively underdeveloped. Given the high level of saving and investment in China, the banking system therefore plays a crucial role in the efficient allocation of resources.

China's state-owned banking system has been plagued by a legacy of policy lending to state enterprises that has resulted in the accumulation of a large stock of nonperforming loans (NPLs). While the exact magnitude of NPLs in the banking system has been the subject of much debate, there is little doubt that significant progress has been made in recent years in reducing the overhang of NPLs and strengthening the balance sheets of the major banks. Supervision and regulation of the banking system have also visibly improved. But all of these improvements will need to be underpinned by more fundamental changes in the incentive structure for banks. Policies that encourage banks to intensify the commercial orientation of their lending operations, with more careful assessment of the viability of and risks associated with specific projects, are essential. Measures such as the recent liberalization of lending rates will no doubt be helpful in this respect, but a great deal remains to be done to strengthen the financial system.

Although there is no explicit deposit guarantee system in place, the resolution of the NPL problem in state-owned banks is likely to have fiscal repercussions. This raises concerns about the sustainability of the fiscal position. But China is not a typical developing country in this dimension. With a deficit below 3 percent of GDP and public debt of only about 25 percent of GDP, fiscal sustainability is hardly an immediate concern. The problem is that there are substantial medium-term fiscal obligations related not just to the remaining contingent liabilities in the banking system, but also the unfunded obligations of the state pension system, and the rising expenditure pressures for education, health and other social needs.

Early action in undertaking reforms in some of these areas would considerably reduce the looming fiscal pressures. For instance, some calculations by the World Bank suggest that the long-term costs of the unfunded liabilities of the pension system could be brought down from nearly 70 percent of GDP to less than 10 percent of GDP with some relatively modest changes in parameters such as the retirement age for workers in state enterprises, the ratio of pension benefits to average wages etc.

Another important challenge facing Chinese policymakers is that of unbalanced development across the country. Rural-urban income differences have widened sharply over the last two decades. More importantly, economic opportunities, especially employment prospects, have continued to dwindle in rural areas and in the inland western provinces. While some of these disparities are the natural by-product of a fast-growing economy, they pose a serious threat to social stability. Rising unfunded mandates that have been passed on to local governments and a revenue transfer system that is not sufficiently progressive have exacerbated these problems. Reforms of the structure of intergovernmental fiscal relations will be essential to deal with regional disparities in incomes and other economic and social outcomes.

Many of the inefficiencies and problems in the economy tend to be ultimately reflected in labor market outcomes. While China has, by most measures, a "flexible" labor market and the official unemployment rate remains relatively low, the number of working-age persons who do not have jobs is actually quite large. When one adds to these the rural underemployed—conservatively estimated at 150 million—the problem of nonemployment appears staggering. What's more, even with GDP growth in the range of around 8 percent, it is likely that the net flows into unemployment will in fact increase over the next 2-3 years. Workers laid off as a result of the restructuring of state enterprises and the flow of new entrants into the labor force are likely to overwhelm the capacity of the economy to absorb labor. Faster growth in the short run would help mitigate this problem but, ultimately, it is only policies that generate sustained and balanced growth that will enable China to eventually tackle this problem in a meaningful way.

I turn next to a discussion of what I think are some broader policy priorities, in addition to those mentioned above, that are necessary to accomplish this objective.

The Way Forward

China's traditional approach to reform has been an incremental one, with carefully controlled pilot projects in a limited set of areas eventually setting the stage for deeper reforms. In many ways, this gradual approach has worked well. And, given the size and complexity of China's economy, more drastic approaches to reform may not be viable. At its current stage of development, however, when China stands at a decisive moment of economic transformation, the interconnectedness of the various reforms will be difficult to get around. Furthermore, China may no longer have the luxury of taking a cautious approach to reform. For instance, with China set to open up its banking sector to foreign banks by 2007 under WTO accession commitments, foreign competition for domestic banks will soon be an inescapable reality.

What Chinese policymakers need is a potent set of tools to create the sort of economic transformation that would prepare China for moving to the next stage of its development. For instance, creation of a broad and efficient social safety net will be important to ease the social costs of enterprise restructuring and would also be useful in promoting the inter-sectoral reallocation of labor, both from the public to the private sector and from declining to growing industries.

Another tool would be provided by a move toward greater exchange rate flexibility. The maintenance of a de facto fixed exchange rate regime can complicate domestic monetary management, as evidenced by the recent rapid accumulation of international reserves and its fallout in terms of faster domestic monetary expansion. Having more flexibility in the exchange rate would give China an autonomous monetary policy, a powerful tool to counter domestic and external shocks.

There have of course been calls for a revaluation of the renminbi, based on the argument that China's rapid export growth and accumulation of international reserves constitute clear evidence of a deliberate policy to keep the currency undervalued. But this issue is not as straightforward as it may seem. First of all, it is difficult to estimate the equilibrium or appropriate exchange rate for any country, let alone a developing country like China that is undergoing massive structural change. Second, it is far from clear that the rapid growth of Chinese exports is by itself sufficient to argue that China's exchange rate is greatly undervalued. Its export growth, which in large part reflects China's emergence as a processing center for trade between Asian economies and western industrial country markets, has been matched by growth in its imports. Indeed, China's overall trade balance posted a small deficit in the first three months of 2004. Third, the pressures on the exchange rate in the future will depend on a host of factors, including capital account liberalization, and could just as easily reverse.

Thus, it seems far more productive to frame the issue in terms of more exchange rate flexibility for China rather than trying to find a particular level of the exchange rate that would make all concerned parties satisfied. There is little doubt that the transition to a different exchange rate regime always poses some risks of short-term instability. But these risks are only likely to grow over time, especially as capital controls grow increasingly ineffective, as they invariably do. Thus, the current domestic circumstances—when growth is robust—may be an opportune time to take the first steps in what should ideally be a phased move toward greater flexibility. This would provide some breathing room for foreign exchange markets to develop and for domestic firms to adapt to a different regime. Maintaining or even selectively tightening some capital controls during this period of transition could soften the adjustment process and also mitigate any risks associated with pressures on the banking system.

A more fundamental issue that has implications for the effectiveness of the other elements of the reform strategy is that of institution building. A large and persuasive body of academic research has shown how the quality and robustness of domestic institutions can, in addition to more basic economic policies, affect a country's long-term growth prospects. More importantly, the quality of institutions can affect a country's experience with globalization, both in terms of enhancing the benefits and controlling the inevitable risks associated with this phenomenon. Academic research has still not identified which institutions are the key ones for fostering growth. But there is an emerging consensus that a sound legal framework, strong financial sector supervision, good corporate governance, and low levels of corruption are conducive to growth. Having good institutions will help foster the expansion of the private sector, which has accounted for much of China's recent dynamism, and the strengthening of the remaining state sector enterprises. Like other emerging markets, however, China faces the difficult question of whether to improve its institutions before opening up its economy further or using the pressures of opening up itself to generate significant improvements in the quality of its institutions.

As with most other issues that China's leadership faces, there are no easy or clear answers to some of the challenges I have discussed. And yet, with the stakes so high, there is little choice but to push ahead with needed reforms in a concerted and broad manner. As the Chinese Premier Wen Jiabao has said in a different context "Failure is not an option." The very fact that the main challenges are being discussed in an atmosphere of candor and realism do, however, give one hope. This approach may also help in building social consensus that will be essential for the reform process. Translating good intentions into sound and decisive policy actions now remains the main challenge for Chinese policymakers. And there is much at stake, not only for China but also for the global economy, in getting things right.

Notes

The author is chief of the China division in the IMF's Asia and Pacific Department. This article is based on a lecture delivered at the plenary panel of the Harvard China Review's Seventh Annual Conference in Cambridge, MA. It draws extensively upon work done by members of the IMF's China team, some of which is summarized in a recent IMF study.¹ The views expressed in this article are those of the author and do not necessarily represent those of the IMF or IMF policy.

¹ "China's Growth and Integration into the World Economy: Prospects and Challenges," edited by Eswar Prasad, with contributions from Steven Barnett, Nicolas Blancher, Ray Brooks, Annalisa Fedelino, Tarhan Feyzioglu, Thomas Rumbaugh, Raju Jan Singh and Tao Wang, IMF Occasional Paper No. 232, 2004.