Introduction: China faces challenges of reform

Economic growth accelerated from 8% in 2002 to 9.1% last year. 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 six years, some signs of economic overheating are causing concern.

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% last year. 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 Rmb319.8 billion ($38.6 billion), the same as in 2003. This will lower the deficit-to-GDP ratio from 2.7% in 2003 to 2.5% in 2004. The six-year expansionary fiscal policy is likely to be phased out. Related to this move, the Ministry of Finance announced that funds raised by treasury bond issues in 2004 would be used mainly for economic restructuring and social development rather than promoting economic growth.

The March 2004 NPC outlined the government's main aims. Key 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 state-owned enterprise (SOE) reform. Although rapid economic growth will continue to be a focus, by itself this is not enough to achieve sustained socio-economic progress.

A more balanced development agenda is being adopted. This 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 and 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 north-east); 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, create a sound social security system and respect human rights. As part of this agenda, the government plans to allocate Rmb95.5 billion from the 2004 budget, up by Rmb10 billion from 2003, for spending on education, health, science and technology, and culture and sport, with priority given to rural areas.

Concerned that the rapid rise in bank lending and liquidity could lead to deterioration in loan quality and an increase in inflation, the People's Bank of China (PBOC) 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. Two months later it issued prudential regulations to control property loans, particularly in high-end housing projects. 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%. PBOC tightened monetary policy again, effective April 25 2004, when it raised the reserve requirement ratio to 7.5% for most banks and to 8% for banks considered to be inadequately capitalized. It had already raised the re-discount 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, however, 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 set up the China Banking Regulatory Commission (CBRC) in April 2003 to take over the functions of regulating and supervising banks from PBOC. One of CBRC's goals is to improve management of the country's four major state-owned commercial banks. 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 non-bank financial institutions to ensure that they were taking the appropriate measures to reduce their non-performing loans (NPLs).

Subsequently, in December 2003, the Standing Committee of the NPC 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 PBOC's role in the economy, especially in currency policy. Other amendments made to the Law on Commercial Banks free the state-owned banks 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 state-owned commercial banks. It injected $45 billion of foreign reserves to recapitalize the Bank of China and the China Construction Bank. A similar package was announced for the Industrial and Commercial Bank of China in January 2004 and the Agricultural Bank of China will also receive additional funding.

PBOC widened the lending interest rate bands for financial institutions from January 1 2004. The upper limit on lending rates for commercial banks and city credit cooperatives is now 1.7 times the benchmark rate and twice the rate 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 renminbi 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 renminbi remained within a narrow band around Rmb8.28/$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 renminbi. 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, however, take steps to ease the pressure brought by high foreign exchange reserves: (i) the State Administration of Foreign Exchange (Safe) 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 began accepting renminbi deposits on February 26 2004, marking the first offshore convertibility of the PRC's currency. The banks, including HSBC and Bank of East Asia, will change Hong Kong dollars into renminbi up to Rmb20,000 per day per account for funds on deposit, and up to Rmb6,000 per day for cash transactions.

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

Safe 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 was set in April 2003. It acts to supervise the 196 central SOEs that had Rmb6.9 trillion in state assets at end-2002, and it appoints or removes senior SOE executives and has a say in the transfer of state holdings, corporate mergers, closures or other significant changes in SOEs. A main focus for the Commission will be to improve corporate governance such that it can exert its powers through well-functioning boards of directors. The Commission 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, meaning that most non-government 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 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 main 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 priority on balanced, sustainable socio-economic 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

Although the government set an economic growth target of 7% 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%, 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 Asia.

However, over the medium term, the government will need to tackle several issues to ensure sustainable socio-economic development.

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 phase-out of the expansionary fiscal policy will slow government-dependent investment.

Economic growth will be unsustainable in the long run if one of its main 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 (for instance consumer credit bureaus) and greater support must be given to financial institutions when they repossess assets on which consumers default.

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 key partners in 2003, trade friction, especially with the US and EU, could intensify in 2004-2005, possibly hampering 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 Cepa between the mainland and Hong Kong will become effective. That will also stimulate trade.

Strong domestic demand, especially for oil, steel, grain and raw materials, will be the main engine of import growth. Capital imports will continue to grow strongly because of rapid economic development. Import growth rates, while somewhat lower than in 2003, will be about 16% to 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 about 1 to 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.

This is an excerpt from the Asian Development Outlook 2004. This has been reprinted with permission from the Asian Development Bank. For info related to development in Asia and the Pacific, see www.adb.org.