The Chinese economy has continued to show resilience, reflecting strong consumption and investment, and further progress in structural adjustment. The key challenge is to balance the need for containing inflation, sustaining strong growth, and accelerating the transformation of the growth model. The task is complicated by the difficult external environment, which acutely constrains macroeconomic policy options and rebalancing efforts.
I. Recent economic developments and policies
Despite the weak recovery, continued financial market fragility and heightened sovereign risks in the developed economies, the growth in China has remained strong and continued to rebalance in favor of domestic demand, thanks to the package of comprehensive reform measures. Retail sales grew by 18.4 percent in 2010 and 16.6 percent in the first five months of 2011, driven by the household income growth (urban household per capita disposable income rose 11.3 percent in 2010, and rural household net per capita income by 14.9 percent), while fixed asset investment growth moderated to a more sustainable rate of 23.8 percent. With import growth outpacing that of export growth by 3.6 percentage points, the trade balance further narrowed from 4 percent of GDP in 2009 to 3.1 percent in 2010, followed by another 18.2 percent reduction in the first half of 2011. Current account surplus as a share of GDP continued to decline from the precrisis double digits to 5.2 percent in 2010 and 2.04 percent in the first quarter of 2011.
Inflation pressure has intensified, reflecting the sharp food price increase and the abundant domestic and global liquidity, and the associated surge in global commodity prices. It also reflects longer-term changes, such as the structural increase in labor, land, as well as environmental protection costs. Last year saw an average minimum wage increase of 22.8 percent across the country.
As the staff rightly noted, our authorities began to withdraw the monetary stimulus as soon as the recovery took hold. Since early 2010, the People’s Bank of China (PBC) has raised reserve requirements on 12 occasions and policy rates on 5 occasions. Surprisingly, the staff reports have missed the significant constraint of the external environment on the monetary policy options. For example, the frequent tightening steps were interrupted for about two quarters of the year by the heightened sovereign risks in Europe. And more importantly, the near-zero policy rates in major advanced economies have limited the room for the PBC to rely on interest rate adjustments, as the higher domestic rate, combined with appreciation expectations, would not only fuel speculative flows but also fail to address the challenges arising from the sectoral differences and the fast-evolving financial system. The monetary policy mix may be better assessed in such a setting. In addition to the reserve requirement and policy rate adjustments, as well as the flexible use of open market operations, the PBC has adopted “aggregate financing” as a key indicator for gauging monetary and financial conditions. It has also introduced transparent and rules-based dynamically differentiated reserve requirement ratios to provide incentives for the individual institutions to respond to the need for capital buffer as it fluctuates with business cycles. They believe that the configuration of the price-based instruments with macroprudential tools suits the present external and domestic context.
Given the strong economic growth and revenue performance, the fiscal policy will focus on improving expenditure composition, particularly increasing social spending to encourage consumption while ensuring fiscal sustainability. The government will continue tax reform and structural tax reduction to facilitate rebalancing. The recent amendment to the income tax law simplified the tax structure, raised the exemption threshold by 75 percent, and revised the tax rate for the lowest bracket from 5 percent to 3 percent. Our authorities are well aware of the risks associated with the accumulation of local government debt—a legacy associated with the crisis response measures. Although such debt is small relative to GDP, and has been largely used to finance fixed asset investment and expected to generate cash flows, our authorities have taken preemptive actions, including introducing an effective monitoring and risk warning system, and standardizing local government debt management.
To address the risk of potential property bubbles, both demand and supply side actions were taken, including differentiated lending standards, larger supply of land, and affordable housing. The stress tests by commercial banks indicate that the real estate sector credit risks remain manageable.
II. Transformation of the growth model
China’s far-reaching rebalancing efforts have yielded remarkable results. The multi-prong measures have resulted in an average 9.7 percent real annual increase in urban household per capita disposable income in the last five years, and 8.9 percent real increase in rural household net per capita income. During the same period, retail sales grew at an average annual rate of 18.1 percent, while the weight of the service sector edged up 2.7 percentage points. There has been a leap forward in strengthening the social safety net. The health insurance has covered 1.26 billion participants. The rural participation rate has reached 96 percent, with 836 million covered by the new rural medical insurance introduced in 2009. The government contribution to the health insurance increased 66.7 percent in 2010 on top of the 50 percent rise in 2009. The reimbursement ratio has reached 60 percent. The new rural pension scheme introduced in 2009 has already attracted 190 million participants. More than 50 million have begun to benefit from the scheme. The energy saving and environmental protection measures, which resulted in a 19.1 percent reduction in energy consumption per unit of GDP in the last five years, are also conducive to rebalancing. To encourage import, tariffs were significantly reduced on 33 tariff items covering energy, raw materials, and consumer products effective July 1, following the application of lower duties on over 600 items early this year. As a result, the contribution of domestic demand to GDP growth increased from 81.9 percent in 2007 to 91 percent in 2008 and 139 percent in 2009, before stabilizing at 92.1 percent in 2010. Since 2005, the domestic share of aggregate demand has also edged up by 2.9 percentage points to 97.4 percent.
Our authorities are fully aware of the enormous challenges to their rebalancing efforts, including the need for creating 25 million jobs for the new urban labor force each year in the Plan period. As the population begins to age, the demand for social protection will be more acute. The “Twelfth Five-Year Plan” on economic and social development illustrates our authorities’ determination to transform the growth model by accelerating structural reforms with a strategic focus on expanding consumer demand. It sets out policy guidance in 10 areas, including accelerating growth in household income, providing lasting incentives to expand consumption, and allowing market forces to play a key role in resource allocation. The Plan has been the most comprehensive and elaborate policy framework to rebalance demand that G20 members have ever put forward. It is legally binding and embodies a monitoring and evaluation mechanism. We wish to highlight a few relevant elements.
1. Expanding employment and improving income distribution to increase consumption
While increasing public service for employment, expanding training, and encouraging entrepreneurship, measures will be taken to accelerate income distribution reforms to raise the labor share of national income. The Plan envisages a real annual growth of over 7 percent in per capita household disposable income (faster than the projected real GDP growth), and an annual minimum wage growth over 13 percent. This will also reinforce the relative factor cost changes under way. According to the U.S. Bureau of Labor Statistics, during 2002–2008, manufacturing sector real wages doubled in China, compared to 20 percent in the United States.
2. Strengthening the social safety net to reduce precautionary saving
Over the Plan period, out-of-pocket expenses will be further reduced for health insurance participants. The pension insurance system is expected to have all the urban and rural population covered by end-2012. About 36 million units of affordable housing will be provided.
3. Allowing market forces to play a basic role in resource allocation and strengthening environmental protection
The Plan envisages 30 percent reduction in water consumption per unit of industrial value added, a further 16 percent reduction in energy consumption per unit of GDP, and other targets for emission reduction of major pollutants. The price reforms involving natural resources, including refined oil, natural gas, water, and electricity will be front-loaded as priority agenda for 2011.
4. Promoting the development of service and nontrade sectors
The Plan aims at a 4 percentage-point increase in the service sector share of GDP, particularly by promoting financial, logistics, and tourism services.
The structural measures, especially those aimed at promoting consumption and nontradable sectors, together with the relatively faster increase in factor costs, are expected to help narrow the current account surplus and bring the RMB exchange rate even closer to its equilibrium. We disagree with staff assessment that the RMB remains substantially below the level consistent with medium-term fundamentals, which is based on reserve changes, the most recent REER movement, and the shaky medium-term current account projections.
First, under the current international monetary system, the exceptionally loose monetary policy in major reserve-issuing economies had important implications for reserve changes in other countries. The factors underlying changes in reserves and key assumptions for staff medium-term current account projections, which have shown persistently large errors, certainly deserve further examination. Second, the REER-related assessment should be based on longer-term trend than what the staff paper seems to focus on. The movement in the past year has been complicated by the large fluctuations among the major currencies. Since 1994, the year the RMB exchange rates were unified, both the BIS and IMF have recorded RMB REER appreciation of over 50 percent, with 21 percent appreciation since mid-2005. Furthermore, structural changes, such as the increasing cost of labor and capital and the convergence of domestic and international metropolitan property prices, will fundamentally affect China’s competitiveness.
Staff’s exchange rate assessment, which is derived from medium-term current account projections based on the assumption of unchanged policies and constant exchange rate, ignores the trend exchange rate movement and the far-reaching legally-binding rebalancing measures that will be implemented in the medium term.
III. Financial reform and FSAP
China’s precrisis financial reforms have been an important buffer against the global crisis. With a combination of quantitative and price instruments, the monetary policy framework, which aims at maintaining not only price stability, but also sustaining growth, has enabled the economy to weather multiple shocks including food price fueled inflation, domestic natural disasters, and the constraints by zero-rate policies in the advanced economies to the withdrawal of stimulus. The strengthened financial regulation and supervision, as well as the corporate governance, risk controls, and strong capital buffer of the financial institutions put in place before the global crisis have also enabled the financial system to respond effectively to the shocks.
The banking sector is generally healthy, with the completion of restructuring and public offering of all major commercial banks. Banks are profitable and well-capitalized, with NPLs at historical low levels. Hard financial constraints are being put in place. The rapid development of financial markets has facilitated the diversification of financing. The nonfinancial corporate sector saw a 122.9 percent increase in its funding from the equity market in 2010. The bond market has become the sixth largest in the world. The development of the financial markets has also improved conditions for interest rate marketization, better resource allocations, and financial innovation.
The new Five-Year Plan calls for deepening financial reforms, including further reforming financial institutions, accelerating the development of a multi-layer financial market, and strengthening financial regulation and supervision. Among many detailed actions, it envisages the establishment of a deposit insurance system, a countercyclical macroprudential framework, and a resolution mechanism for systemic financial risks; further interest rate marketization; further improving the exchange rate regime; phasing out restriction on the cross-border use of the renminbi; and progress toward capital account convertibility.
Our authorities attach great importance to the FSAP exercise as a comprehensive health check for the financial system. As for the four near-term risks mentioned in the FSSA, we would like to emphasize that both the NPL level and volume have been dropping steadily. The off-balance sheet exposures are small relative to bank balance sheets.
As the FSAP results confirm the general health of China’s financial system, the exercise focused on further financial sector reform. We note that the FSAP recommendations were largely consistent with what has been laid out in the Plan. Some recommended actions are already being put in place. A subtle difference was that staff preferred a clear reform sequence and road map, while our authorities believe that, although it is important to have a clear direction and an integrated and coordinated approach to reform design, predetermined timing, sequencing, and pace could complicate and even slow down implementation. Flexibility for responding to unforeseen shocks is critical. For example, the progress in promoting capital account convertibility and exchange rate regime reform was interrupted twice by external financial crises. Each time, renewed efforts were needed to rebuild consensus.
IV. Spillover effect
The current spillover analyses were largely a summary and attempted verification of some third-party concerns. We would have benefited from an independent analytical framework by staff.
On the inward spillover, the reports fail to capture the significant shocks to the authorities’ decision-making, firm and household behavior, and the progress in rebalancing. First, the prolonged massive unconventional easing by the major central banks not only fueled inflation pressures but also constrained the options regarding policy mix, as well as the timing, path, and pace of the monetary policy normalization in emerging market economies. Even those with floating regimes were also forced to resort to capital controls. Without the external shocks, China’s monetary stimulus withdrawal would have experienced a different pace and would have relied more on price instruments. Second, the global crisis and recession negatively affected the fiscal performance and expenditure composition of the emerging market economies. Third, more profoundly, the external shocks caused major interruptions to reforms in China, particularly the exchange rate reform. Fourth, the spillover slowed the progress of rebalancing. As noted in the FSSA, the Lehman collapse marked a sudden surge in China’s household and corporate savings, undoing much of the rebalancing efforts in China. The household deposits growth jumped from 1 trillion yuan in 2007 to an average of more than 4.3 trillion yuan in the three years after the subprime shock, while corporate deposit growth surged from 2 trillion yuan in 2008 to 6 trillion yuan in the following year. We find the real shock from the U.S. subprime crisis much stronger than suggested in the staff spillover reports. It caused China’s exports to plunge for 13 consecutive months, with a 52 percentage-point drop in export growth and a sharp decline in FDI inflow. It has significant impact on business activity, employment, and fiscal performance.
On the outward spillover, we would like to highlight a few points. First, the report fails to mention China’s role as an important source of global stability and growth. China has resisted the pressure for depreciation during the recent major episodes of large downward exchange rate movement in many other emerging market economies. While focusing on the rising export share (which is, as a matter of fact, not out of line with its share in global GDP), staff ignores the sharp rise in China’s import share (from 6.1 percent in 2005 to 9.1 percent in 2010). Second, contrary to the view that China’s capital controls diverted flows to other EMEs, since the outbreak of the crisis, China has been easing rather than tightening its restrictions and remains one of largest net capital recipient. Third, as a large and diversified importer and exporter as well as FDI destination, by facilitating the completion of the production chain, it helps the economies at the higher end of the value chain to relocate uncompetitive operations to China, and LICs to participate in the global division of labor. Fourth, as China raises its living standard, it frees up development financing for other low- income countries and contributes to the global efforts to achieve the millennium goal.