On behalf of my authorities, I would like to thank staff for their constructive and candid dialogue held during the mission. My authorities welcome staff’s thorough assessment of the Chinese economy, and see merit in staff’s recommendations in several policy areas. Valuing the Fund’s expertise and role in the international monetary system, my authorities will continue to maintain close cooperation with staff going forward.
Recent economic developments
The Chinese economy is transiting to its new normal amidst an uneven and brittle global economic recovery process. China’s real GDP growth edged down from 7.4 percent in 2014 to 7.0 percent in the first half of this year, which is still high compared to economies of similar size. Labor market conditions remain firm amidst strengthening tertiary industry and consumption, while new industries, such as e-business, have grown at a vibrant pace.
Meanwhile, price pressure in China remains subdued, mainly due to the moderation in food price inflation, the substantial appreciation in the renminbi effective exchange rate, and the decline in global oil and commodity prices. In particular, the y-o-y CPI inflation rate moderated to 1.3 percent in the first half of this year from 2.0 percent in 2014, while the y-o-y producer price inflation rate dropped to -4.6 percent from -1.9 percent over the same period. With all that said, my authorities agree with staff that the risk of deflation in China has been contained, given the firm core price and labor cost pressures, and the ample policy space to guard against the risk.
My authorities will endeavor to foster new growth engines and upgrade traditional ones, including through building up highly efficient markets for resource allocation, enhancing the provision of public goods and services, and promoting innovation and industrial upgrading by implementing the “Internet Plus” and “Made in China 2025” strategies. My authorities will also continue to integrate China with the global economy through the implementation of the “One Belt, One Road” strategy and new free trade agreements.
My authorities have proactively provided fiscal support to counter the downward pressure facing the economy and promote inclusive growth. Spending on infrastructure investment, environmental protection, healthcare, and other social expenditure all picked up, while tax cuts and fee reductions were made to alleviate the burden on small and micro enterprises. The budget deficit in 2015 is set to rise to 2.3 percent of GDP from the actual deficit of 2.1 percent of GDP in 2014.
With the general government debt level registering about 40 percent of GDP in 2014, China’s fiscal indebtedness remains manageable, particularly after taking into account the favorable interest rate-growth differential and strong government asset position. My authorities continue to caution against staff’s augmented fiscal measures, given that such measures also include the debt of local government financing vehicles operating on pure commercial basis.
To harden budget constraint and safeguard fiscal sustainability and transparency, my authorities amended the Budget Law and issued new guidelines, involving: (1) promulgating the modality of local government debt issuance and repayment; (2) making it mandatory to disclose budget information; (3) fine-tuning the management of local government debt, and; (4) improving the performance assessment criteria of local governments; (5) promoting public-private partnership (PPP) in infrastructure investment1; (6) developing an early-warning system and contingency management mechanism; and, (7) introducing a multi-year budget framework, which can reduce fiscal procyclicality.
In addition, my authorities have taken steps to improve the alignment of responsibilities between the central and local governments by enhancing the fiscal transfer system and have boosted budget efficiency. My authorities have also required both central and local governments to reduce the amount of accumulated surplus carried over from the previous years. Meanwhile, to address the funding pressures facing the local governments, my authorities launched local government debt swaps amounting to RMB 3.0 trillion—which have replaced the existing short-term and high interest rate commercial bank lending with long-term and low-cost local government bonds.
China’s monetary condition remains stable under a prudent monetary policy stance. Growth in M2, RMB deposits, and nonbank financing have shifted to a low gear amidst the strengthened regulation of interbank and nonbank businesses, reduced foreign exchange inflows, and ongoing structural adjustments in the economy. Against the downward pressure facing the economy, my authorities implemented a combination of both price- and quantity-based measures to ensure adequate liquidity and reasonable growth in credit and social financing, including: (1) conducting open market operations (2) lowering the benchmark lending rate and cutting the required reserve ratio; and, (3) adjusting the differentiated reserve requirement. Thanks to these efforts, funding pressures have eased, while bank lending, particularly to the rural sector and small and micro enterprises, continues to increase at a firm pace.
With the proposed removal of the loan-to-deposit requirement, it is expected that the banking sector can further strengthen its support to the real economy, and the stability of money market will be improved. Recognizing the merit of an interest rate corridor in the interbank market, my authorities will also continue to improve the interest rate transmission mechanism, so as to transit eventually to a policy rate that is based on interbank market operations.
The significant progress made over the years has resulted in near-full interest rate liberalization. Most interest rates had already been liberalized, and the SHIBOR has increasingly become the benchmark for pricing financial products. Membership of the self-regulatory market interest-rate pricing mechanism has expanded, while interbank issuance and trading of negotiable certificate of deposits has picked up. Marking another milestone in the liberalization process, the deposit insurance scheme and negotiable certificates of deposit for individual investors and nonfinancial corporate were launched recently. Thus, after raising consecutively the deposit rate cap to the current level of 1.5 times the benchmark rate—with anecdotal evidences suggesting that in many cases the cap is not binding—, conditions may become ripe for completely removing the cap by the end of this year, which will then finish the whole liberalization process.
The banking sector remains sound, thanks to strengthened capital level, stable return, and reduced cost-to-income ratio. Notwithstanding a moderate pickup in nonperforming loans, the regulator’s latest stress-testing results also indicated that the sector can withstand a wide range of macrofinancial shocks—including severe credit shocks from local government financing platforms, correction in the real estate sector, and off-balance sheet exposures.
According to the FSB’s latest estimate, the size of China’s shadow banking system remains moderate in comparison to that in other major economies, as well as the size of the Chinese economy2. The FSB’s latest peer review also recognized the notable progress made in implementing the 2011 FSAP recommendations on strengthening the macroprudential framework and regulating nonbank credit intermediaries.
My authorities have endeavored to improve the governance and the operational efficiency of large commercial banks, and open up the sector for private participation with the successful establishment of five private banks. My authorities have also approved reform plans and provided funding support to the three policy banks, to strengthen their roles in providing medium and long-term financing and supporting the agricultural and external sectors.
It is worth noting that, with the banks’ lending rate being liberalized already; banks would offer different lending rates in accordance with the credibility and risk profile of borrowers. As SOEs are generally bigger and have higher credit rating than private firms, which are mostly SMEs, the respective interest rate spreads would reflect mainly the risk premium of the borrowers—as in other countries—and would not have much to do with the ownership of the firms. As such, we strongly suggest staff to shift their analytical focus from a simplified ownership concept to shareholding system of both commercial banks and borrowers, their risk pricing and competition environment, in order to have a better description of the interest rate development in China.
The real estate market continues to adjust in an orderly manner. Due to a buildup of inventory, the real estate market has moderated since 2014, bringing ramification to the real economy. In view of these, my authorities relaxed the mortgage policy (for second-home buyers), increased financial support to property market development, and expanded capital-gains tax exemption. As a result, signs of stabilization in the real estate market have emerged in recent months. Going forward, my authorities will continue to recalibrate real estate market policy as necessary, which, together with the ongoing urbanization and hukou reforms, will be conducive to a healthy development in the market.
Despite some turbulence recently, the development of China’s stock market will continue on the back of sound macroeconomic fundamentals. Amidst the start of interest rate cuts, and rising margin financing, the Shanghai Composite Index recovered from its undervalued level of about 2000 and eventually registered an increase of about 150 percent from its level in July 2014. The subsequent warranted correction, however, is complicated by the acceleration of the unwinding process. As such, my authorities implemented a series of conventional and unconventional measures—which are in line with international practices while taking into account country-specific circumstances—to restore market confidence, prevent a disorderly unwinding of margin financing, and contain spillover. Since then, the market has stabilized, and it is expected that once the market restores fully its norm, the unconventional measures will be phased out.
The turbulence had limited systemic implication for either the real economy or the financial system, as: (1) Chinese households allocated less than 10 percent of their wealth to equities, and estimated stock market wealth effect in China was found to be small; (2) despite its rapid growth, equity financing still accounts for less than 5 percent of total social financing; (3) the total amount of money borrowed from the banking sector accounts for less than 2 percent of total banking assets.
Going forward, my authorities will further identify and reduce market failure, improve crisis response, strengthen the integration and coordination of the financial supervisory framework.
China’s external position remains broadly stable amidst a volatile external environment. The current account surplus edged up to 2.8 percent of GDP in the first quarter of this year from 2.1 percent of GDP in 2014. Two-way movements in the RMB/USD exchange rate have become more frequent, after repeated steps in widening the daily floating band. More importantly, China has basically exited from its intraday interventions on the foreign exchange market. Reflecting the fundamental role of the market force in the RMB exchange rate formation mechanism, foreign reserves have moderated since the second half of 2014, amidst outflows of capitals that offset the current account surplus.
Given the sizable 35% real appreciation of the RMB since 2005, the subdued current account surplus, and emerging capital account deficit, there is little doubt that the RMB is no longer undervalued. Thus, my authorities welcome the shift in the Fund’s view on the RMB’s valuation. I would also encourage staff to continue to refine the External Balance Assessment methodology and recognize that the size of China’s foreign reserves is broadly appropriate against a backdrop of volatile capital flows, avoiding a mechanistic application of the Fund’s reserve adequacy metric.
On the capital account, 35 out of the 40 capital account items are now fully or partially convertible—according to the Fund’s latest Annual Report on Exchange Arrangements and Exchange Restrictions—and it should be noted that summary indices of capital control (e.g., Chinn-Ito Index) cannot reflect the true picture of China’s capital account openness, particularly since such indices do not take into consideration the continued expansion of existing channels (i.e. cross-border investor programs) and the size of actual flows.
My authorities want to point out that the capital account opening process is gaining momentum with the launch of the Shanghai-Hong Kong Stock Connect in 2014 being followed by the launch of the mutual recognition of funds between China and Hong Kong SAR, the launch of the Shanghai-Hong Kong Gold Connect, and the freer access of relevant overseas institutional investors to the onshore interbank market.
At the same time, my authorities continue to broaden channels for RMB flows, including through expanding the RMB Qualified Foreign Institutional Investor (RQFII) Program, and introducing the RMB Qualified Domestic Institutional Investor (RQDII) Program. The RMB is now the fifth most used global payment currency, the second most used currency in trade financing, and the ninth most traded currency in the world.
China has embarked on a new round of trade liberalization, China (Shanghai) Pilot Free Trade Zone (FTZ) was established in 2013, followed by the establishment of new FTZs in Guangdong, Tianjin, and Fujian, After the recent signing of bilateral trade agreements with Australia and Korea, China will continue to advance new free trade agreements and promote the multilateral trade system. On the other hand, China’s overseas direct investment surpassed foreign direct investment for the first time in 2014. My authorities will continue to encourage overseas investment through implementing the “One belt, One road” strategy3 and cooperate closely with the existing IFIs and the newly-established Silk Road Fund, Asian Infrastructure Investment Bank as well as the New Development Bank in helping address the infrastructure investment gap facing many countries.
Reflecting the transition to a more balanced and sustainable growth path, the tertiary sector and consumption continue to strengthen its importance in the economy, while the central and western regions continue to catch up with the eastern regions. Meanwhile, thanks to my authorities’ steadfast efforts to strengthen the social safety net—including through implementing the hokou reform and the new urbanization plans announced last year—the urban-rural income inequality gap continues to narrow, while urban and rural saving rates had declined over the past two years. At the same time, the private sector continues to thrive, with the sector’s shares in fixed asset investment (excluding rural household), goods exports, and bank loans to enterprises all increasing steadily over time to reach 40-50 percent in the last two years.
On the environmental front, China’s forest coverage has continued to increase over the past two decades, rising from less than 13 percent of total land area in early 1980s to 22.6 percent in 2012. Carbon emission per unit of GDP has been reduced by 33.8 percent since 2005. To further contribute to the global combat against climate change, my authorities had recently pledged to cap carbon emissions by 2030 or earlier, raise the consumption share of non-fossil fuels from the current 11.2 percent to about 20 percent, and cut carbon emissions per unit of GDP by 60-65 percent from the corresponding level in 2005.
Finally, my authorities have recently started to release data on China’s foreign reserves in accordance with the Special Data Dissemination Standard (SDDS). With comprehensive technical preparation, conditions are ripe to subscribe to the SDDS by the end of this year.
As of May 25, 2015, 1043 PPP projects amounting to RMB 1.97 trillion had been revealed, covering areas including transportation, water conservancy, and environmental protection.
According to the FSB’s Global Shadow Banking Monitoring Report 2014, the size of China’s non-bank financial intermediation amounted to USD 3.0 trillion as at end-2013, while that of the U.S. and the U.K. amounted to USD 25.2 trillion and USD 9.3 trillion respectively. Using the more narrower measure of shadow banking, the size of China’s shadow banking amounted to USD 2.7 trillion as at end-2013, while that of the U.S. and the U.K. amounted to USD 14.0 trillion and USD 4.7 trillion respectively.
The “One belt, One road” strategy refers to the New Silk Road Economic Belt, which will link China with Europe through Central and Western Asia, and the 21st Century Maritime Silk Road, which will connect China with Southeast and South Asian countries, Africa, Europe, and even other regions.