IMF Survey, Volume 35, Issue 22

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Country Focus: To Sustain Rapid Growth, China Needs to Rebalance its Economy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 2006
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China’s economic growth is projected to remain strong, with inflation well under control. But the latest annual assessment of the economy argues that, for rapid and stable growth to be sustained over the medium term, China should rebalance the economy so that growth is driven more by consumption than by investment and exports.

The IMF’s most recent forecast shows China’s real GDP growth reaching 10.5 percent in 2006, up from 10.2 percent last year. Inflation is projected to dip to 1.4 percent this year from a recent peak of 3.9 percent in 2004, while China’s trade balance continues to climb and its large stockpile of international reserves grows further (see table and Chart 1).

According to the IMF staff report, released on October 31, the key immediate concern is rapid credit and investment growth (see Chart 2, panel 1). “Abundant liquidity in the banking system could touch off further increases in lending growth and investment, with the probable consequence of creating new nonperforming loans and undoing some of the progress made in reforming the banking sector,” the report says.

Tightening monetary policy

The Chinese government recognizes the need in the near term to contain investment and credit growth and has instituted a number of administrative actions and a tightening of monetary policy in response. However, the report calls for additional steps to be taken, given substantial liquidity in the banking system, continuing large capital inflows, local government pressure on banks to expand lending, and diminishing restraint on credit growth by the large banks as they complete their recapitalizations (see Chart 2, panel 2).

Full steam ahead

China’s growth is continuing unabated, along with a buildup of its trade surplus and reserves.

Proj.1Proj.
20032004200520062007
(percent change)
Real GDP10.010.110.210.510.0
Consumer prices (period average)1.23.91.81.42.2
(billion dollars)
Current account balance4669161219259
Trade balance4559134196241
Exports4385937629591,168
Imports394534628763928
Capital and financial account balance53111633625
Change in net international reserves (increase -)-117-206-207-259-284
Gross international reserves24126198261,0851,369
(percent of GDP)
Overall budget balance3-2.4-1.5-1.3-1.2-1.1

As of November 17, 2006.

Includes gold, SDR holdings, and reserve position in the IMF.

Central and local governments, IMF definition.

Data: National Bureau of Statistics of China and IMF staff estimates and projections.

As of November 17, 2006.

Includes gold, SDR holdings, and reserve position in the IMF.

Central and local governments, IMF definition.

Data: National Bureau of Statistics of China and IMF staff estimates and projections.

At the same time, having to tightly manage the exchange rate has created a major conflict in monetary policy implementation. To deal with this, the authorities have relied on administrative controls and moral suasion; but the effectiveness of the controls is diminishing, and the government’s use of moral suasion to influence bank lending decisions directly contradicts its goal of creating a banking sector operating on a sound commercial basis. Thus, allowing the exchange rate to move more flexibly and be increasingly determined by market conditions would enhance monetary policy independence. The insufficient discretion given to the central bank to set interest rates is another important impediment to timely monetary policy action.

Chart 1Heading up

China’s trade balance continues to climb, but its market is drawing in Asian imports.

(billion dollars, customs data)

Data: National Bureau of Statistics of China and IMF staff estimates.

Chart 2Strong performance

Growth, led by investment (panel 1), has been strong, with liquidity in the banking system remaining high (panel 2).

Data: National Bureau of Statistics of China and IMF staff estimates.

Rebalancing growth

The report points out that an appreciation of the currency will also contribute to the sustainability of China’s growth. It would help avert the buildup of short-term foreign currency liabilities that will occur if the exchange rate remains undervalued and if administrative controls on the financial system are maintained. In addition, a currency appreciation will help improve the allocation of investment and its efficiency by giving the right price signals to potential investors. By increasing households’ purchasing power, and thereby boosting consumption, it would aid in rebalancing the economy over the medium term. The report urges China to more fully use the flexibility afforded by the current exchange rate system and allow greater movement in the renminbi–U.S. dollar exchange rate to enable a further significant appreciation of the currency in nominal effective terms (see Chart 3). “This is in China’s best interest and the timing is right, as such an appreciation is unlikely to create significant economic disruptions, given the strength of the Chinese economy,” the report says.

In addition to serving China’s own interest, greater exchange rate flexibility would contribute to an orderly process for resolving global current account imbalances. Dealing with global imbalances requires a concerted effort by all countries, because a disorderly correction would be bad for everyone, the report adds.

Chart 3Small appreciation

The renminbi has appreciated against the dollar by 3 percent since China’s exchange rate reform in July 2005 (left panel), while intraday fluctuations remain within a narrow band (right panel).

Data: National Bureau of Statistics of China and IMF staff estimates.

Boosting consumption

Domestically, China’s government will have to play an important role in rebalancing the country’s growth. It can help boost consumption through further reform and development of the financial sector. Additional steps are needed to develop China’s capital markets and improve the banking system. Developing bond and equity markets is important for improving intermediation and increasing incentives for banks to seek out small and medium-size enterprises. It will serve to boost consumption by providing greater opportunities for direct and indirect household participation in the financial markets.

Chart 4Underweight

Personal consumption declined to less than 40 percent of GDP in 2005, coinciding with a fall in the share of disposable income.

(percent of GDP)

Data: National Bureau of Statistics of China and IMF staff estimates.

The government also can play a critical role through increased spending on health care, education, and pensions, which would encourage households to reduce high precautionary savings. Household consumption has dropped to less than 40 percent of GDP (see Chart 4). Boosting consumption will serve to rebalance growth in the economy and provide an opportunity to spread the benefits of growth more equitably across all levels of society.

The report says that income disparities across regions continue to widen, with some localities facing difficulties in funding expenditure mandates, especially in health care and education. These structural imbalances in subnational finances need to be addressed, including by assessing the possibility of reforming tax assignments across levels of government, rebalancing expenditure responsibilities in line with resources, and reforming the transfer system to move toward a more rule-based system that ensures that all local governments have enough resources to meet their spending responsibilities.

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