During 2002, there was renewed vigor in investment, stimulated by post-WTO private capital spending as well as public investment in the government's stimulus program. Both imports and exports grew sharply, and China emerged as the favorite destination for foreign direct investment. Foreign exchange reserves rose, reaching almost 12 months of import cover, and the external surplus continues to hold. Debt, though growing, is still low by international standards.

Despite such robust economic performance, serious short- and long-term challenges remain. These were brought into focus during the stocktaking that occurred at the 16th Party Congress of the Communist Party in October 2002 and discussions at the National People's Congress (NPC) in March. Several of these were reiterated in pronouncements by senior officials following the recent change in administration that saw Hu Jintao appointed President, Wu Bangguo as head of the NPC, and Wen Jiabao as Premier.

Among the major highlighted risks are those related to fiscal sustainability, continued growth in inequality (in particular rural distress), and an orderly transition to a market economy with an expanded role for the private sector. The government has renewed its commitment to tackling the toughest economic issues through appropriate policies and a reorganization of government functions, while recognizing the overall risk of attempting radical domestic reforms in the context of an inhospitable international economic environment. It has, therefore, projected a lower growth rate of 7 percent for 2003, and a growth rate of exports that is just one-third of the 2002 outcome.

Recent Economic Developments

Output: The blistering pace of growth of the Chinese economy during 2002 and in the first quarter of 2003 stems from three sources (Table 1). First, as revealed by the 17.3 percent real growth (y-y) of fixed investment in 2002 (and an even higher 25.7 percent in the first quarter of 2003), the economy is receiving a boost from the macroeconomic stimulus program, which is now in its sixth year. The fiscal deficit was 3 percent of GDP, slightly lower than the 3.3 percent deficit of 2001, and was combined with easier monetary and financial policies.

Second, the post-WTO accession effect has played out in increased foreign investment in China, as well as in energizing urban consumer demand for services and some categories of products (such as cars and upscale real estate). Third, the continuing evolution of global cost and demand patterns coupled with the greater access to foreign markets provided by joint venture enterprises re-ignited China's exports, which rose a solid 22.3 percent during 2002. During the first quarter of 2003, they rose by 32.5 percent (y-y).

Sectoral Pattern: The sectoral pattern of this growth is relatively unchanged (Figure 1). However, it should be noted that the performance of the primary sector, mainly agriculture, continues to improve. This is significant inasmuch as 2002 was characterized by poor rainfall, drought, and the first year of liberalized agricultural imports after China joined the WTO. It reflects in part the ability of some farm households to diversify production away from grain to higher value added activities.

Table 1: Basic Economic Statistics

a/ Nominal values b/ World Bank estimate based on Atlas methodology

Source: World Bank and IMF staff estimates and official data

Value-added in industry recorded its highest increase since the Asian financial crisis, led by foreign-funded enterprises feeding the domestic boom in demand for industrial products as well as consolidating production in China for expanded sales in other markets. This strong performance has continued into 2003, with industrial growth during the first quarter of 17.2 percent (y-y). The problem with under-valuation of China's services sector output still exists. While the sector grew by 7.3 percent in 2002, compared to 7.4 percent the previous year, it is believed that some services growth is recorded in the manufacturing statistics, reflecting the high degree of vertical integration of economic activities that exists within Chinese firms, especially the state-owned enterprises (SOE).¹

The shape of industrial production changed noticeably during 2001-2002. On the energy front, two developments are worth noting. First, the rapid growth of industrial production is pressuring conventional energy supplies, despite improved pricing, continuing efficiency in production and distribution of power, and diversification to alternative sources. For the first time since 1997, the electricity supply-demand balance has become worrisome, with 18 provinces facing shortages during 2002. Together with water, the availability of adequate supplies of energy is an important determinant of the long-term growth prospects of China. Recent increases in the domestic prices of diesel and gas, in line with the new formulae that track international price developments closely, suggest that alternatives to make up for electricity supply disruptions may become progressively more expensive for retail consumers. Energy dependence on foreign sources is rising, with 2002 imports of crude oil increasing by 15.2 percent to reach 69.4 million tons equivalent. Second, the closure of nearly 60,000 small coal-mining pits in the past few years is having a favorable impact on productivity. The larger state-owned mines now account for 73 percent of the market (compared to 57 percent five years ago). It is expected that, as a result of the better management that is expected, this will have a favorable effect on reversing China's poor mine safety record and on the environment.

The role of automobile production-an increase of 55 percent during 2002-is receiving a lot of attention. Many analysts and some officials identify this industry segment and its ancillary industries as a potential leading sector in the future industrial development of China. Unfortunately, imports are also rising fast-82 percent in 2002. The population of China is large and growing, and increasingly locating in urban areas. Current and prospective purchase patterns among urban consumers suggest that policies to promote the sector will have to be especially sensitive to the costs of environmental pollution and congestion.

Figure 1: Sectoral Composition of Growth

Source: National Bureau of Statistics

Another focus of attention in the industrial sector is the growth of China's exports of light manufactures and household goods in 2003, which the SARS epidemic centered on Guangdong and Hong Kong is likely to affect. The Pearl River economy accounts for nearly $90 billion of exports and 10 percent of the output of China. Therefore, the recent drop in business travel and purchaser-supplier activity, especially during the crucial April-June period when most business transactions in the contract-manufacturing regime are negotiated, is likely to have adverse effects. This comes on top of the squeeze on profitability in China's export-oriented industries that compete fiercely in a relatively slowly growing global market, especially the textile sector, which faces rising prices for cotton.

Demand: Except for the uncertainties associated with the effect of SARS on the growth of domestic and external consumption, general demand prospects are strong. Fixed investment rose by 17.3 percent in 2002, and a slightly higher rate during the first quarter of 2003. The construction of capital projects, which rose by 16.3 percent, contributed 60 percent of the increase. The effect on investment of five years of macroeconomic stimulus spending is evident in the massive new public construction that has taken place in roads and subsidiary transport facilities, in the expansion of utilities, water conservation, forestry, and other public services. However, direct funding from the budget has supported just 14 percent of this increase in investment. Improved enterprise profitability accounted for a large increase in internal financing, but FDI, financial institution lending, and bonds grew rapidly. For example, the corporate bond market provided much needed financing for the railway and telecommunications sector, as well as for the Three Gorges Project. Total issuance amounted to RMB37 billion from 13 issuers and 17 issues, up 106 percent (y-y). In 2003, 3 corporate bond issues have raised RMB6.5 billion from the market. The newer modes of infrastructure finance that have developed in China in recent years will play a critical role in supporting demand as the government gradually reduces budgetary stimulus measures but, more importantly, will help meet the country's huge demand for development projects. Box 1 discusses some issues associated with infrastructure finance.

The efficiency of domestic investment needs to be raised. China's incremental capital-output ratio (ICOR) of 5, although a crude measure, reflects the dominance of long-gestation infrastructure investments in resource use and the reported lower efficiency of investments made (and largely financed) at sub-national levels. It is likely that over the long term China will be able to generate the same level of growth and possibly higher employment from a lower level of investment. An immediate concern related to demand in the economy is the increase in the domestic savings rate. As shown in Table 1, consumption continues to rise at a slower rate than total income (however measured), despite the macroeconomic stimulus program. Over the past five years, it has averaged an increase of 6.7 percent per year, compared to an income growth rate of 7.6 percent. However, during this period, and especially in 2002, the composition of public spending in the stimulus package progressively has targeted areas that would raise consumption directly. Higher transfers for civil service salaries and other government operating costs, pensions, and rural and low-income programs have been successful in propping up consumption as well as investment. Recent official pronouncements suggest that this shift in composition will continue to occur, with emphasis given to allocations that have a quicker and more powerful impact on demand. The use of public funds and policies to resolve rural distress and public sector payments arrears, and for the creation of a better social security program, should have a favorable effect on domestic demand.

During 2002, on average real urban disposable incomes rose by 13.4 percent, and urban consumption rose by 4.8 percent. By contrast, real rural net incomes rose by 4.8 percent (up from 4.2 percent in 2001), while rural consumption rose by 4.4 percent (up from 3.5 percent the previous year). As shown in Table 2, the trend in urban-rural standards of living continues to be disturbing. Widening urban-rural inequality and its potential to undermine growth and social cohesion suggests that better targeting of government stimulus spending toward lower income groups will have a dual payoff-more powerful short term stimulus and long term growth.

Box 1: Infrastructure Finance

A re-examination of infrastructure finance is underway in China. This stems from several factors-large development needs, highlighted by the Western Region Development program; budgetary pressures, including the need for curbing reliance on extra-budgetary resources for infrastructure construction at local levels; recognition of the complex financial needs of capital projects that cannot always be met by conventional loans, true especially of cases involving private-public or foreign participation; and the promotion of urbanization that, at least in its initial stages, tilts the balance towards infrastructure and away from corporate finance.

There are no precise estimates of the likely demand for infrastructure finance, but some conservative estimates place the total at US$1 trillion equivalent for this decade. In the near-term, bank lending for infrastructure will continue to be dominated by China Development Bank (CDB), which extended US$24 billion to state projects in 2002. During 1998-2002, in the context of the stimulus program, CDB lending represented over 40 percent of total infrastructure loans. The four state-owned commercial banks are also significant lenders. In total, therefore, at end-2002 infrastructure loans accounted for 37 percent of total local currency loans.

However, new forms of infrastructure finance have emerged. In 2002, some institutions (for example, Shenzhen Development Bank, Minsheng Bank) debuted "public entrusted loan schemes" by intermediating funds between, on the one hand, retail investors (minimum participation of RMB10,000) and enterprises (RMB500,000) and, on the other, final borrowers for projects such as water sewage processing and industrial parks. By end-2002, such private and public forms of entrusted loans amounted to only RMB240 billion (compared to bank lending of RMB13,980 billion). However, they are attractive vehicles for investors (average return of 3 percent, compared to 1.98 percent in bank deposits), who look to the commercial banks, official project promoters, and other enhancements as risk mitigation mechanisms that permit them to participate in otherwise complex and non-transparent financial packages for infrastructure investment. This instrument is likely to grow, especially if the roles of commercial banks and project sponsors are clarified and disclosure strengthened.

At the same time, controversy surrounds similar "capital trust schemes" offered by the trust and investment companies, the first of which highlighted in its offering document an estimated 5 percent annual return. Individual schemes are restricted to 200 settler and minimum participation of RMB50,000 per settler. Lax disclosure has marked the offerings of such funds, inadequate due diligence, and unclear guidelines for trust administration. This prompted the central bank to issue a warning in October 2002 about the excessive growth of such instruments and inherent product risks.

Clearly, high demand for infrastructure finance and liberalization of the financial sector will stimulate innovation in this market segment. However, the involvement of less sophisticated investors in public or quasi-public financial products warrants closer market supervision and a robust legal framework. Project finance and risk management skills at financial institutions need to be raised. The rates at which CDB and the state commercial banks are accelerating infrastructure lending will heighten their project finance related risks and exposure to public projects. This exposure is higher than suggested by their loan portfolios; commercial banks hold large volumes of government and CDB bonds that were also raised to support infrastructure investment. Eventually, local governments should be able to borrow directly to meet their infrastructure finance needs, conditioned on strengthening the current system of intergovernmental finance. Private investors can also be tapped, but first require a stronger enabling environment for participating in infrastructure investment.

Table 2: Average Urban and Rural Income and Spending (RMB/year per person) a/

a/ Disposable income of urban residents, net income of rural residents. b/ Estimated

Source: National Bureau of Statistics and World Bank staff estimates.

External demand continues to play an important role in promoting growth and employment. Since the third quarter of 2001 the net effect on demand of foreign purchases of China's exports and Chinese residents' purchases of imported goods has been positive, reversing the trend during 7 of the 10 previous quarters. During 2002, exports rose by 22.3 percent, assisted by a 7.4 percent real effective depreciation of the Renminbi, while imports grew by 21.2 percent. However, imports into the processing trade grew significantly faster than exports, 30.1 percent and 22 percent, respectively. The more rapid increase in imports is no longer restricted to the processing regime-the overall import content of Chinese economic activity has risen in the first year after WTO accession. During the first quarter of 2003 imports rose by 52.4 percent (y-y), compared to an export growth rate of 33.5 percent, partly reflecting accelerated purchases ahead of the anticipated conflict in Iraq. Notwithstanding the momentum on trade, several factors-SARS, dampened global trade-suggest that exports will grow slowly over the next few quarters, moderating China's overall economic growth rate. It is difficult to provide reasonable estimates of China's near-term growth prospects given the high level of uncertainty regarding international trade and incomplete information about the economic policy intentions of the new administration in China. Based on first quarter developments, our projections suggest that GDP growth is likely to slow to the 7-7.2 percent range during 2003.

Macroeconomic Policy

Fiscal-Monetary Policy: The coordination of fiscal and monetary policy, but also the pace of economic reform and creation of a better investment climate, will play a key part in determining short and medium term prospects. Fiscal policy has been an important pillar supporting economic activity in China since 1998. High revenue buoyancy-reflecting reforms in taxation and improved collection efforts-facilitated an expansionary budgetary stance. During 2002, total revenues rose by 15.4 percent and the revenue to GDP ratio rose to 18.6 percent (compared to 11.6 percent in 1997). Despite higher government expenditure, the size of the budget deficit has fallen relative to total output in the economy, from a peak 4 percent of GDP in 1999 to last year's 3 percent. Slower revenue growth is projected for 2003, so the budget deficit is expected to rise as a share of total output to 3.4 percent.

Four issues have resurfaced about the size of the fiscal deficit and continuation of the policy of macroeconomic stimulus. First, the rapid increase in public debt, from 11.4 percent of GDP in 1997 to 25.3 percent in 2002, has kept the question of fiscal sustainability on the front burner. The burden of servicing government debt limits the availability of resources for development spending, especially in the social sectors. However, most analysts agree that the prospects for revenue increases in the future make it highly likely that the current level of budget deficits is sustainable.

Second, despite this, the existence of additional liabilities (contingent, implicit, or hidden, for example, banking losses, pension payments, or local government debt) increases pressures for fiscal consolidation. Obviously, the problem will need to be addressed on several fronts-for example, policies to cut costs and improve operations at banks and to implement social security reforms and a better functioning intergovernmental fiscal system; asset sales to improve the financial position of banks and the social security fund. In addition, the rapid growth of the Chinese economy will create favorable conditions for reducing the size of such liabilities. However, it is equally clear that there will be need for fiscal intervention, albeit phased-in over time to match the resources available in the government budget. For example, under most reasonable scenarios the four state-owned commercial banks would find it difficult to simply "grow" out of their current portfolio problems. The size and nature of a fiscal intervention package to support their own efforts to trim costs and improve lending practices to reduce losses is yet to be determined.

The third issue is concerned with the potential for government borrowing and the need for reform in the government bond market. Total borrowings to cover the budget deficit in 2002 reached RMB593 billion (US$72 billion), of which RMB258 billion was for debt servicing, and RMB25 billion for on lending to local government.² The 2002 borrowing was effected through RMB446 billion of marketable debt and RMB147 billion of non-marketable savings certificates. Despite commendable market building initiatives (for example, appointment of market-makers, desegregation of markets, extension of maturities, fixed rate issues, greater transparency of offerings), under-subscription problems arose for three issues, and government securities turnover stayed at low levels. The essential ingredients for an efficient government securities market are being developed. These include the legal framework, improved sales techniques (market-based pricing through auctions, revised distribution mechanisms, standardization of debt instruments), development of market intermediaries and institutional investors, better clearance and settlement, and effective regulatory and prudential supervision.

Finally, the need for closer fiscal-monetary-foreign exchange policy coordination has been highlighted. Many analysts have argued for an "exit strategy" from expansionary fiscal policy-the need for fiscal consolidation. More active use of monetary policy has been proposed since last year, when the growth of money supply (M2) was raised to 16.8 percent while foreign exchange reserves rose 34.9 percent. There is increasing recognition that the existence of deflationary pressure in the economy makes a further increase in money growth feasible, as it is unlikely to kindle inflation. The CPI shows that prices fell 0.8 percent during 2002, the third year of declining prices since the beginning of the macroeconomic stimulus program in 1998. There has been a small up-tick in prices in the first quarter of 2003 (0.5 percent, y-y). However, it is not clear if this represents anything other than strong demand associated with the Spring Festival holidays and the recent pass-through of international oil price increases to consumers in China. The longer-term decline in prices seems to be broad-based, seen in retail and ex-factory prices as well and, with the exception of fuels and associated products, it has affected the purchasing price index of raw materials. Nevertheless, it is still unclear that the monetary policy transmission mechanism is effective; in fact, there is concern that an easy money policy will further weaken bank portfolios, given the way in which many bank-lending decisions are made.

The one exception to the price developments mentioned above is the trend in real estate prices, which, although subject to substantial local price variations, is strongly upwards. Land prices rose rapidly during 2002, in some areas as much as 25 percent followed by the sales price of houses. There is concern about a real estate bubble developing in the major urban markets. Public entrusted loan schemes and capital trust funds provide niche financing for real estate development, but commercial banks are also important lenders to this sector. An official source stated that as of November 2002, total commercial bank real estate lending and lending against employee housing funds amounted to RMB734 billion (US$89 billion) and RMB113 billion (US$14 billion), respectively. This contrasted sharply with the total of RMB19 billion in 1998. Banks are known to be lax in implementing prudential debt service ceilings on borrowers, which could have severe effects on bank portfolios in the event of an increase in interest rates. Although the risks are less apparent now, given the historically low interest rates in the economy, they will multiply fast during a period of general recovery. In December 2002, the central bank cautioned domestic banks to control their real estate lending in order to control systemic risks in the banking system. A task force has been established to examine post-June 2001 commercial bank lending for real estate development.

External Payments: A strong trade performance is only one of several factors that accounted for China's robust external payments position in 2002. Still, it is worth noting some characteristics of trade last year. First, although global trade volumes rose by an anemic 2.7 percent last year, compared to 12.9 percent in 2000 and 0.6 percent in 2001, China's exports rose strongly, recording double digit increases to all regions, and especially strong in light engineering and durable consumer goods. Consequently, China's share of world markets rose to 5.1 percent. Second, there was a massive increase in imports from neighboring countries, putting to rest for the time being at least the idea of an emerging "China threat". China's imports from ASEAN rose by 34.4 percent and those from Japan and Korea rose, respectively, by 25 percent and 22.2 percent. Third, the rise of component imports was associated mainly with the actions of multinational enterprises, many of which have either expanded or relocated their finished goods production facilities to China. The composition of such trade during 2002 indicates the emergence of the type of production networks likely to develop in the post-WTO accession period.

The last of these elements is linked closely to the actions of foreign investors in China. During 2002, China emerged as the leading destination for FDI, absorbing US$52.7 billion in inflows, a 12.5 percent increase over the previous year. They combined with the strong trade performance to raise foreign exchange reserves from US$212.2 billion in 2001 to US$286.4 billion in 2002, which provides nearly 12 months of import coverage. External sector vulnerability is low, with short term debt (remaining maturity basis) estimated at 25 percent of the total. Total external debt reached US$191 billion at end-December, and external debt servicing is at 6% of exports. The nominal exchange rate has been stable although, as mentioned earlier, the real effective exchange rate depreciated by 7.4 percent during the year.

Structural Agenda

Several significant political events have occurred in China since our economic update of September 2002. A new administration took office in March 2003, followed by a smooth, even routine, transition of personnel from lower to higher offices at central and provincial levels. Earlier, in October 2002, the 16th Party Congress of the CPC effectively transferred political power from the so-called "Third Generation" of leaders to the "Fourth Generation".

As expected, such momentous changes offered several opportunities for stocktaking on the economy. While stressing the continuity of general economic policies, the discussions identified new challenges or approaches that will be taken up in the future. It is still too early to comment on the direction that economic policies are likely to take in the future, except to point to China's excellent record of accomplishment in this respect. However, this economic update highlights two elements of the policy agenda that are worth monitoring carefully.

The first of these relates to the connection between better management of state assets, ownership transformation, and private sector development. At its base, the new strategic guidance provided by the Party Congress in October and the March reorganization of government departments' signals a supportive stance towards the private sector. In ideological terms, the CPC explicitly undertook to "protect all legal labor income and legal non-labor income", and expressed its firm support to the coexistence of public and private ownership.

At the same time, specific decisions were made regarding the institutional framework in which the government will exercise its ownership rights in the 170,000 plus state owned enterprises (SOE) that exist in China today. A State Assets Supervision and Management Commission have been established under the State Council. It will absorb the relevant functions of the erstwhile State Economic and Trade Commission, the CPC Central Committee Enterprise Working Committee, and the Ministry of Finance. It will focus on the management of Central government SOE, excluding financial institutions and other state assets such as public services units, land, and natural resources.

Clearly, strengthening the performance of SOE, ownership transformation, and development of the private sector form a policy continuum. The government has periodically declared its intention to withdraw from many commercial segments of the economy, including the aborted program to sell shares in SOE through the securities market. In 2002, the government enabled the sale of state ownership stakes to foreign investors, domestic private investors, and to the existing managers of SOE. The last of these has proved to be contentious (including in discussions at the CPPCC and NPC), not least because of the involvement of financial institutions under less-than-transparent conditions. In general, though, streamlined management of the SOEs should increase asset values, which will yield economic benefits not only while such assets are under state ownership, but also at the point of sale to effect ownership transformation.

The second aspect of the strategic agenda that will be highlighted in this update is related to the above, but should be seen in the broader context of the current reappraisal of human development policies in China. The concept of a xiaokang (comfortable, or well-off) society that has been articulated as a proximate target for China's economic thrust until 2020 includes a stronger sense of economic and social equity than has ever been articulated since the beginning of reforms in 1978. The new administration has signaled its intention to pursue equity more vigorously, building on China's successes, recognizing weaknesses in past policies, but also addressing issues within a framework that is consistent with the thrust towards resizing government and promoting private sector participation. Thus, for example, the new Law on Promoting Private Education (December 2002) recognizes the potential of the private sector to satisfy the increasing demands for education, commensurate with the rising premium on skills in the Chinese economy.

Figure 2: Price Developments

Source: National Bureau of Statistics

The main purpose of the Law is to integrate the private sector into the formal system by creating an environment that is supportive of institutions and individuals interested in establishing private educational institutions. In addition, a related pilot experiment in Changxin county in Zhejiang province is experimenting with an education voucher system to broaden the choice that students will have in selecting private schools. Preliminary assessments of this program show that equity in educational opportunities has increased, even as enrolments have risen in the entire school system within the county. A similar pilot has been in existence in Ruian city in Henan province, again with favorable results.

This is not to suggest that China's public sector is turning its back on human development. On the contrary, the strategic thrust is toward broadening the range of instruments deployed to reach the country's important goals in this area. This involves a fundamental reassessment of many of the weaker public sector programs. A case in point is the new policy for rural health, detailed in October 2002 by the CPC Central Committee and State Council in its documents on Strengthening Rural Health Work.

Until the mid-1980s, the health care strategy of China focused on prevention and public health, the use of minimally trained personnel to provide basic health services and community financed services. Progress in health indicators, including infant and maternal mortality and life expectancy, was substantial. However, despite overall economic growth and poverty reduction, the health system in rural areas has deteriorated over the past two decades, and health conditions have stagnated in rural areas. Medical services and drugs are unaffordable to many segments of the rural population.

The new policy is intended to address this problem, mainly by improving the system of financing rural health care at different levels of government, the introduction of a rural health insurance scheme, and increased targeted transfers for health to the poor and vulnerable groups. Some of the new initiatives have been piloted, and it is likely that the model insurance schemes will require the participation of non-government service providers. There are big challenges ahead for rural health care. However, the government's willingness to address them offers useful insights into the kinds of policy initiatives that are under consideration today.

Notes:

1. For over a decade, the contribution of the sector to total value added has been frozen at about one-third. However, services have absorbed about 7.9 million people per year in productive jobs that have at least three times the average productivity of jobs in agriculture (which is the main source of labor transfer to services). There has been an explosion in consumer and producer services over the past decade, which is visible, even to the casual observer.

2. Cumulative borrowings since the start of the macroeconomic stimulus program in 1998 have reached RMB2.34 trillion (US$283 billion). Borrowings so far in 2003 have amounted to RMB147 billion, out of a planned level of about RMB600 billion for the whole year.

(China.org.cn April 25, 2003)