Public Information Notice No. 05/122

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the People's Republic of China

September 12, 2005

On August 3, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the People's Republic of China.¹

Background

China's rapid economic growth and integration into the global economy continued apace. GDP grew by 9½ percent in 2004 and in the first half of 2005, while its composition shifted as investment growth moderated somewhat and the contribution from net exports increased. Retail sales growth remained robust, suggesting continued strong consumer demand. After peaking at 5.3 percent (year-on-year) in the third quarter of 2004, inflation declined to 1.8 percent in July 2005, largely due to a reversal of food price increases as agricultural production rose.

The external current account surplus rose to US $69 billion (4¼ percent of GDP) in 2004, as export growth remained strong throughout the year, while import growth slowed, reflecting some moderation in investment and an increase in the supply of some domestic import substitutes. China's trade balance strengthened further in the first seven months of 2005, with exports increasing by 32 percent (year-on-year), while imports grew by 14 percent. A larger external current account surplus, together with strong capital inflows, led to a further sizable increase in gross official reserves. Reserves increased by US $207 billion in 2004 and by a further US $101 billion in the first half of 2005 (excluding US $15 billion in reserves used for bank recapitalization), bringing the level at end-June to US $719 billion. While FDI inflows (mainly from Hong Kong SAR, Korea, and Japan) remained strong, a substantial part of the reserve accumulation over this period was accounted for by net non-FDI capital inflows (including errors and omissions) largely attracted by the prospects of a renminbi appreciation.

During 2004, the authorities took a number of steps to tighten macroeconomic policies. The People's Bank of China (PBC) raised the reserve requirement ratio and short-term re-lending and rediscount rates, increased bank deposit and lending interest rates, and eliminated the ceiling on lending rates. These measures were supplemented with guidance provided by the PBC and the China Bank Regulatory Commission to influence banks' lending decisions. As a result of these measures, and restrained lending by the three large state-owned banks that have been recapitalized, broad money growth declined to 15.7 percent and loan growth to 13.2 percent by June 2005, down by around 4 and 7¾ percentage points, respectively, from their growth rates in 2003. Nevertheless, considerable liquidity remains in the banking system, reflected in the still high excess reserve ratio and low interbank interest rates. On the fiscal side, the deficit fell to 1½ percent of GDP, about one percentage point of GDP below its targeted level in the 2004 budget and the actual outcome for the deficit in 2003. This was helped by strong revenue overperformance, about half of which was used to finance increases in social expenditure and subsidies and to clear up old government liabilities, including arrears on VAT refunds to exporters.

Real GDP growth is projected to slow slightly during the year and to average around 9 percent in 2005, assuming that appropriate macroeconomic policies will be in place to further slow investment growth. The external current account surplus is expected to increase 2 percentage points to 6 percent of GDP, mainly reflecting strong export growth and lower import growth. Inflation should average around 3 percent in 2005, as slower food price increases will likely be partially offset by a rise in non-food prices as some of last year's rapid producer price increases is passed through to consumer prices and certain administered prices are raised. A significant risk remains that, as large capital inflows add liquidity to the banking system, macroeconomic policies would need to be tightened further if investment growth rebounded. Protectionist sentiments in some of China's trading partner countries have increased in recent months, particularly after textile exports from China to these countries grew sharply with the end of the quota system. A further intensification of such sentiments could adversely affect exports. Moreover, a disorderly unwinding of global current account imbalances would also threaten China's growth, as economic activity in all countries would likely suffer lingering adverse effects.

China has continued to implement a broad range of structural reforms. In the banking sector, progress has been made in strengthening supervision and improving bank operations, especially in the three large state-owned commercial banks, which have been recapitalized. State-owned enterprises have become more market oriented and corporate and management restructuring has continued. A number of steps also have been taken in line with China's WTO commitments, including further tariff reductions that lowered the unweighted average tariff rate by half a percentage point to 10 percent in 2005.

Executive Board Assessment

Executive Directors commended the authorities for the success in sustaining high economic growth rates and for their efforts over the past year to guide the economy toward a soft landing. While recent data suggest that growth has shifted away from investment toward consumption and exports, and inflation has come down, the risk of a rebound in credit growth and investment calls for continued vigilance, given the considerable liquidity already in the banking system. Directors noted that medium-term prospects are generally favorable, although oil price volatility, a disorderly resolution of global imbalances, and trade restrictions against China could pose potential challenges for the authorities. They stressed that appropriate policy responses and continued implementation of structural reform, particularly in the financial sector, public finances, and the labor market, will help establish a solid foundation for China's further integration into the global economy and improve living standards and income distribution across regions.

In view of the need to ensure that the pace of investment and credit growth remains in check, Directors generally considered that steps should be taken to drain more of the excess liquidity out of the banking system through open market operations. Moreover, the authorities should stand ready to take other policy actions, including increases in interest rates and reserve requirements, if investment and lending show signs of resurgence. A few Directors recommended a cautious approach to further tightening, particularly given evidence of excess capacity in certain sectors. Directors also noted that the effectiveness of monetary policy would be greatly enhanced by granting the People's Bank of China more discretion over interest rate policy. They recognized that administrative measures remain necessary and effective for curbing credit growth in certain sectors, given the stage of China's financial sector development. Nevertheless, Directors called on the authorities to gradually increase reliance on market-based instruments. Enhanced supervision of bank lending and strengthened prudential rules should also help keep near-term credit growth in check and enhance overall financial stability.

Directors noted that the widening current account surplus over the past two years, combined with continued strong capital inflows, has led to a large build-up in international reserves and has complicated the conduct of monetary policy. Against this background, Directors welcomed the change in the exchange rate regime—an important move toward greater exchange rate flexibility—and encouraged the authorities to utilize the flexibility afforded by the new arrangement. Noting the difficulty in assessing with a reasonable degree of confidence the "equilibrium" exchange rate for China, they agreed that a more flexible exchange rate, not simply a revaluation, is key to providing scope for monetary policy independence and enhancing the economy's resilience to external shocks. Going forward, many Directors supported a gradual, cautious approach to further increasing exchange rate flexibility, in order to coordinate such steps with financial sector reforms and capital account liberalization, and to allow time for the economy to adjust and for market-based instruments to be developed further. However, a number of other Directors recommended that the authorities allow the exchange rate to move more quickly toward a level that better reflects underlying market forces.

Directors emphasized that greater exchange rate flexibility is in China's best interest. They also considered that, as correcting global imbalances is a responsibility of all the major countries, China's move toward greater exchange rate flexibility would contribute directly to that process, as well as indirectly by facilitating greater exchange rate adjustments in other Asian countries.

Directors agreed that the likely outturn of the 2005 budget is broadly appropriate. They welcomed in particular the shift in expenditure from investment to social spending, and urged further reallocation in this direction to help constrain investment growth while increasing much needed spending on health and education. Directors encouraged the authorities to save any revenue overperformance that accrues to the central government, thereby helping to restrain domestic demand.

Directors supported the authorities' aim to continue fiscal consolidation over the medium term in order to keep debt at sustainable levels while meeting growing demands on public funds, including potentially large contingent liabilities. Most Directors encouraged further significant cuts in the nominal deficit target when conditions permit, and saw scope for such a reduction in the 2006 budget, on the expectation that revenue would continue to overperform relative to the budget projection and that all outstanding arrears on VAT refunds would be cleared in 2005. A few Directors cautioned that the need for further fiscal consolidation should be weighed against China's large infrastructure and social spending needs.

Directors emphasized that fiscal consolidation should be accompanied by strengthening the structure of the public finances, reforming the tax system, and addressing structural imbalances in subnational finances, including by clarifying expenditure responsibilities and reforming the transfer system to move toward a more rule-based equalization system. The central government should also make adequate resources available to local governments to fund existing pension and other social liabilities. Fiscal management should be strengthened further, particularly by adopting a revised budget classification system and expanding the coverage of the treasury single account.

Directors welcomed the focus being placed on financial sector restructuring to improve intermediation of China's large private savings. They welcomed in particular the progress made in three of the four large state-owned commercial banks, and urged that a restructuring plan be formulated for the Agricultural Bank to ensure the health of the banking system. Directors emphasized the need for all banks to strengthen their balance sheets, and improve their commercial orientation, risk management, internal controls, and governance. They welcomed the liberalization of lending rates, which was an important step taken by the PBC to help develop the banking sector and encourage banks to improve the pricing of risk. Further efforts are needed to eliminate the involvement of government in bank management and business operations. Diversifying bank ownership could bring much needed technical expertise and enhance governance.

Directors commended the China Bank Regulatory Commission for the progress in improving bank supervision. Further efforts will be needed to ensure that all banks can comply with capital adequacy requirements with full provisioning as required by existing guidelines. Directors stressed that the adoption of a new bankruptcy law that provides sufficient protection to creditors and allows for an adequate market mechanism to facilitate liquidation will be important for resolving existing and future non-performing loans in an orderly manner. Directors welcomed China's decision to participate in an FSAP and looked forward to an early assessment. They welcomed the authorities' commitment to curb money laundering and combat the financing of terrorism, and looked forward to the enactment of comprehensive legislation that is consistent with the core recommendations of the Financial Action Task Force.

Directors supported the plans to accelerate the development of bond and equity markets. They noted that a key first step would be to eliminate the current system of government approval for corporate bond issuance, and replace it with a more market-oriented system based on disclosure of operational and financial information for issuing firms. In addition, removing the cap on corporate bond interest rates would allow proper pricing of such bonds. It is also important to limit the use of public resources to protect investors, which could lead to moral hazard.

Directors observed that state-owned enterprises (SOEs) have become more market oriented, with corporate and management restructuring and increased foreign ownership. Nevertheless, additional reforms are still needed to ensure their long-term viability. Directors urged the government to exercise stronger governance over the SOEs. Strengthening the ownership role of the State Asset Supervision and Administration Commission and requiring profitable SOEs to pay dividends to the government are essential to focus enterprises more on increasing their net worth.

Directors welcomed improvements in the quality of economic statistics, but noted that incomplete data in several areas still hamper the monitoring of macroeconomic developments. A continuing priority for further improvement is the compilation and timely publication of annual and quarterly real GDP data on an expenditure basis. Directors encouraged the authorities to make full use of Fund technical assistance to improve balance of payments statistics and ensure that the reporting of data on the international investment position is completed as soon as feasible.