Over the past five years, external demand for China's output has been affected
by the shocks of the Asian financial crisis (1997-98) and the global economic
slowdown (2001). In addition, the increasing pace of corporate reform as well
as weak rural income put downward pressure on domestic consumption and investment.
In the face of weakened external and domestic demand, the government engaged
in expansionary fiscal and monetary policies to sustain growth and job creation.
Consequently, the economy managed to maintain an average growth rate of 7.8
percent over the period 1997-2001.
Expansionary fiscal policy, especially an increase in government infrastructure
spending, continued in 2002. The government has also raised civil servants'
pay from July 1, 2002, the fourth hike after those in 1999 and 2000 (twice).
These stimulative measures have contributed to maintaining growth in domestic
demand. Monetary policy has also been broadly stimulative throughout the past
five years. Interest rates were reduced in successive steps in 1998 and 1999.
In February 2002, the People's Bank of China (PBC) reduced interest rates by
another 0.5 percentage points, and in May, it raised the target growth rate
for M2 from 13 percent to 14 percent.
By August, it was clear that China's economy had regained its growth momentum.
This was due to the combination of an increase in external demand resulting
from the moderate recovery in the global economy and expanding foreign direct
investment, as well as the effect of the domestic stimulative measures. However,
deflation, which had re-emerged in September 2001, continued throughout 2002.
Output and Expenditure
GDP growth accelerated from 7.3 percent in 2001 to 7.6 percent and 8.0 percent
in the first two quarters of 2002. Industry was the key engine of growth, with
output increasing from 8.7 percent in 2001 to reach 9.3 percent and 9.9 percent
in the first two quarters of 2002. Manufacturing output increased from 9.9 percent
in 2001 to 11.7 percent in the first half of 2002. Indicative of the foreign
direct investment (FDI) and export driven growth, output of foreign funded enterprises
rose by 12.2 percent in first half of the year and accelerated to 14.1 percent
in July. The services sector, which had slowed from 7.4 percent in 2001 to 6.2
percent in 2002 Q1, turned around to grow robustly by 7.0 percent in Q2. On
the other hand, growth in agriculture, which had increased from 2.8 percent
in 2001 to 3.3 percent in 2002 Q1, fell to 1.9 percent in Q2. This was due partly
to the effect of the spring drought, which resulted in a 2.9 percent decline
in summer grain production.
Reflecting the effect of stimulative fiscal policy, total fixed asset investment
rose substantially from 12.1 percent in 2001 to 21.5 percent in the first-half
of 2002. Investment by state owned enterprises and foreign funded enterprises
were particularly strong. Overall, the bulk of public investment was contributed
by the local authorities, rising by 30.9 percent compared to the 1.2 percent
increase in central government investment. Moreover, in line with the government's
focus on the less developed regions, investment growth in capital construction
was particularly strong in Gansu, Guizhou, Shaanxi, Hunan, Jiangxi, Inner Mongolia
and Shanxi, rising 25-50 percent, compared to the national average of 23.6 percent.
Property investment, which rose 33 percent in the first-half, accounted for
about a quarter of total fixed asset investment. Property sales reached about
7.5 percent of GDP. There was an also significant linkage to the financial sector
through loans to the construction sector, property developers and households.
Housing mortgage loans had reached RMB 650 billion by June 2002, accounting
for about 10 percent of the total stock of outstanding loans of all financial
institutions. Property prices have been rising rapidly, with prices in Shanghai
increasing by 30-50 percent over the past year. This was substantially boosted
by speculative demand, which was estimated by the market to account for over
20 percent of the purchases. Indicative of the rapidly increasing supply, the
ratio between newly commenced constructions area to area sold rose sharply during
the first half of 2002, to 3.5 in Beijing and 1.9 in Shanghai. Concerned about
risks of property market bubble, six government ministries jointly issued a
circular in August 2002 to tighten the supply of land as well as to control
new property projects by developers with poor financial standing. There is still
little sign that the rural-urban income gap is narrowing. Urban incomes rose
by 17.5 percent in the first half, compared to 8.5 percent in 2001. Over the
past 30 months, income growth in the rural areas has strengthened too-rising
from only 1.9 percent in 2000, to 4.2 percent in 2001, and again to 5.9 percent
in the first-half of 2002-but lags behind urban income growth by a significant
margin. Indicative of the weaknesses in net income and the weakening domestic
terms of trade for farmers, rural retail sales continued to fall, declining
from 8.3 percent in 2000 to 7.7 percent in 2001, and further to 6.7 percent
in the first half of 2002. By contrast, nominal retail sales in urban areas
registered an increase from 9.3 percent in 2001 to 10.1 percent in the first
Prices, Wages and Employment
Both consumer and producer prices continue to decline. After falling by 0.6
percent in the first quarter, the CPI fell by a larger 1.1 percent in the second
quarter. However, the monthly trends indicated that deflation could be abating,
with the decline moderating to 0.9 percent in July. Producer prices declined
by a smaller 1.7 percent in August, compared to the 2.3 percent fall in July,
and the 3.4 percent drop in the first six months of the year. A part of the
decline in prices was likely the result of rising productivity in the industrial
sector. However, a significant contributory factor was the effect of excess
supply. Inefficient SOEs, facing soft budget constraints and with supporting
loans from the state commercial banks, have continued to cut prices aggressively
to clear inventories. In addition, the support of local governments to local
enterprises was a contributing factor in excess production. Apart from excess
supply, the sustained deflation was also partly due to the recent global commodity
prices decline, as well as the WTO tariff reduction effect. In particular, import
tariffs (weighted average) declined from 9.1 percent in 2001 to 6.4 percent
in early 2002.
Employment continues to decline in the state owned units and urban collectives.
Based on administrative records, the number of employees within state owned
units fell from 81.0 million at end-2000 to 76.4 million at end-2001. In the
first half of 2002, it fell by a further 1.2 million. Employment in urban collectives
declined by 2.1 million in 2001 and a further 0.3 million in the first half
of 2002. However, since late 2001, the rate of retrenchment in the state owned
units and urban collectives appeared to have moderated, especially compared
to the period 1997-2000. Jobs were created in the other non-state owned sectors.
Based on administrative records, which are incomplete (as they exclude the smaller
private and informal sector), employment in the non-state sector rose from 20.1
million at end-2000 to stabilize at 22.2 million at end-June 2002.
Job creation continues to be at the top of the national policy agenda. This
was re-emphasized in September at a major national employment conference. An
emphasis on job creation by private businesses, labour-intensive industries
and the services sector was stressed. This urgency in job creation is likely
to lead to policies facilitating greater access of the private sector (both
local and foreign) into hitherto closed sectors like telecom, finance, power,
transportation, media and tourism. Domestic private businesses are also likely
to gain greater access to capital, both from the state commercial banking system
as well as the stock market.
Fiscal policy has played the main role in priming the economy over the past
five years. It continued to play an important role in the first half of 2002.
Total revenue grew by 9.2 percent while expenditure increased by 17.8 percent.
The slower increase in revenue, compared to the 23.1 percent recorded in 2001,
resulted from sharply lower corporate income tax as well as a substantial decline
in tariff revenue and stamp duty. The growth rate of corporate income taxes
(14.6 percent of tax revenue in 2001) fell from 47.2 percent in 2001 to 11.7
percent in the first half of 2002, and of value added taxes (36 percent of tax
revenue) from 19 percent to 11.5 percent. Tariff revenue (5.6 percent of tax
revenue) fell by 26 percent and collections of stamp duty (1.9 percent of tax
revenue) declined by 65 percent, resulting largely from the rate cut from 0.4
percent to 0.2 percent in November 2001 as well as the fall in the stock market.
Increased expenditure for capital construction (46.4 percent), culture, science,
education and healthcare (27.4 percent), pension and social security funds (41.4
percent) as well as government administration (25.6 percent) accounted for the
sharp rise in government spending. The government is issuing RMB 592.9 billion
in Treasury bonds this year to fund spending as well as an additional RMB 150
billion in special bonds to finance public works. Preliminary estimates indicated
that expenditure has increased beyond the estimated 11 percent in the budget,
while revenue collection has also fallen short of the projected increase of
10 percent. Consequently, maintaining the fiscal deficit below the target of
RMB 309 billion, or 3 percent of GDP for the year, represents a challenge.
In view of the slowing tax revenue collection and rising expenditure, there
is increasing pressure to reduce tax evasion, especially by private firms, foreign
funded enterprises, state owned enterprises in some key industries as well as
high income individuals. The personal income tax amounted to only RMB 71.6 billion
in 2001, or about 4.4 percent of total fiscal revenue, a comparatively low ratio
by international standard. Over the past several months, the tax authority has
launched a campaign against tax evasion by private firm owners and high-income
individuals, particularly celebrities, entrepreneurs and high profile athletes.
Some cases have been brought to court, resulting in major headlines in the local
At a recent fiscal policy conference, the government announced its intention
to maintain the deficit target for this year; it is likely, however, to be breached
if present trends continue. Spending on government administration, education,
science and healthcare, pension and social security funds are difficult to cut
in the short run. Consequently, for the second half of the year, state investment
especially by SOEs and the public sector could bear the brunt of adjustment
and the rapid growth of fixed asset investment could moderate.
As at end June 2002, external debt reached US$ 169 billion (13.5 percent of
GDP) of which 31 percent was short-term debt. The debt service ratio was about
7.3 percent. Official data on the stock of explicit government debt (including
bonds issued in 1998 to recapitalize the four state owned banks) was relatively
low at 25 percent of GDP at end 2001. However, quasi-fiscal liabilities could
increase the public debt to GDP ratio substantially. This would include contingent
liabilities associated with potential loan losses in the banking sector as well
as the potential cost of the pension system reform. Consequently, medium term
fiscal sustainability continues to require judicious management of the trend
in the fiscal deficit, accompanied by state asset sales, and SOE and banking
reform, especially by reducing the potential for new non-performing loans.
As a result of banking reform and strengthened financial risk control, the
growth of credit continued to slow. Outstanding loans rose by 12.2 percent in
the first half. On the other hand, outstanding deposits increased by 16.5 percent.
In particular, outstanding deposits of the household sector increased by 17.4
percent. Consequently, the loan-deposit ratio continued to fall from 80.3 percent
in 2000 (end period), to 78.2 percent in 2001 and further to 76.8 percent by
end June 2002. State commercial banks (SCB) have been cautious about lending,
preferring to place funds in deposits at PBC or buy government bonds, rather
than extend credit to the corporate sector.
Concerned that the slowdown in SCB lending could aggravate the deflationary
trend, PBC adopted several stimulative measures during the first half of the
year. In February, the PBC cut interest rates, with the one year lending rate
reduced by more than 0.5 percent point to 5.3 percent. This was the first reduction
since mid 1999. In May, the target growth rate for M2 for 2002 was raised from
13 percent to 14 percent. In addition, the PBC issued directives to commercial
banks, urging them to boost lending to consumers and the SME sector. However,
in view of the turnaround in growth since the second quarter, particularly the
rise in domestic and external demand, the third quarter meeting (in July) of
the Monetary Policy Committee of the PBC has suggested keeping interest rates
unchanged in the near term. The focus has been redirected towards tackling structural
problems of the financial system.
The monetary base increased by 17.1 percent in the first half as a result of
central bank intervention to stabilize the RMB. This was largely due to continued
trade surplus coupled with the effect of robust inflow of FDI. Consequently,
foreign reserves rose by US$30.6 billion in the first half, to reach US$242.8
billion by end June.
With moderate recovery in the US economy, as well as the significant increase
in FDI over the past two years, exports expanded by 19.4 percent in the first
nine months of the year. Imports also rose by a more modest 13.2 percent, and
show signs of accelerating in tandem with strong FDI inflows. Actual FDI continued
its upward trend, rising by 20.7 percent in the first seven months to reach
US$30.6 billion. Contracted FDI also rose by 32.9 percent to reach US$55.4 billion.
The trade balance registered a surplus of US$ 15.5 billion over January-July.
This appears to herald a new phase of export expansion. The key driver is the
rising confidence of foreign investors resulting from WTO accession, as well
as the relocation of manufacturing production from US, Japan, and EU to China.
The price decline in manufactured products and margin-squeeze around the world
has encouraged companies to shift their production base to low cost locations
such as China. This structural factor accounts for the expansion of Chinese
exports at double-digit rate while the global economy was slowing down. This
is confirmed by econometric estimates which indicate that over and above the
effect of output growth in the US, FDI inflows have a significant effect on
China's export growth, particularly of exports to the industrial country markets,
and exports to all destinations of electronics and telecom equipment.
In addition, export growth has been boosted by the increasing participation
of the domestic private sector in direct exports, as well as the rising competitiveness
from a weaker RMB on an effective exchange rate basis. The nominal effective
exchange rate depreciated by 6.1 percent in 2002H1, while the real effective
exchange rate fell by a larger 7.2 percent.
Presently, the key engines of growth are public sector fixed asset investment
and expanding external demand, driven by rising FDI and export. Private consumption
spending and private investment have yet to become self-sustaining to take over
as key independent engines of growth. In addition, as many SOEs consolidate
or are increasingly facing harder budget constraints as state commercial banks
restructure, easy bank loans would be curtailed. Hence, private investment (domestic
or foreign) increasingly would need to fill the void. Consequently, the removal
of all barriers to facilitate private sector development would be crucial for
expanding private investment as well as creating new jobs and sustaining private
The support from external demand, particularly the structural increase in export
growth driven by FDI relocation and global out-sourcing is likely to be sustained.
However, the cyclical weakening of the US economy, the potential for instability
in the Middle East, as well as surging oil price cast a cloud over export growth
over the next 12 months. Presently, 56 percent of China's oil import are from
the Middle East, especially Iran, Saudi Arabia, Oman and Yemen. Some estimates
indicate that a sustained increase of US$5 in oil price would lead to a fall
of 0.4 percentage point in China's GDP growth. More significantly, unsettled
conditions in the Middle East could lead to rising uncertainty, with detrimental
effects on private investment, consumption, and the financial market throughout
the major OECD countries.
On present trends, the government might need to slow down spending on fixed
asset investment due to budgetary considerations. While surging FDI and export
can help to cushion the economy, international market conditions might compel
the government to continue spending to sustain growth momentum. On balance,
it is likely that the macroeconomic agenda for the new administration that is
expected to be introduced following the 16th Party Congress in November and
the National People's Congress meeting early next year will continue to reflect
the need for balancing fiscal consolidation with the urgent need to support
domestic consumption (especially in rural areas) and employment.
Profitability recovered around May, after a sharp decline in the first quarter.
By end-August, the accumulated profit of all industrial enterprises was 10 percent
higher than last year. However, the profit of state owned and controlled enterprises
was still 4.1 percent lower than last year.
Social stability has become increasingly a binding constraint to the reform
of the corporate sector. In early 2002, there was worker unrest in Daqing, Helongjiang
province and other northeastern cities. This could have influenced policy making;
for example, the proposed NPC reading of the new bankruptcy law was postponed
to next year. Reflecting rising social pressure, government spending on social
security has grown substantially in the past few years. Total expenditure on
"minimum living allowance" rose from RMB0.2 billion in 1998 to RMB4.6
billion this year. Central government expenditure on social security had also
risen from 1 percent of total budget expenditure in 1997 to an expected 6.3
percent in 2002. However, Despite mounting social pressure the general direction
of reform has been maintained. In some cases, reform has even gained greater
momentum. In particular, ownership transformation in the corporate sector continued;
AMCs have been active in disposing NPLs and initiating corporate restructuring.
By June 30, 2002, the four AMCs had disposed NPLs with face value of RMB 210.4bn
and collected RMB45.4bn in cash. The cash recovery rate reached 21.6 percent.
With WTO accession, China is speeding up the process of opening its SOEs and
financial institutions to foreign ownership. SETC has been working on a new
regulation expected to facilitate the merger and acquisition of large SOEs by
foreign multinationals. During the Central Financial Working Conference in February
2002, a decision was taken to "allow foreign and private investors to acquire
debts, equities and physical assets held by AMCs in accordance with relevant
regulations". In June, two CSRC regulations were released to allow the
establishment of fund-management joint ventures between Chinese and foreign
firms. BNP Paribas Peregrine set up China's second JV investment bank in late
February. Its key partner was a Wuhan based securities company, with Haier as
a key shareholder. In the meantime, a new version of "Instructive Directory
for Foreign Investment" was published in February by SDPC, SETC and MOFTEC,
and took effect from April 1. The directory was revised in line with China's
WTO commitments. Among 371 items, the category of "encouraged" expanded
from 186 to 262, while the category of "restricted" fell from 112
Ownership transformation continued domestically, particularly at the local
level. An official from Shenzhen municipal government confirmed that the government
was going to sell up to 49 percent of the ownership of its urban transportation
group. The sale would be open to foreign and domestic private investors. An
SDPC document entitled "Opinions on Promoting and Guiding Private Investment",
highlighted the determination of the authorities to promote private sector development.
It spelled out the following policies: (i) encourage and allow entry of private
investors to all areas that are open to foreign investors; (ii) private investors
investing in areas where preferential policies are available are also entitled
to the same set of preferential policies; (iii) securities regulatory agencies
and state owned banks must treat private investors in an equal manner; (iii)
certain kinds of tax holidays should apply to support private firms in their
Corporate governance reform in China is gaining momentum. With increasing awareness
among policy makers, corporate governance reform has been high on the agenda
of the government. CSRC and SETC have implemented corporate governance inspections
on listed companies, with a special focus on the behavior of state owned controlling
shareholders. The China Association of CPAs had also issued an "instructive
opinion" on internal control of accounting firms, as part of its ongoing
efforts to raise the quality of services of the accounting industry. In an attempt
to speed up the development of the market for corporate control, CSRC published
a draft regulation on merger and acquisition in the stock market for public
comments and suggestions. In addition, Shenzhen Stock Exchange had set up rules
for transactions involving more than 500,000 shares, to encourage the development
of market for corporate control. In late March, CSRC set up a "Reorganization
Review Committee" to check irregularities in the re-organization of listed
company involving substantial acquisition, sales and swap of assets.
NPC vice chairman Cheng Siwei announced that the existing Securities Law would
be amended in 2-3 years. The NPC Standing Committee reviewed the long delayed
Investment Fund Law recently. The latest revision deleted many controversial
parts of the draft to make it acceptable to all relevant parties. Amendment
of the Company Law and the Insurance Law has also been put on NPC's agenda.
Despite successive interest rate reductions and steady growth rates in monetary
aggregates, the growth of domestic credit slowed during the past year. This
has been viewed by many as insufficient to sustain economic growth at a desirable
rate, and a debate was triggered on the effectiveness of monetary policy.
Reduced credit growth should come as no surprise as the authorities are strengthening
regulatory rules, including those pushing commercial banks to reduce non-performing
loans. All state commercial banks have reported NPL reduction by around 3 percentage
points in the past year. This phenomenon is consistent with experience of most
countries, which have gone through financial restructuring and transition from
centrally planned to market economies. In such circumstances, money multipliers
decline and become unstable and monetary policy becomes less effective and its
impact less predictable. Even if monetary aggregates continue to grow, banks
may be investing new funds mainly in government securities and other safe assets
while cutting credit to firms. This was exactly what is happening with Chinese
banks. In this process, SME are often the most severely affected. Without structural
changes, the effect could become more pronounced. However, despite the near
term impact on growth and access to credit by small firms, reduced credit growth
is a signal that the banks might be changing their methods of credit risk management.
This is a necessary and urgent reform in China. But experience suggests that
getting through this phase can take many years.
Consistent with the stated sequencing strategy for interest rate liberalization,
i.e., to liberalize interest rates in rural before urban areas, but also to
curb continued flow of funds out of rural areas, rural credit cooperatives (RCCs)
in 8 counties were selected for participation in a pilot project on further
expansion of the margin of float above regulated interest rates. This pilot
covered both deposit rates and lending rates. Deposit rates could go up 20 percent
(in certain instances 50 percent) and lending rates could go up by 70 percent
(in certain cases 100 percent) above regulated rates. It is believed that this
experiment will be expanded further if the authorities are reassured that no
disruptive financial activities are caused by the bigger freedom to set rates
On June 23, 2002, the State Council announced the termination of the state
share reduction scheme, thus putting to an end the suspense of investors and
temporarily shored up stock prices. The Provisional Measures on Downsizing
State Shares for Social Security Funds, issued by the CSRC on June 12, 2001
was aimed at whittling down the state share while bolstering the social security
budget. The Measures required the firms to sell state-owned shares equivalent
to 10 percent of proceeds from IPO or additional share issues. The proceeds
from sales would be used to fund the social pension system.
The state share makes up 70 percent of the value of China's stock markets, and
an increase in the number of shares available to circulate on the markets would
certainly cause the price of currently circulating stocks to decline. In part,
this is simple supply and demand problem. But what is more important is that
China's stock markets are "Policy Markets" to some degree. That is
to say, investors hold stocks today because they believe that the government-as
a majority stockholder-will implement policies that will keep the value of shares
high. Thus, state share reduction may signal a reduced willingness by the government
to prop up the market. After the issue of the Measures, the A-share index plunged
30 percent between June and October last year. During this period, the total
market capitalization of A-shares had shrunk by more than RMB 1800 billion,
with tradable market capitalization losing RMB 571.7 billion. On October 23,
2001, the provisional Measures were suspended by CSRC.
Although China today compares favorably in education and health accomplishments
with most of the countries of similar income levels, substantial challenges
exist due to remaining pockets of poverty, persistent structural weakness and
widening disparity of income and inequality in sharing the benefits of growth.
In the last two decades, income inequality within the rural and urban areas
has widened, as did the gap between the rural and urban areas. Other social
indicators also show significant difference by region; for example, in 1999
infant mortality in inland provinces was three times higher than the rate for
China still faces serious problems in the social sector. In social security,
the government faces problems related to pension and social safety net. A way
to solve this problem is the pilot program of social security reform in Liaoning.
Liaoning was chosen by the State Council as a sole national social security
reform pilot in 2000. The pilot program was launched on July 8, 2001, and included
the combination of 5 social insurance (pension, medical, unemployment, work
injury and maternity, and the basic living standard allowance for the urban
residence). The general objectives are to establish a social security system
that is independent of multiple resources of fund, standardized security system
and socialized public administration and service. The main tasks of improving
the social security system are to adjust and improve the basic pension system
for urban enterprises employees; to study and formulate pension schemes for
staff of government organizations and institutions; to speed up the establishment
of the basic health insurance system for urban enterprises employees; to shift
from the system of guaranteeing the basic living standard of laid-off workers
of SOEs to the unemployment insurance scheme; to strengthen and improve the
system of minimum living security of the urban citizens; to socialize the administration
and services delivery of social security; to strengthen financing and management
of social security fund as well as to speed up the process of social security
So far, Liaoning has been implementing the program for a year. The information
system at the provincial level has basically been built-up and put into operation.
During the implementation, Liaoning has encountered some major problems, such
as pension coverage expansion, contribution arrears, the weak linkage between
hospitals and the medical insurance administration, overly expensive medicine
prescribed by the designated hospitals as well as the lack of monitoring of
labor market movement. The experience of this pilot may have significant policy
and institutional implications for the overall social security reform agenda.
However, whether or not the pilot program will be extended to the rest of the
country will depend on the monitoring and evaluation of the pilot experience.
In the area of public health, a particular problem is the extent of HIV infection
(see Table 1). In April 2002, the Ministry of Health estimated that HIV infection
in 2001 was about 850,000. On the other hand, the estimate by the UNAIDS was
over one million. HIV is gradually spreading from people of high-risk behavior
to the general population. Far beyond a health problem, HIV epidemic could endanger
China's economy, human resources, education and social stability.
(china.org.cn November 6, 2002)
Table 1: Adult HIV data and estimates for China
Estimated total adult HIV
Adult HIV prevalence
9 to 1
7 to 1
5 to 1
4 to 1
Male HIV prevalence
Female HIV prevalence
UNAIDS data 2001