Public Information Notice: IMF Concludes 2002 Article IV Consultation with the People's Republic of China

September 3, 2002

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On August 5, 2002, the International Monetary Fund's (IMF) Executive Board concluded the Article IV consultation with China.1


Over the last five years, the Chinese economy has weathered two major external shocks—the Asian financial crisis of 1997-98 and last year's global economic slowdown. Supported by appropriate macroeconomic policies and structural reforms, the economy was able to manage the challenges posed by these shocks well, while continuing its transformation toward increased market orientation. Growth averaged nearly 8 percent a year; the external position strengthened further; reforms advanced in the key financial and banking sectors; and external liberalization continued, culminating in China's accession to the WTO in December 2001.

Economic activity in China slowed in the course of 2001, before recovering in early 2002. Export growth, which had peaked at close to 40 percent (year-on-year) in early-2000, decelerated sharply throughout 2001 as external demand weakened. Import growth also declined but with a lag. Domestic demand growth slowed as well, despite continued expansion of public sector fixed investment. As a result, GDP growth declined from 8 percent in 2000 to 7.3 percent in 2001. In the first quarter of 2002, a rebound in exports and surging public-sector fixed investment boosted GDP growth to 7.6 percent. However, consumption growth appears to have moderated, with retail sales growth slowing somewhat. Deflation reemerged in late 2001 and continued in early 2002, reflecting both temporary factors, such as lower international commodity prices and WTO-related tariff cuts, as well as longer-term factors, such as continued excess supply conditions in certain sectors. Unemployment continues to be a pressing issue, and despite a pick up in the growth of rural incomes in 2001, it continued to lag urban income growth, exacerbating regional income disparity.

Despite last year's slowdown of export growth, China's external position has strengthened further. While the current account surplus narrowed slightly in 2001 to 1.5 percent of GDP, the financial account improved significantly, including from surging foreign direct investment ahead of China's entry into the WTO. Official reserves rose by US$47 billion in 2001, and a further US$31 billion in the first six months of 2002, reaching US$250 billion by end-June, more than four times the level of short-term external debt. Although the real effective exchange rate has risen by over 6 percent since end-1999, China's external competitiveness has remained strong, as indicated by continued rising export market shares.

Based on the strong first-quarter outcome and improved external conditions, GDP growth is expected to reach 7½ percent in 2002 and 7¼ percent in 2003. Deflationary pressures should ease beginning in the second half of 2002 as domestic demand picks up and world commodity prices rise. While export growth should be sustained by the global recovery, imports are also expected to rise, partly due to WTO-related trade liberalization. As a result, the current account surplus is expected to remain unchanged at about 1½ percent of GDP this year, before declining to 1 percent of GDP in 2003.

Progress has continued in addressing the intertwined problems in the banking and state-owned enterprise sectors, although a large unfinished reform agenda remains. In the banking sector, stricter prudential regulations, reduced government interference, and improving corporate governance in state-owned commercial banks appear to have induced a reversal of the long-standing deterioration in asset quality as a result of improving lending practices. The prudential framework was strengthened further in early 2002 with the introduction of new loan classification and provisioning requirements, consistent with international best practice. The asset management companies have started to dispose the nonperforming loans they acquired from the banks in 1999-2000; through end-2001, they have sold about 13 percent of those assets, with an average cash recovery rate of 21 percent. In the state-owned enterprises, the government's reform strategy continues to focus on "corporatizing" the large enterprises (by introducing the shareholding and modern management systems) while "letting go" of the smaller enterprises (mainly through privatization, mergers, or closure); increasing competition through further external and domestic liberalization; and strengthening the social safety net to help cushion the social impact of reforms.

Executive Board Assessment

Executive Directors commended the Chinese authorities for pursuing policies and structural reforms that have positioned the economy to weather well the external slowdown of last year, while continuing its transformation toward increased market orientation. They noted that the near-term economic prospects remain favorable, with a strong domestic growth momentum and a robust external position. Looking ahead, the key challenges will be to achieve sustained rapid economic growth and maintain financial stability over the medium term, while successfully managing the social costs of the transition. This will require continued implementation of sound macroeconomic policies and completion of the unfinished reform agenda, including, in particular, by addressing the intertwined problems in the banking, state-owned enterprises (SOEs), and fiscal sectors.

Directors supported the present accommodative stance of monetary policy and saw room for further lowering interest rates in the event economic prospects worsen significantly. A number of Directors cautioned that the underlying causes of deflation should be monitored closely, and suggested that faster SOE reform should be part of an appropriately comprehensive policy response. Directors highlighted the importance of continued efforts to improve the effectiveness of monetary policy, and, in this context, generally supported recommendations for further progress in liberalizing lending rates, lowering the remuneration of excess reserves at the central bank, and pursuing banking system reforms. A few Directors cautioned on the use of policy guidance to encourage State Commercial Banks (SCBs) to increase their lending, although the non-binding character of this guidance was noted.

Directors considered that a gradual move toward greater exchange rate flexibility would facilitate China's adjustment to the major structural changes underway and its growing integration into the world economy. They acknowledged that a variety of factors will be relevant for the authorities in deciding the appropriate pace at which the move toward greater flexibility should be achieved, such as the strength of the domestic financial sector, the pace of capital account liberalization, and the global financial environment. A number of Directors underscored that the present strong external position and favorable growth outlook provide an important opportunity for China to make such a move from a position of strength. Directors suggested that steps to strengthen the exchange market—so that it reflects more fully and directly the supply and demand for foreign exchange in the economy—should form an integral part of the move to greater flexibility, and they encouraged the authorities to make progress in this area.

Directors urged the authorities to maintain the steady path of fiscal consolidation realized in recent years. While noting the welcome support to domestic demand provided recently by an expansionary fiscal policy in the face of uncertainties about the recovery, Directors also stressed that timely attention should be given to addressing potential vulnerabilities in the medium-term fiscal outlook. These include the quasi-fiscal liabilities in the banking system and the likely future costs of pension reform, infrastructure, and other social needs. Directors welcomed the planned further joint work by the staff and the authorities toward refining the estimates of quasi-fiscal liabilities, especially those arising from nonperforming loans in the financial system. They acknowledged that the precise impact of these potential liabilities on the budget is difficult to gauge as it will depend on the pace and vigor with which structural reforms and policies, including asset sales, are carried out, and, in this context, Directors recognized the authorities' commitment to continued sustained implementation of their wide-ranging reform agenda. Although the budgetary impact and appropriate policy response will therefore need to be continuously re-evaluated over time, Directors suggested that it would be prudent to expect that substantial demands may be placed on the state finances. To meet these demands, Directors underscored the importance of achieving the budget target for 2002, and urged the authorities to reduce the state budget deficit further over the next few years.

Directors welcomed the broad range of ongoing fiscal reforms that will help support medium-term consolidation efforts, including particularly the progress made in strengthening tax administration and the budget process. They encouraged continued efforts at reforming the pension system and further expanding the tax base. Noting that there is room to make transfers to local governments more effective in reducing regional disparities, Directors also suggested an early revamp of the system of intergovernmental fiscal relations with a view to better ensuring public service delivery and supporting conditions for stronger economic growth in poorer provinces.

Directors commended recent progress in banking reforms. They welcomed, in particular, the loan classification system and provisioning requirements introduced in early 2002 and the signs of improving risk management and asset recovery by SCBs. Directors urged continued forceful action to strengthen the prudential regime and enhance incentives for sound banking, including through strict enforcement of the new prudential rules and further strengthening of supervisory capabilities. They also recommended that the authorities make specific loan loss provisions tax-deductible and reduce further the tax burden on the banking sector. Many Directors considered that China would benefit from participation in the Financial Sector Assessment Program, which will help take stock of the ongoing reforms and identify vulnerabilities and priorities for future development.

Directors recommended that the authorities accelerate the restructuring of bank ownership and internal operations. They expressed support for early corporatization of SCBs and continued efforts to improve risk management and controls, retrain staff, and upgrade legal and accounting standards. The ability of banks to resolve distressed debts should be strengthened, including by improving the legal framework of creditor rights, foreclosure, and bankruptcy. Specialized nonperforming loan resolution units established by some banks should be further developed, and this practice adopted by other banks. Directors emphasized that further capital injections by the state should be made conditional on improvements in banks' performance, and, looking ahead, the authorities were encouraged to transform the SCBs into joint stock banks and list them in the stock exchange when appropriate.

Directors emphasized that efficient asset disposal should remain the top priority of China's asset management companies (AMCs). They welcomed the progress made by the AMCs thus far, while encouraging measures that would further enhance their capacity and legal powers for effective asset disposal.

Directors endorsed the high priority that the authorities attach to reforming the SOEs, noting that continued strong progress in this area will also facilitate a sustained expansion of the private sector and a successful completion of financial sector reforms. Among the wide range of SOE reforms under way, Directors underscored the importance of hardening enterprise budget constraints. All new lending to SOEs should be made on a strictly commercial basis, and SOEs unable to raise sufficient operating capital should be either supported directly from the budget—with appropriate restructuring—or forced to exit from the market. In addition, Directors urged accelerated efforts at establishing modern enterprise management systems; reducing the state's shareholding in SOEs; and increasing competition, including by breaking up large state utilities and monopolies.

Directors urged the authorities to build further on recent labor market reforms, which have contributed to strong job creation in the private sector in recent years. Nevertheless, unemployment and underemployment remain a pressing problem as the economy adjusts to the effects of SOE reforms and WTO accession, and further strong efforts will be needed to facilitate job growth in the private sector by improving access to capital, developing the SME-sector, reducing barriers to entry, and encouraging freer movement of labor. Directors also supported the government's efforts to upgrade education and training, and welcomed, in particular, the progress being made in strengthening the social safety net, which is a critical component of the SOE reform process. Directors noted the challenges facing the authorities in addressing rural-urban and regional income disparities, and, in this context, expressed interest in the implementation of the "Develop the West" initiative.

Directors welcomed the authorities' commitment to develop the stock and bond markets. They encouraged the continuation of ongoing efforts to improve stock market oversight, rationalize listing and delisting rules, improve accounting and disclosure standards, and upgrade corporate governance. Additional steps should aim at bringing more private companies to the market, developing institutional investors, improving the initial-public-offering process, and strengthening bond market liquidity and infrastructure.

Directors commended the considerable progress in upgrading China's economic statistics, and welcomed, in particular, China's recent participation in the General Data Dissemination Standards (GDDS). They urged the authorities to follow through with the full implementation of the plans for improvement contained in the GDDS, and also saw scope for further improving data provision to the Fund in a number of areas important to IMF surveillance.

Directors commended China's commitment to debt relief for heavily indebted poor countries, or HIPCs.


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