IMF Executive Board Concludes 2006 Article IV Consultation with the People's Republic of ChinaPublic Information Notice (PIN) No. 06/103
September 11, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On July 31, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the People's Republic of China.1
China's output growth continues to be strong. Based on the revised official data, GDP growth in 2005 reached 10 percent, roughly the same as in the previous year. Indicators for the major components of demand suggest that output growth could have been much higher than officially estimated in 2005. Economic activity maintained its momentum in the first quarter of 2006, with further evidence of acceleration in investment. GDP grew by 10¼ percent (year-on-year) in the first quarter. Total nominal fixed investment increased from 25.7 percent in 2005 to 29.8 percent in the fist half of 2006. Net exports continued to be strong, although the pace of import growth has accelerated. Indicators also suggest that consumption remained robust. Despite strong growth, inflation remains subdued. After peaking at 5¼ percent (year-on-year) in mid-2004, headline CPI inflation fell to 1¾ percent in 2005 and 1½ percent by May 2006, largely driven by a significant moderation of food price inflation.
The external position strengthened substantially in 2005. The trade surplus was the main driver, surging to $135 billion in 2005 compared to $59 billion in 2004. Export growth was robust given the strong world demand and China's increasing role in processing trade. The overall slowdown in import growth resulted in a large increase in the current account surplus in 2005 to over 7 percent of GDP, up from 3½ percent in 2004. This slowdown largely reflected a switch away from imports toward domestically produced inputs, a moderation in the investment demand for machineries, and some reduction in raw material inventories. The trade surplus continues to strengthen in 2006, with a surplus through May 2006 of $47 billion, significantly higher than the $30 billion recorded for same period last year. Despite a pickup in import growth driven mostly by primary products and machinery, export growth remains strong. Reserves increased by $208 billion in 2005, broadly in line with reserves accumulation in 2004, and by a further $76 billion in 2006, bringing the level at end-April to about $895 billion. Net FDI inflows reached $68 billion in 2005 compared to $53 billion in 2004. Over the period, non-FDI capital flows sharply reversed to an outflow of $22 billion in 2005 (including errors and omissions), compared to an inflow of $85 billion in 2004.
Less than full sterilization of foreign exchange reserve accumulation has left substantial liquidity in the banking system, and credit growth appears to be accelerating. While broad money (M2) has accelerated since mid-2005, reaching 19 percent annual growth through May 2006 (compared to PBC's annual target of 16 percent growth), credit growth averaging around 13½ percent in 2005, remained relatively subdued, reflecting more cautious lending by the large state-owned banks undergoing restructuring and "moral suasion" on the part of the PBC. However, credit growth has since risen to 16 percent in May 2006 (compared to the PBC's annual target of 12 percent). In response, the PBC increased the benchmark lending rate modestly in May (by 27 basis points), the second such increase in 10 years and announced that the reserve requirement ratio of all banks except the rural credit co-operatives will be raised by 0.5 percentage point to 8 percent on July 5 2006. Short-term interest rates have risen somewhat since early November, as the People's Bank of China (PBC) stepped up open-market operations, but they remain well below the 2½-3 percent levels of 2004.
Staff projects GDP growth to remain around 10 percent in 2006. This forecast assumes that appropriate macroeconomic policies will be in place to constrain investment growth—unless these policy actions are taken, GDP growth could easily exceed the 10 percent forecast. Export growth is expected to remain strong, but to moderate from its 2005 pace. Import growth, although higher than in 2005, would remain subdued as investment and export growth slows. Consumption growth is expected to remain relatively strong, as rural incomes continue to rise and consumer credit facilities expand. The export slowdown and higher import growth should keep the external current account from growing further relative to GDP in 2006. However the outturn in the first few months of 2006 points to the possibility that export growth may not slow as much as generally expected, which could result in a further widening of the annual current account surplus. Inflation is expected to remain below 2 percent in 2006, as falling prices in sectors with overcapacity will likely be offset by a modest rise in services inflation, as well as some upward adjustments in certain administered prices. With price declines confined to certain sectors, the risk of generalized deflation in the economy at present appears small. In the near term, a significant risk remains that macroeconomic policies will not be sufficiently tight to contain investment growth. In particular, there is a need for monetary policy to prevent a surge in credit growth from tipping off a boom-bust cycle and an associated rise in banks' nonperforming loans. Growing protectionist sentiments in China's major markets, especially the United States and the EU, also present a major risk. Moreover, a disorderly unwinding of global imbalances would threaten China's growth, as economic activity in partner countries would likely suffer lingering adverse effects. Although less immediate, avian flu remains a threat.
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 sustaining high economic growth and noted that China's prospects for the future remain favorable, provided that the risks and challenges faced by the country are addressed. They broadly endorsed the government's medium-term economic reform strategy, particularly the need to rebalance the economy away from heavy dependence on investment and exports for growth towards consumption.
Directors agreed that liquidity in the banking system is abundant and noted that, in light of this, a further pick-up in the already high rate of credit and investment growth remains a near-term risk. While the monetary policy actions taken so far were welcomed, it was emphasized that additional steps will likely be needed. Directors viewed that the authorities should further step up reliance on open market operations to drain liquidity from the banking system, and observed that this may need to be supplemented by other monetary policy measures, such as additional hikes in benchmark interest rates and/or the reserve requirement ratio.
Directors emphasized the importance of improving the effectiveness of monetary policy. Directors noted that the authorities also use moral suasion and administrative steps to restrain credit and investment growth. While recognizing that there might be need for such measures, a number of Directors noted that they made it difficult for banks to operate fully on a commercial basis. Directors stressed that greater exchange rate flexibility is needed to enable the PBC to use its monetary policy instruments more effectively. Some Directors also viewed the PBC's lack of sufficient discretion in setting interest rates as an impediment to timely and effective policy action.
Many Directors found it appropriate for China to continue to allow greater flexibility in its exchange rate in a gradual and controlled manner. They shared the authorities' concern that accelerating exchange rate flexibility could have an adverse impact on macroeconomic stability. Some of these Directors also viewed that exchange rate adjustment alone would have a limited impact on external balances. A number of other Directors, however, stressed that the flexibility afforded by the current exchange rate system should be used more extensively. These Directors noted that the current strength of the Chinese economy provides a favorable context for adjustment and should serve to alleviate the authorities' concerns about the potential adverse economic effects. Directors noted that greater exchange rate flexibility, along with other policy changes and reforms in China, will aid in rebalancing the economy over the medium term, and will contribute to the orderly resolution of the global current account imbalance, in conjunction with concerted policy efforts by other key economies.
Directors noted that the last few years of fiscal consolidation have created the space for a needed step-up in social spending, which would serve to help rebalance growth towards consumption, as well. In this regard, they considered the initiatives in the 2006 budget to raise social spending to be appropriate from a near-term perspective. Directors supported the priority given by the authorities to developing comprehensive plans to reform the provision of key social services, such as health care, education, and pensions, and to improving implementation capacity, including the reforms entrained in the budget process (the revised budget classification, chart of accounts, and extension of the treasury single account). They noted that such steps will be needed before embarking on large scale increases in spending in these areas. Directors also emphasized the importance of reforms in center-local fiscal relations, and urged the authorities to ensure all local governments have adequate resources to meet their spending responsibilities.
Directors commended the progress achieved in bank reform. They noted that improving intermediation of China's large private savings will be critical to rebalancing economic growth over the medium term. In this regard, they welcomed the authorities' efforts to further improve the banks' commercial orientation, internal controls, and governance, and stressed the need for the early adoption of a formal reform plan for the Agricultural Bank of China (ABC). More generally, Directors recommended the continued scaling-back, and eventual elimination, of government involvement in the management and business operations of the banks. They urged a further strengthening of banking supervision, in particular with regard to assessing banks' foreign exchange and credit risks, and noted that closer monitoring of the flow of new non-performing loans is also essential to the early detection of potential problems.
Directors also welcomed the steps taken to accelerate the development of China's capital markets. They recognized the progress realized in reviving the equity markets, the strong growth in the short-term corporate bills market, and the launching of the interbank market for asset-backed securities, as important steps. While noting that some impediments in the corporate bond market had been addressed by the new Securities Act, Directors observed that allowing bonds to be issued based on a disclosure-based system, while removing the cap on corporate bond interest rates and streamlining regulatory responsibilities, will be key steps to accelerating the development of this market. In this context, they welcomed the authorities' agreement in principle to conduct an Financial Sector Assessment Program and encouraged them to set an early date for participation. Such an exercise would contribute to a stocktaking of recent progress in financial sector reforms and to identifying priorities for further reforms.
Directors commended the authorities for setting up a task force to look into the modalities for greater dividend payments to the government by the state-owned enterprises, and emphasized that such dividend payments should be made to the budget. Directors considered that this policy, by curbing the sharp rise in investment in some sectors and by providing additional resources to fund reforms in social services, will be an important element of the strategy to rebalance growth.
Directors welcomed improvements in economic statistics, including in the national income accounts and the international investment position. Looking ahead, they viewed the publication of annual and quarterly real GDP on an expenditure basis and further improvements in some aspects of balance of payments statistics as key priorities, and urged the authorities to continue to make use of the IMF's technical assistance in these areas.
Directors welcomed China's provision of financial support and debt relief to many low-income countries. Directors encouraged the authorities to share information on these activities with the IMF, to participate fully in the Heavily Indebted Poor Countries initiatives, and to make their lending activities consistent with the low-income country debt sustainability framework.