## 1chnea2019003 ## Source details **Canonical URL:** [1chnea2019003](https://www.imf.org/-/media/files/publications/cr/2019/1chnea2019003.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2019/1chnea2019003.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2019/1chnea2019003.pdf.json) --- ### Context: navigating headwinds and uncertainty - Authorities announced a lower growth target for 2019, a range from 6.0-6.5 percent. - Pivot from “high-speed” to “high-quality” growth; implementation of “competitive neutrality” remains at an early stage. - Government shifted emphasis from deleveraging back to supporting growth in response to slowing activity in H2 2018. - External headwinds: trade conflict with the U.S. escalated since spring 2018 with tariffs and counter-tariffs; conflict extends to foreign investment regime, intellectual property protection, technology transfer policies, industrial policy, cyber security, and the large economic role of the state. - Persistent uncertainty could significantly reduce China’s access to foreign markets and technology if no durable agreement is reached. ### Recent developments: weaker growth, prices, and credit dynamics - Growth and demand - Growth moderated from 6.8 percent in 2017 to 6.6 percent in 2018. - Real GDP growth was 6.4 percent (y/y) in Q1 2019, unchanged from 2018 Q4. - Domestic demand weakened to 4.9 percent in Q1 (compared to 6.7 percent in 2018 Q4); net exports contributed 1.5 percentage points to growth due to contracting imports. - Nominal GDP growth decelerated from 9.1 percent in 2018 Q4 to 7.8 percent in Q1 2019. - Inflation and prices - Core CPI inflation fell to just below 2 percent in mid-2018 and to 1.6 percent in May (2019). - Headline CPI inflation rose to 2.7 percent in May (2019), driven by rising food inflation. - PPI inflation fell sharply to below 1 percent in 2019; noted “4.5 years of PPI deflation” in narrative. - Property market - Real estate investment growth (excluding land purchases) mostly negative in 2018; house price growth and sales growth slowed since late 2018. - Housing inventories started to build up, suggesting the housing cycle may still be in a downturn. - Financial conditions and markets - Bank asset growth fell from 15 percent (y/y) in mid-2016 to 7 percent (y/y) in mid-2018; TSF growth slowed from 15 percent (y/y) in early 2017 to under 10 percent at end-2018; TSF accelerated to 10.6 percent in May (2019). - Shadow banking contracted through 2018; off-balance sheet WMP issuance curtailed. - China equity markets fell by 25 percent in 2018 and rebounded by 19 percent so far in 2019. - Corporate credit spreads widened in 2018; corporate bond defaults rose from a low base, mainly for private corporates. - May 2019 takeover of Baoshang Bank—the first public takeover in 20 years—highlighted balance sheet weaknesses at many small and medium-sized banks. ### External sector and capital flows - Current account and trade - CA surplus declined substantially from about 10 percent of GDP in 2007 to 0.4 percent of GDP in 2018 (a fall of about 1 percentage point in 2018). - Exports and imports grew strongly through most of 2018 (partly due to frontloading ahead of tariffs) before contracting from December 2018. - In 2019, nominal export growth near zero and imports contracting at 4 percent for the first six months of the year (y/y). - Exchange rate and reserves - Bilateral RMB/USD rate depreciated relatively rapidly from mid-June to early August 2018; 20 percent reserve requirement for FX derivatives and the CCAF were re-introduced. - RMB depreciated in real effective terms by about 2½ percent since the last Article IV. - Foreign currency reserves at about US$3.2 trillion (noted elsewhere as US$3.1 trillion by end-2018). - Capital flows and index inclusions - Capital inflows strong in early 2018 then moderated to small net outflows in 2018 Q4; no significant outflow pressures noted. - Inclusion of China A shares in MSCI and local currency government and policy bank bonds in Bloomberg Barclays Global Aggregate Index could result in sizable additional inflows of around US$450 billion over the next 2-3 years (staff estimates). ### Debt, financial sector vulnerabilities, and SOE issues - Debt accumulation - Overall nonfinancial sector debt reached 257 percent of GDP in 2018. - Debt of the nonfinancial sector grew by an average of 3½ percentage points of GDP in 2017 and 2018. - Policy easing led to sharp increase in pace of debt accumulation in 2019 Q1, with household and corporate debt growing by 1 and 3 percentage points of GDP, respectively. - SOEs - Reforms largely completed treatment of zombie central SOEs mainly through mergers and acquisitions by other SOEs rather than bankruptcy, yielding fewer but larger SOEs. - SOE profitability remains weak and about a third of SOEs remain loss making. - SOE debt as a share of total enterprise debt rose sharply as bank lending shifted towards SOEs and away from private firms; SOE debt-to-assets ratio declined even as SOE debt as a share of GDP continued to rise. - Financial sector risks and measures - Interbank funding tightened for some small banks and NBFIs; NCD issuance (about a tenth of small bank funding) fell sharply; PBC injected liquidity and introduced a credit support scheme for banks’ NCDs. - Lending allocation favored SOEs over private enterprises; lending to SMEs curtailed; household lending growth moderated but remained high. - Policy measures: PBC lowered RRR by 350bps across quarters 2018Q2–2019Q1, increased MLF liquidity and created TMLF; targeted RRR cuts for lending to micro and small enterprises (MSEs). ### Authorities’ macro policy response and fiscal measures - Policy characterization - 2018/19 response more focused on rebalancing than 2015/16 stimulus; fiscal policy more targeted; shadow banking and property sector policies remain restrictive so far. - Not all measures consistent with staff advice; PIT reform decreased progressivity by reducing an already small share of progressive tax revenues. - Fiscal measures and quantified impacts (preserve exact numbers) - Tax and infrastructure measures expected to increase the “augmented” deficit by 1½ percent of GDP in 2019. - Under staff’s “augmented” definition, the deficit widened by 0.4 percent of GDP in 2018; augmented deficit expected to widen to 12.7 percent of GDP in 2019. - Key items (Size (% of GDP); Fiscal multiplier effect*; Overall impact on 2019 growth; Recommended/consistent with MT goals?): - Personal income tax--threshold: Size: 0.3; Fiscal multiplier effect*: Medium; Overall impact on 2019 growth: 0.15; Recommended?: No. - Personal income tax--increase in allowable deductions: Size: Less clear; Fiscal multiplier effect*: Medium; Overall impact on 2019 growth: Small; Recommended?: No in general. - Increase of VAT refund on exports: Size: Less clear; Overall impact on 2019 growth: -0.1; Fiscal multiplier effect*: Medium; Recommended?: Yes. - VAT cuts for manufacturing sectors: Size: 0.3; Fiscal multiplier effect*: Medium; Overall impact on 2019 growth: 0.15; Recommended?: Yes. - Tax support for MSEs: Size: Less clear; Fiscal multiplier effect*: Small; Overall impact on 2019 growth: Small; Recommended?: No in general. - Social security contribution cuts: Size: 0.2; Fiscal multiplier effect*: Medium; Overall impact on 2019 growth: 0.1; Recommended?: Yes. - Infrastructure (special purpose bonds): Size: 0.7; Fiscal multiplier effect*: Medium; Overall impact on 2019 growth: 0.35; Recommended?: No. - Total Fiscal Impact: 1.50.8 (Note: *When number not specified, large ≈ 0.8, medium ≈ 0.5, small ≈ 0.3.) - Monetary stance - Regular and targeted easing with partial transmission; cuts in each quarter 2018Q2–2019Q1 to RRR; creation of TMLF; limited pass-through to medium/long-term lending rates. - Government target: large state-owned banks to increase lending to MSEs by 30 percent; objective for private enterprises to receive at least 50 percent of new loans within three years. ### Outlook and risks (baseline, adverse, upside) - Near-term baseline projections and assumptions - Growth is expected to decline moderately to 6.2 and 6.0 percent in 2019 and 2020, respectively, given the authorities’ policy response. (Exact text preserved as in source.) - Key assumptions: current tariffs (25 percent on US$250 billion of U.S. imports from China, 5-25 percent on US$110 billion of Chinese imports from U.S.) stay in place; no new tariffs are imposed; and the policy stimulus is not rolled back. - Headline inflation projected to rise to 2.2 percent in 2019. - Nonfinancial sector debt as a share of GDP expected to rise sharply in 2019 by 10 percentage points; credit growth to pick up to 10.5 percent. - Medium-term outlook - Growth expected to gradually slow to 5½ percent as the economy moves towards a more sustainable growth path. - Aggregate GDP growth could slow from current 6½ percent to 4–4½ percent by 2030 under projected productivity convergence (see Box 1). - Downside risks (selected, exact phrasing preserved) - External escalation in tensions could result in higher tariffs, disrupting supply chains and depressing confidence and investment. - US and other countries’ export ban to certain Chinese technology companies could exacerbate the trend. - Domestic risks: deterioration in asset quality of financial institutions (especially small and mid-size banks), funding stress for banks and non-bank financial institutions, a sharp downturn in the property market, and a return to PPI deflation. - Longer-term: increasing role of the state could worsen resource allocation, especially if combined with reliance on debt to hit high short-term growth targets. - Upside risks - Reduction in trade tensions could spur confidence and investment. - Significant reforms—comprehensive domestic reform package increasing the role of markets, greater openness, and meaningful SOE reform—could significantly lift productivity and potential growth over the medium term. ### Policies under scenarios - Baseline policy stance — “stay the course” - No additional stimulus beyond planned measures; consolidation should resume as external clarity improves. - Augmented debt high: "73 percent of GDP in 2018", projected to "exceed 100 percent of GDP in 2024." - Recommended gradual consolidation: reduce augmented deficit by about "¾ percent of GDP a year over ten years". - Monetary: further easing not recommended; data dependent. - Credit: curb recent credit acceleration and decelerate further in 2020; medium-term credit growth to moderate towards nominal GDP growth or lower; improve efficiency and market-based allocation. - Exchange rate: increase flexibility; phase out reserve requirement on FX forwards; avoid using CCAF within daily trading band; publish FX intervention information. - Adverse scenario (trade escalation) - Example shock: U.S. raising tariffs to "25 percent on remaining imports from China" could reduce growth by "around 0.8 percentage points over the following 12 months". - Warranted response: fiscal expansion of "0.8 percentage points of GDP" (on-budget, centrally financed, pro-rebalancing, targeted to low-income households). - Recommended fiscal package (total size 0.8 percent of GDP) with options such as: - Permanent increase in rural/urban pensions: "0.1" - Increase in social transfers to provinces: "0.1" - Education: "0.1" - Health: "0.1-0.2" - Unemployment benefits: "0.1" - Remove minimum social contribution contributions for low-income households: "0.1" - Full VAT refund on exports: "0.1-0.2" - Monetary: modest, data-dependent easing; RRR cuts and repo rate cuts as effective tools. - Exchange rate: maintain flexibility; intervene to counter disorderly conditions; CFMs may be tightened transparently and temporarily if FX stress persists. - Macroprudential: continue deleveraging; avoid loosening macroprudential policies generally. - Upside scenario (comprehensive U.S.-China agreement) - Scale back stimulus: the fiscal stimulus expected to increase augmented deficit by "1½ percent of GDP" would be too large and should be reduced in 2019. - Withdrawal options: decrease LG infrastructure spending (especially off-budget), accelerate recurrent property tax, raise pollution charges, tighten some PIT reform parameters. - Monetary: may need moderate tightening via increase in PBC 7-day reverse repo rate; credit growth should slow; build bank capital buffers. ### Productivity convergence and long-run prospects (Box 1) - Convergence to frontier - China’s labor productivity converged from 15 percent of the frontier to 30 percent over the past two decades. - Industrial productivity converged from 15 percent of the frontier at the end of 1990s to about 35 percent; service productivity converged from 10 percent to 26 percent. - Service share projected to rise to 65 percent by 2030. - Projected productivity growth and implications - Applying cross-country convergence speeds, industrial and service productivity growth expected to slow to 3–4 percent by 2030, with productivity levels reaching 57 and 44 percent of the frontier respectively. - Aggregate implication: GDP growth would slow from current 6½ percent to 4–4½ percent by 2030. - Faster SOE reform and opening up of the service sector could moderate the pace of slowdown. ### Debt Sustainability Analysis — key DSA figures and implications (Appendix I) - Definitions - “Budgetary” (official) and staff’s “augmented” (broad) government debt definitions used; augmented includes off-budget LGFV and quasi-fiscal liabilities. - Key DSA numbers (exact figures preserved) - Budgetary government debt: 38 percent of GDP in end-2018 → 51 percent of GDP in 2024. - Augmented debt: 73 percent of GDP in 2018 → 101 percent of GDP in 2024. - Augmented primary deficit: around 8.0 percent of GDP in 2018 → around 9.0 percent of GDP in 2019 → 6.4 percent of GDP in 2024. - Budgetary primary fiscal deficit: 3.8 percent of GDP in 2018 → 5.0 percent of GDP in 2019 → 4.0 percent of GDP in 2024. - Special purpose bond quota: RMB 1350 billion in 2018 → RMB 2150 billion in 2019 (about additional 0.7 percent of GDP). - Debt-stabilizing primary balance (augmented): -2.3 percent of GDP in the medium term (about 7 percentage points stronger than projected 2019 level). - Stress tests - Combined macro-fiscal shocks push augmented debt well above baseline; contingent liability shock (budgetary) could raise budgetary debt ~38% → ~67% of GDP in 2020 under specified assumptions (10 percent of banking assets becoming government liabilities). ### Financial sector recommendations and governance priorities - Financial regulation and supervision - Fully implement announced regulatory reforms; uniformly regulate and supervise asset management sector; do not relax micro-prudential regulations for cyclical reasons. - Finalize DSIBs and SIFIs framework with capital surcharges. - Develop resolution regimes and strengthen deposit insurance to facilitate exit of weak institutions. - Bank capital and shadow banking - Strengthen bank capital to facilitate downsizing of shadow banking and improve monetary transmission; encourage profit retention and equity raising from non-bank sources. - Near-term measures to boost bank capital would facilitate reducing shadow banking. - Household debt and macroprudential tools - Contain vulnerabilities from rising household debt: tighten DSTI limit (currently 55 percent) toward international norms of 30-50 percent; apply DSTI to all debt obligations including nonbanks; use DSTI to enhance LTV limits; remove recently introduced income tax deduction for mortgage interest. - Develop personal bankruptcy regime and strengthen credit registries. - SOE and credit allocation - Remove implicit guarantees and other SOE advantages to foster debt and regulatory neutrality; set deleveraging goals in terms of SOE debt/GDP ratio; allow SOE and LGFV bonds to default. - Near-term options: require corporates receiving implicit advantages to explicitly pay the cost to the budget; penalize SOEs failing to meet dividend payout targets (30 percent); increase bank risk weights on loans to corporates receiving guarantees. - Publish the share of bank credit to SOEs and private firms to increase transparency. - Fintech and AML/CFT - Press ahead with comprehensive fintech supervisory oversight based on “substance over form”; strengthen data gathering and KYC requirements; support fintech for financial inclusiveness. - Address AML/CFT shortcomings: increase transparency of beneficial owners; introduce comprehensive legal framework for UN-based targeted financial sanctions; improve supervision and preventive measures. ### Governance, fiscal structure, and structural reform priorities - Fiscal governance and taxes - Reduce misalignment of center-local fiscal responsibilities; accelerate nationwide recurrent property tax; central government to take over certain expenditure responsibilities (pensions, employment insurance, health, education). - Increase equalization grants to support least-developed regions. - Improve fiscal transparency: publish general government accounts and balance sheets; produce fiscal risk statements; include off-budget borrowing in deficit estimates. - Market competition and SOE reform - Increase role of the market: unify product markets, liberalize services, remove local protectionism, amend bankruptcy law, accelerate hukou reform, increase pension portability. - Accelerate opening up: implement new foreign investment law and negative list changes consistently; scenario impacts quoted: Goods tariff, 3.0; Services NTBs, 0.4; FDI, 6.0 (GDP effects). - SOE reform: classify and exit zombies with published classifications and timetables; avoid top-down mergers that reduce competition; improve SOE governance and transparency. - Monetary policy framework and governance - Phase out benchmark deposit and lending rates; clarify PBC reverse repo as key policy rate; base PBC lending facilities on clear collateral rules; give PBC greater accountability and operational independence around a clear inflation objective. ### External policies, BRI, and trade system recommendations - Trade system - Finding: trade tensions should be resolved through a comprehensive agreement that avoids undermining the international system; avoid managed trade deals. - Any agreement should reinforce WTO rules, be non-discriminatory, and be based on market mechanisms and macro fundamentals. - China and partners should work on areas like e-commerce and services, strengthen WTO dispute settlement, and increase openness/transparency on industrial subsidies. - Belt and Road Initiative (BRI) - Finding: BRI lending can bring benefits but requires stronger frameworks for coordination, transparency, debt sustainability monitoring, and competitive procurement. - Recommendation: Complement the BRI-Debt Sustainability Framework with a coordinating body; ensure green, low-carbon, climate-resilient investment projects. - Spillovers - A managed-trade deal could divert trade and investment and weaken the rules-based trading system; IMF staff estimates cite sizable export losses for third countries (examples: EU exporters declines of about "$84 billion"; Korea and Singapore potentially losing exports amounting to about "2.1 and 3.8 percent of their GDP, respectively"). ### AML/CFT assessment (Appendix III) — key findings - Effectiveness: China substantially meets 3 of 11 immediate outcomes; other 8 outcomes assessed as insufficiently effective. - Technical compliance: compliant or largely compliant with 22 Recommendations; 18 Recommendations partially or non-compliant. - Key shortcomings: incomplete FIU data access; implementation gaps on UN-mandated targeted financial sanctions; weaknesses in beneficial ownership transparency; supervision not sufficiently risk-focused; DNFBP implementation pending. ### Recent updates and authorities’ views (statement material) - Q2 GDP growth: 6.2 percent (y/y); nominal GDP growth: 8.2 percent (y/y) in Q2. - High-frequency June indicators: industrial value-added 6.3 percent (y/y); fixed asset investment 6.3 percent (y/y); TSF growth 10.9 percent (y/y). - Inflation in June: headline CPI 2.7 percent (y/y); core CPI 1.6 percent (y/y); PPI 0.0 percent (y/y). - Authorities: describe fiscal policy as “active” with tax and fee cuts totaling nearly 2 trillion yuan; committed to stabilizing leverage and strengthening small bank capital; reiterate commitment to further opening (multiple liberalization measures and foreign access steps listed). - Authorities view trade tensions as a major risk but manageable and emphasize continued opening, IP protection improvements, and multilateral engagement. *International Monetary Fund — People’s Republic of China, Chapter: Productivity Convergence and Potential Growth (content unit 1chnea2019003).* ### 1. Productivity Convergence and Potential Growth ______________________________________________ 13 ### 1. Productivity Convergence and Potential Growth ______________________________________________ 13 ### Context: navigating headwinds and uncertainty - Reform agenda – a pause in deleveraging: - Authorities announced a lower growth target for 2019, a range from 6.0-6.5 percent. - Pivot from “high-speed” to “high-quality” growth; structural reforms continued in several areas but implementation of “competitive neutrality” remains at an early stage. - In response to slowing activity in H2 2018, government shifted emphasis from deleveraging back to supporting growth. - External headwinds – trade tensions and weak global demand: - Trade conflict with the U.S. escalated since spring 2018; rounds of tariffs and counter-tariffs implemented before a ‘truce’ and renewed negotiations. - Conflict extends to foreign investment regime, intellectual property protection, technology transfer policies, industrial policy, cyber security, and the large economic role of the state. - Some aspects of opening up would boost medium-term prospects; other aspects, such as managed trade, could negatively affect the multilateral trading system. - Uncertain environment if no durable agreement reached: - Persistent uncertainty could weigh on near- and longer-term outlook as China’s access to foreign markets and technology may be significantly reduced. ### Recent developments: weaker growth amid regulatory strengthening and external headwinds - Growth and demand: - Growth moderated from 6.8 percent in 2017 to 6.6 percent in 2018. - Real GDP growth was 6.4 percent (y/y) in Q1 2019, unchanged from 2018 Q4. - Domestic demand weakened to 4.9 percent in Q1 (compared to 6.7 percent in 2018 Q4); net exports contributed 1.5 percentage points to growth due to contracting imports. - Nominal GDP growth decelerated from 9.1 percent in 2018 Q4 to 7.8 percent in Q1 2019. - Inflation and prices: - Core CPI inflation fell to just below 2 percent in mid-2018 and to 1.6 percent in May (2019). - Headline CPI inflation rose to 2.7 percent in May (2019), driven by rising food inflation. - Industrial Producer Price Index (PPI) inflation fell sharply to below 1 percent in 2019, with PPI inflation below CPI inflation since Dec 2018; noted “4.5 years of PPI deflation” in the narrative. - Property market: - Growth in real estate investment (excluding land purchases) was mostly negative in 2018; house price growth and sales growth slowed since late 2018. - Housing inventories have started to build up in recent months, suggesting the housing cycle may still be in a downturn. ### External sector and capital flows - Current account and trade: - CA surplus declined substantially from about 10 percent of GDP in 2007 to 0.4 percent of GDP in 2018 (a fall of about 1 percentage point in 2018). - Export and import growth remained strong through most of 2018 (partly due to frontloading of exports ahead of tariffs) before contracting from December 2018. - In 2019, nominal export growth near zero and imports contracting at 4 percent for the first six months of the year (y/y). - Exchange rate and reserves: - Bilateral RMB/USD rate depreciated relatively rapidly from mid-June to early August 2018; 20 percent reserve requirement for FX derivatives and the CCAF were re-introduced. - RMB depreciated in real effective terms by about 2½ percent since the last Article IV. - Foreign currency reserves at about US$3.2 trillion. - Capital flows and index inclusions: - Capital inflows strong in early 2018 then moderated to small net outflows in 2018 Q4; no significant outflow pressures noted. - Inclusion of China A shares in MSCI and local currency government and policy bank bonds in Bloomberg Barclays Global Aggregate Index could result in sizable additional inflows of around US$450 billion over the next 2-3 years (staff estimates). ### Debt, financial sector developments, and risks - Debt accumulation: - Overall nonfinancial sector debt reached 257 percent of GDP in 2018. - Debt of the nonfinancial sector grew by an average of 3½ percentage points of GDP in 2017 and 2018. - Policy easing led to sharp increase in pace of debt accumulation in 2019 Q1, with household and corporate debt growing by 1 and 3 percentage points of GDP, respectively. - Financial deleveraging and shadow banking: - Bank asset growth fell from 15 percent (y/y) in mid-2016 to 7 percent (y/y) in mid-2018, driven by a fall in claims on other financial institutions. - Total social financing (TSF) growth slowed from 15 percent (y/y) in early 2017 to under 10 percent at end-2018; TSF growth accelerated in 2019 to 10.6 percent in May (2019). - Shadow banking contracted through 2018; off-balance sheet wealth management products issuance curtailed. - Credit allocation and access: - Bank lending favored SOEs over private enterprises; lending to SMEs was curtailed. - Household lending growth moderated but remained high; short-term credit expanded rapidly in part to circumvent mortgage restrictions. - Bank stress and market funding: - May 2019 takeover of a medium-sized “zombie” bank (Baoshang) with solvency and liquidity problems—the first public takeover in 20 years. - Announcement of negotiated haircuts to large creditors’ claims raised counterparty risk concerns and highlighted balance sheet weaknesses at many small and medium-sized banks (joint-stock commercial banks, city commercial, and rural banks account for about 45 percent of total banking assets). - Interbank funding tightened for some small banks and NBFIs; NCD issuance (about a tenth of small bank funding) fell sharply; PBC injected liquidity and introduced a credit support scheme for banks’ NCDs. - Financial conditions: - Financial conditions tightened strongly in 2018, then loosened somewhat after monetary policy eased from summer 2018. - China equity markets fell by 25 percent in 2018 and rebounded by 19 percent so far in 2019. - Corporate credit spreads widened in 2018, more for lower-rated borrowers; corporate bond defaults rose from a low base, mainly for private corporates. ### Rebalancing, structural reforms, and social outcomes - Rebalancing progress: - Mixed progress in 2018: external rebalancing resumed with net exports contributing negatively to growth; internal rebalancing toward consumption accelerated. - Internal rebalancing toward services progressed more slowly; credit efficiency did not improve further after a big improvement in 2017. - Environmental rebalancing continued but progress in reducing inequality was limited. - Absolute poverty fell to less than 3 percent of the population—close to authorities’ goal of eliminating it by 2020—but spatial and rural-urban inequality remains a challenge. - Structural reforms and opening up: - Authorities cut tariffs twice, lowering the effective tariff rate by over 2 percentage points to 7.5 percent in 2018. - New foreign investment law passed with provisions on equal treatment and prohibiting forced technology transfer; to take effect in January 2020. - Negative list for foreign investment revised, relaxing restrictions in agriculture, mining, and infrastructure. - Financial sector opening accelerated: removal of foreign ownership limit for Chinese banks and asset management companies; restrictions on foreign ownership in futures, securities and life insurance companies to be fully lifted by 2020. - Negative List for Market Access released; IP protection strengthened via an IP tribunal in the supreme court and patent law revisions. - Limited reform of the “hukou” system undertaken. - China moved up 32 places to 46th in the World Bank’s 2019 Doing Business Rankings. *International Monetary Fund — People’s Republic of China, Chapter: Productivity Convergence and Potential Growth* ### 14. But some recent reforms have increased the dominance of SOEs and worsened the ### 1chnea2019003 - 14. But some recent reforms have increased the dominance of SOEs and worsened the ### State-owned enterprises: dominance, profitability, and debt - Recent reforms largely completed the treatment of zombie central SOEs, but this came mainly through mergers and acquisitions by other SOEs rather than bankruptcy, yielding fewer but larger SOEs. - Overcapacity cuts: - Improved profits in upstream, SOE dominated sectors. - Improved the profitability of industrial SOEs relative to private enterprise in downstream sectors. - These factors contributed to: - A decline in the SOE debt-to-assets ratio even as SOE debt as a share of GDP continued to rise. - A sharp rise in SOE debt as a share of total enterprise debt, reflecting a shift in bank lending towards SOEs and away from private firms. - Overall SOE performance: - SOE profitability remains weak and about a third of SOEs remain loss making. ### Authorities’ macro policy response to the slowdown - General characterization: - Compared to the 2015/16 stimulus, the 2018/19 policy response is more focused on rebalancing, with fiscal policy more targeted and policies aimed at shadow banking and the property sector remaining restrictive so far. - Not all measures are consistent with staff advice; notably, the Personal Income Tax (PIT) reform decreased the progressivity of the tax system as a whole by reducing the already small share of progressive tax revenues. - Fiscal measures and details: - Tax and infrastructure measures expected to increase the “augmented” deficit by 1½ percent of GDP in 2019. - Under staff’s economic-based (“augmented”) definition of the general government sector (including estimated off-budget investment spending), the deficit widened by 0.4 percent of GDP in 2018, mainly due to higher expenditure. - Augmented deficit is expected to widen to 12.7 percent of GDP in 2019. - Key fiscal policy items (preserve exact descriptions and numbers): - Personal income tax--threshold - Thresholds effective Oct 1, 2018, new law in place from Jan 1, 2019. Raises the threshold for tax exemption from RMB 3500 to 5000 per month; adds special deductible items; and shifts from taxing monthly to annual income. - Size (% of GDP): 0.3 - Fiscal multiplier effect*: Medium - Overall impact on 2019 growth: 0.15 - Recommended/consistent with MT goals? No. Tax base is already narrow. PIT one of the few progressive taxes. Reducing regressive payments, such as those related to social security, would target inequality better. - Personal income tax--increase in allowable deductions - Additional deductions on six categories: expenditure on children's education, continuing education, critical illness treatment, mortgage interest payment, rental expenses, and elderly care. E.g. a typical family with one child and a 60-year-old parent can enjoy additional pre-tax deductions of RMB 2000 per capita, equivalent to raising the exemption further from RMB 5000 to RMB 7000. - Size (% of GDP): Less clear - Fiscal multiplier effect*: Medium - Overall impact on 2019 growth: Small - Recommended/consistent with MT goals? No in general. Recommend the targeted tax credit for children. Do not recommend the mortgage interest deduction. Encourages debt finance and, along with the deduction for rental expenses, distorts consumption choices toward housing. - Increase of VAT refund on exports - Effective Sep 18, 2018, an increase in the VAT rebate for exports by 2 pp (weighted average). VAT refund on exports is RMB about 1600 billion (1.8% of GDP) as of 2018. - Size (% of GDP): Less clear, - Overall impact on 2019 growth: -0.1 - Fiscal multiplier effect*: Medium - Recommended/consistent with MT goals? Yes. The increase of VAT refunds to exports is a welcome step, but we recommend moving towards a standard VAT system where exports are zero rated. - VAT cuts for manufacturing sectors - Effective April 1, 2019. Reduction of the standard and of one of the reduced VAT rates. Reducing the current rate of 16% in manufacturing and other industries to 13%; lowering the rate in transportation, construction and other industries from 10% to 9%; and, maintaining the 6% rate on all other items. - Size (% of GDP): 0.3 - Fiscal multiplier effect*: Medium - Overall impact on 2019 growth: 0.15 - Recommended/consistent with MT goals? Yes. The resulting compression of VAT rates is welcome and will allow future consolidation into even fewer rates than the current three. - Tax support for MSEs - Micro and small businesses enjoy now half corporate income tax for taxable annual income exceeding 1 million but less than 3 million, and lower rates for the taxable income below 1 million. - Size (% of GDP): Less clear - Fiscal multiplier effect*: Small - Overall impact on 2019 growth: Small - Recommended/consistent with MT goals? No in general. The measures support MSEs, but these types of preferential rates can cause threshold effects and prevent growth of MSEs. - Social security contribution cuts - Effective May 1, 2019. Lower the employers' contributions to 16%. - Size (% of GDP): 0.2 - Fiscal multiplier effect*: Medium - Overall impact on 2019 growth: 0.1 - Recommended/consistent with MT goals? Yes. Other measures should be used to break the long-term social security contribution-benefit gap. - Infrastructure (financed by special purpose bonds) - Special purpose bonds quota increases from RMB 1350 billion in 2018 to RMB 2150 billion in 2019. Also, some rail and road construction announcements, but without detailed plans. - Size (% of GDP): 0.7 - Fiscal multiplier effect*: Medium - Overall impact on 2019 growth: 0.35 - Recommended/consistent with MT goals? No. - Total Fiscal Impact1.50.8 - * When number not specified, large is about 0.8, medium is about 0.5, and small is about 0.3. - Monetary and credit measures: - Regular and targeted easing with partial transmission. - With a cut in each quarter of 2018Q2 – 2019Q1, the PBC lowered the reserve requirement ratio (RRR) for banks by a total of 350bps, increased liquidity through the medium-term lending facility (MLF), and created a new ‘targeted’ medium-term lending facility (TMLF). - April RRR cut had limited impact as it was offset by a decline in other PBC-provided liquidity; July RRR cut led to a decline in interbank interest rates, which only partially transmitted to medium and longer-term lending rates. - Targeted support for private sector: - PBC ‘targeted’ some RRR cuts for lending to micro and small enterprises (MSEs). - Government target: have the large state-owned banks increase lending to MSEs by 30 percent in the 2019 Government Work Report. - Separate objective: private enterprises to receive at least 50 percent of new loans within three years. ### Authorities’ assessment and views - Authorities’ observations for 2019 Q1: - Real GDP growth: 6.4 percent in Q1. - Unemployment rate: stable at around 5 percent (less than the 5.5 percent target). - PPI inflation: continued to rise. - National industrial capacity utilization rate in Q1: the second highest Q1 rate since 2013. - Growth rates of M2 and TSF: remained steady, basically matching the growth rate of nominal GDP. - Housing market: viewed as broadly stable; recent rebound in house prices after the 2019 Spring Festival seen as temporary and mainly seasonal. - Shadow credit reforms: successful in reducing leverage in the financial market, particularly in asset management businesses; banks continued to bring off-balance sheet assets onto their balance sheets. - Policy emphasis: - Implementing policies focused on high-quality development and adhering to supply-side structural reforms, deepening market-oriented reform, and accelerating opening up. - Conditions for high-quality growth seen as positive: improving business environment, large domestic market, high potential to upgrade and transform industry. - Consumption remains a strong driver of growth; macro-control improving; “active” fiscal policy intended to increase corporate competitiveness and stabilize exports. - Credit growth rebounding and supporting the real economy. ### Outlook and risks - Near-term baseline assumptions and projections: - Growth is expected to decline moderately to 6.2 and 6.0 percent in 2019 and 2020, respectively, given the authorities’ policy response. (Exact text preserved as in source.) - Key assumptions: current tariffs (25 percent on US$250 billion of U.S. imports from China, 5-25 percent on US$110 billion of Chinese imports from U.S.) stay in place; no new tariffs are imposed; and the policy stimulus is not rolled back. - Domestic demand expected to strengthen in remainder of 2019 as a result of the stimulus; export growth expected to be positive, partially supported by ‘frontloading’, leading to an increase in import growth. - Headline inflation projected to rise to 2.2 percent in 2019, due to higher food prices. - Reflecting easing measures, nonfinancial sector debt as a share of GDP is expected to rise sharply in 2019, by 10 percentage points, and credit growth to pick up to 10.5 percent. - Medium-term outlook: - Growth expected to gradually slow to 5½ percent as the economy moves towards a more sustainable growth path. - Credit efficiency expected to improve, but not sufficiently to prevent debt-to-GDP from rising further. - Augmented debt is on an upward trajectory and is not projected to stabilize over the medium term (Appendix I). - Constraints: petering gains from structural transformation and urbanization, and aging in the longer term. - Risks: - Downside risks: - External escalation in tensions could result in higher tariffs, disrupting supply chains and depressing confidence and investment. - US and other countries’ export ban to certain Chinese technology companies could exacerbate the trend. - Domestic risks: deterioration in asset quality of financial institutions (especially small and mid-size banks), funding stress for banks and non-bank financial institutions amid greater concerns about counterparty risk, a sharp downturn in the property market, and a return to PPI deflation, which could generate a self-reinforcing downward cycle affecting weaker private corporates in particular. - Longer-term risks: weaker external demand or reversal of globalization could weigh on growth prospects; increasing role of the state could worsen resource allocation, especially if combined with reliance on debt to hit high short-term growth targets. - Upside risks: - Reduction in trade tensions could spur confidence and investment; stimulus measures could have larger impact leading to overshooting of near-term growth. - Significant reforms to boost productivity—comprehensive domestic reform package increasing the role of markets, greater openness, and meaningful SOE reform—could significantly lift productivity and potential growth over the medium term. ### Productivity convergence and long-run growth prospects (Box 1) - Current convergence status: - China’s labor productivity converged from 15 percent of the frontier to 30 percent over the past two decades. - Sectoral shifts: employment share of agriculture fell from 60 percent to below 30 percent; industry and services shares rose to 28 and 46 percent respectively. - Industrial productivity converged from 15 percent of the frontier at the end of 1990s to about 35 percent; share of high-tech in industrial value-added was 43 percent in 2015 based on 2011 international dollars. - Service productivity converged from 10 percent of the frontier at end 1990s to 26 percent; transportation services at 40 percent, ICT services at 28 percent, wholesale and retail trade below 12 percent of the frontier. - Where convergence is heading: - China has entered “deindustrialization” since 2012, with labor shifting from industry to services; industrial productivity is about 1.3 times services productivity, so deindustrialization will likely exert downward pressure on aggregate growth. - Further productivity convergence likely but at a slower pace. - Applying convergence speeds from cross-country experience, industrial and service productivity growth expected to slow to 3–4 percent by 2030, with productivity levels reaching 57 and 44 percent of the frontier respectively. - Service share projected to rise to 65 percent by 2030. - Aggregate implication: GDP growth would slow from current 6½ percent to 4–4½ percent by 2030. - Faster SOE reform and opening up of the service sector could moderate the pace of slowdown by boosting productivity growth. *Source: PEOPLE’S REPUBLIC OF CHINA — INTERNATIONAL MONETARY FUND (excerpt from the supplied content).* ### 22. Key issues. Financial deleveraging and improved control over LG off-budget infrastructure ### 22. Key issues. Financial deleveraging and improved control over LG off-budget infrastructure financing led to slower, but safer, growth in 2018. ### Baseline policy stance — “stay the course”; avoid additional stimulus and excessive credit growth - Fiscal policy - No additional stimulus is needed as the planned stimulus is sufficient to stabilize growth in 2019 and 2020 despite the recent tariff increase. - Given the risk of further escalation, consolidation should wait for greater clarity on trade and the external environment, but resume as tensions ease and the outlook becomes clearer. - Policy space should be used to offset any negative impacts from needed structural reforms instead of geared towards achieving excessively-high growth targets. - Augmented debt is high: "73 percent of GDP in 2018", rising rapidly, and is projected to "exceed 100 percent of GDP in 2024." - Consolidation can be gradual given China’s fiscal space (large assets, low borrowing costs). Reducing the augmented deficit by about "¾ percent of GDP a year over ten years" would stabilize debt while keeping the growth impact manageable. - To increase the quality of medium-term adjustment, focus on: - limiting infrastructure spending (especially off budget), - boosting progressive and pro-rebalancing taxes (e.g. PIT, property, and carbon), - spending more on health, education, and transfers to poorer households and regions. - Monetary policy - Further monetary policy easing is not recommended as actions already taken are sufficient, still being transmitted, and core inflation remains anchored. - Further actions should be data dependent, including on the impact of fiscal loosening and credit growth. - Credit and financial sector - After progress on reducing credit growth in 2018, credit growth accelerated in 2019. Aggregate credit growth remains high and credit allocation has worsened. - The recent credit acceleration should be curtailed to prevent an increase in credit growth in 2019, and further deceleration should occur in 2020. - In the medium term, credit growth should moderate towards nominal GDP growth or lower and the efficiency of credit needs to improve, through a more market-based allocation of credit instead of targets on lending to private enterprises. - Reforms should focus on reducing the pace of credit growth to SOEs and pricing credit appropriately. - Near-term measures to boost bank capital would facilitate further downsizing of shadow banking and increase banks’ resilience to shocks. - Exchange rate and capital flows - Flexibility of the exchange rate should increase to facilitate adjustment to the new external environment, with public communication and FX intervention used when needed to counter disorderly market conditions. - Authorities should refrain from using the CCAF in the daily trading band to control the exchange rate, while the reserve requirement on FX forwards should be phased out. - CFMs should not be used to actively manage the capital flow cycle and substitute for warranted macroeconomic adjustment and exchange rate flexibility. - Publishing information on FX intervention would improve the transparency and communication of the framework. - Further capital account opening should be carefully sequenced and targeted. - Policy coordination - Stronger planning and calibration of policies, and coordination among agencies, would enhance policy traction, reduce volatility and mitigate the risk of start-and-stop reforms. ### Policies under an adverse scenario (trade escalation) - Shock and required response - A further escalation of the trade tensions, e.g., the U.S. raising tariffs to "25 percent on remaining imports from China", could reduce growth by "around 0.8 percentage points over the following 12 months", driven by a sharp fall in demand and tightening of financial conditions, with significant negative spillovers globally. - Against this shock, further easing, primarily through fiscal measures, would be warranted. - A fiscal expansion of "0.8 percentage points of GDP" could be used to stabilize the economy. Such an expansion should be on-budget and centrally financed, pro-rebalancing, and targeted to low-income households. - Recommended fiscal measures under an adverse scenario (total size 0.8 percent of GDP) - Expenditure options (size and characteristics): - Permanent increase in rural/urban pensions: "0.1" (% of GDP) — Large multiplier; Targeted: Yes; Consistent with MT goals?: Yes - Increase in social transfers to provinces: "0.1" — Large; Targeted: No; Consistent with MT goals?: Yes - Education: "0.1" — Large; Targeted: Yes; Consistent with MT goals?: Yes - Health: "0.1-0.2" — Large; Targeted: Yes; Consistent with MT goals?: Yes - Unemployment benefits: "0.1" — Medium; Targeted: Yes; Consistent with MT goals?: Yes - Revenue and other measures: - Remove minimum social contribution contributions for low-income households: "0.1" — Large; Targeted: Yes; Consistent with MT goals?: Yes - Full VAT refund on exports: "0.1-0.2" — Medium; Targeted: No; Consistent with MT goals?: Yes - Note on multipliers: "* When number not specified, large is about 0.8, and medium is about 0.5." - Monetary policy under adverse scenario - As core inflation could fall along with growth, further monetary policy easing may be warranted but should be modest, data dependent, and factor in the impact of other easing measures on inflation. - As RRRs are still high ("13.5 percent for large banks"), the most effective easing would take the form of further RRR cuts, followed by a cut in the PBC 7-day reverse repo rate. - Exchange rate and capital flow management - The exchange rate should remain flexible and market-determined to help absorb the tariff shock. - Greater depreciation pressures and potential capital outflows will call for clear public communication and possible FX intervention to counter disorderly market conditions. - If FX market pressures persist and lead to herding and financial system stress, tightening existing CFMs in a transparent and temporary manner may be appropriate as part of a broader policy package to stabilize the economy and markets. - Financial sector and macroprudential stance - Financial sector reform and deleveraging should continue. Macroprudential policies should not be loosened in general. - Distortionary administrative restrictions (e.g. on home purchases and sales) should be relaxed before relaxing any housing macroprudential policies. - Government intervention to support the stock market should be avoided; if systemic risks arise from forced selling by firms reliant on stock-collateralized borrowing, transparent direct support to those firms could be considered. ### Policies under an upside scenario (comprehensive U.S.-China agreement) - Fiscal policy - If a comprehensive agreement with the U.S. is reached, stimulus measures should be scaled back. - The fiscal stimulus expected to increase the augmented deficit by "1½ percent of GDP" would be too large and should be reduced in 2019 with fiscal consolidation proceeding more rapidly. - Options to withdraw stimulus include: - decreasing LG infrastructure spending, particularly off-budget spending; - accelerating implementation of a recurrent property tax; - raising pollution charges; - tightening some of the PIT reform parameters. - Monetary and financial policies - With stronger output and inflation outlook, monetary policy may need to tighten moderately via an increase in the PBC 7-day reverse repo rate. - Credit growth should slow. - Efforts to build bank capital buffers via external injections or profit retention should be intensified. - Exchange rate and capital account - The exchange rate could strengthen, creating room to more rapidly eliminate distortionary restrictions such as the reserve requirement on FX forwards and the counter-cyclical adjustment factor in the daily trading band. ### Authorities’ views and actions - The authorities broadly agreed with staff’s growth forecasts and policy recommendations. - They described their fiscal policy as “active”, focused on supporting domestic demand through tax and fee cuts, and noted policies were frontloaded; policy impacts expected to show gradually in the second quarter of 2019. - They viewed monetary and credit policies as prudent and appropriately calibrated; they did not intend to loosen monetary policy in the baseline but noted some additional targeted measures to increase credit to the private sector and SMEs may be undertaken. - On exchange rate policy: - Authorities reiterated commitment to increasing FX flexibility and deepening market reforms and noted the exchange rate had become more flexible in recent years. - They confirmed no new administrative measures or CFMs were put in place since the last Article IV other than the CCAF and the reintroduction of the "20 percent reserve requirement on FX forwards." - PBC will closely monitor exchange rate movement, promote market-oriented exchange rate reform, maintain exchange rate flexibility, and dynamically assess and adjust macroprudential measures. - PBC is establishing a macroprudential management framework for managing cross-border capital flows and stressed that actively managing the capital flow cycle is not a target of such macroprudential regulation. - They noted that China’s disclosure of FX intervention data meets international standards since joining IMF’s SDDS. - On banking sector reform - Authorities are pressing ahead with financial regulatory reform and opening up financial services. - To strengthen solvency of small banks, they encourage profit retention and capital raising from outside sources; consolidation through acquisitions is an option if those measures fail. - Contingency planning - Authorities prepared contingency plans in case of an adverse scenario, with pipeline projects at central and local levels to support public housing, farming, rural connectivity, regional development, basic public infrastructure, and to strengthen unemployment insurance and job training. - They noted adequate monetary policy room to deal with a worse external environment: "RRRs still above 10 percent and nominal interest rates well above zero", and increased exchange rate flexibility has expanded room for monetary policy. - They emphasized focusing on policy transmission, targeted measures to improve credit structure, and refraining from excessive credit growth. ### External policies and global spillovers - Key issue: China needs to limit adverse spillovers from its own policies and work with partners to build a stronger multilateral system that promotes open and stable trade. - Spillovers from trade tensions - Ongoing tensions weigh on global trade and confidence; how they are resolved may shape the global trading system for years. - A preferential or “managed trade” deal between the two largest economies could divert trade and investment and weaken the rules-based global trading system, adding medium-term risk for the global economy and causing direct spillovers that put at risk substantial EU and Asian exports. - U.S.-China trade structure and potential managed-trade effects - U.S. exports to China: "~$130 billion" (goods) - U.S. imports from China: "~$530 billion" - Bilateral goods trade deficit: "~$400 billion" - Closing the bilateral trade deficit substantially through guided purchases would be difficult — e.g., increasing certain U.S. export categories by 400 percent would be required to cut the gap in half in the near term. - A managed-trade scenario could cause trade diversion and sizable export losses for third countries; IMF staff estimates highlighted potential impacts such as EU exporters seeing declines of about "$84 billion" and Korea and Singapore potentially losing exports amounting to about "2.1 and 3.8 percent of their GDP, respectively." - Longer-term effects of a managed-trade deal - A modeled scenario of a "50 percent reduction in the bilateral U.S.-China trade deficit" implemented via increased purchases of U.S. goods would generate sectoral dislocations; examples: Vietnam and Australia could see declines in extractive industries, while electronics would be most affected in Korea and Malaysia. - Long-run productivity effects of such reallocations are negative; aggregate losses could be amplified by adjustment costs and dynamic responses of labor and capital accumulation. *Source: IMF staff estimates.* ### 33. The global economy would benefit from a more open, stable, and transparent, rules- ### 33. The global economy would benefit from a more open, stable, and transparent, rules-based international trade system ### Trade system: findings and recommendations - Finding: Trade tensions between China and the U.S. should be quickly resolved through a comprehensive agreement that avoids undermining the international system and not through a managed trade deal that targets a compression in the U.S.-China trade deficit. - Recommendation: Any agreement between two large and systemically important trading partners should: - reinforce WTO rules, - be non-discriminatory, and - be based on market mechanisms and macroeconomic fundamentals. - Recommendation: China and its trading partners should work constructively to address shortcomings in the trading system and enable a system that can more readily adapt to economic changes in the international environment. ### China’s role in modernizing trade and related policies - Recommendation: China should work together with international partners to advance trade negotiations in areas such as e-commerce and services. - Recommendation: Ensure the continued enforceability of existing WTO commitments through a well-functioning, improved WTO dispute settlement system. - Recommendation: China may accept more open investment regimes, and transparency/reduction on industrial subsidies. - Recommendation: As a global leader in e-commerce and fintech, China could collaborate with other countries to set global standards on industry regulation, digital standards, and cyber security. - Finding: More generally, China can support the international system and benefit from further opening up and other structural reforms that enhance competition. ### External lending and the Belt and Road Initiative (BRI) - Finding: China’s external lending, such as through the Belt and Road Initiative (BRI), has the potential to bring significant benefits to partner countries by directing financing to much-needed infrastructure projects, strengthening bilateral trade, and deepening global value chains. - Recommendation: Strengthen external lending frameworks to promote greater coordination, cooperation, and transparency to maximize benefits to partner countries by directing financing to most needed infrastructure projects. - Recommendation: Enhance debt sustainability monitoring, improve trade policies and customs procedures, and strengthen exchange rate and financial sector policies in partner countries. - Finding: The authorities’ new BRI-Debt Sustainability Framework (DSF) is a positive step to enhancing discipline in external lending. - Recommendation: Complement the BRI-DSF with a coordinating body charged with monitoring debt sustainability and overseeing broader BRI issues. - Recommendation: Use competitive project selection with open procurement and private sector participation and sound project assessment to strengthen resource allocation while mitigating environmental, financial, and corruption risks. - Recommendation: Adhere to global standards that promote transparent and sustainable lending practices by fostering cooperation among borrowers, creditors and international organizations and enhance capacity building. - Recommendation: Enhance environmental sustainability by ensuring investment projects are green, low-carbon, and climate resilient. ### Authorities’ views on trade and BRI - Finding: Authorities noted trade tensions are a major risk to the global economy and hoped all parties would seek to maintain and strengthen the multilateral and rules-based trade system. - Finding: Authorities emphasized there are no winners in a trade war and China is committed to credible consultations based on equality and mutual benefit. - Finding: Authorities consider China well placed to navigate increased uncertainties given economic resilience—-diversification of exports to non-US destinations and increasing role of domestic demand and policies—-and still sufficient room for fiscal and monetary policy maneuvers. - Authorities’ WTO reform priorities: - resolving the impasse on the selection of appellate body members, - restricting the abusive use of national security exemptions, and - curbing the increasing prevalence of unilateral trade actions. - Finding: Authorities underscored the broad scope of the BRI (infrastructure projects, financial and trade connectivity, policy coordination, cultural ties) and are actively working towards full implementation of the new BRI-DSF by gathering necessary data and building capacity among government agencies and financial institutions. - Finding: Authorities underscored a recent commitment towards green investment under the initiative and noted there are no plans to change the oversight framework of the BRI at present. ### Deleveraging and de-risking: key issues - Finding: Concerted efforts to strengthen financial regulation, reduce regulatory arbitrage, and improve the institutional framework for financial supervision led to a contraction of shadow banking and financial interconnectedness, resulting in a needed decline in credit growth and corporate debt. - Finding: Negative aspects include deteriorating bank business models and profitability, comparatively low system-wide capital (particularly in small and medium sized banks), rapidly rising household debt, and worsening credit allocation as private firms’ access to credit was curtailed. - Priority: Avoid regulatory backtracking and continue with structural regulatory reforms to reduce still-elevated vulnerabilities, while boosting bank capital. ### Financial sector recommendations (FSAP-related and others) - Recommendation: Fully implement announced regulatory reforms. Specifically: - Uniformly regulate and supervise the asset management sector; implement reforms introduced from late 2017 without delays. - Do not relax micro-prudential regulations, even temporarily, for cyclical reasons or to offset tighter financial conditions. - Recommendation: Strengthen bank capital to facilitate downsizing of shadow banking, encourage migration of these assets onto bank balance sheets, and improve the transmission of monetary policy. - Finalize the DSIBs and SIFIs framework, including additional capital surcharges. - Encourage retention of profits and/or provide tax incentives to raise equity (such as an Allowance for Corporate Equity (ACE)) from non-bank sources rather than increasing capital through cross-bank holdings of perpetual bonds. - Recommendation: Develop resolution regimes for banks applied consistently across banks and strengthen the deposit insurance system to facilitate exit of weak institutions. - Recommendation: Contain vulnerabilities from rising household debt by strengthening macroprudential tools and developing a personal bankruptcy regime. - The debt-service-to-income (DSTI) limit (currently 55 percent) should be tightened to international norms of 30-50 percent, applied to all debt obligations including those from nonbanks (e.g., P2P lending). - Use DSTI more actively to enhance loan-to-value limits, for example by restricting the use of unsecured loans for mortgage down payments. - Extend systemic risk assessment of the household sector beyond aggregate credit and housing market indicators and improve the quality and scope of the credit registry. - Over time, develop a personal bankruptcy regime and strengthened institutional arrangements (e.g., asset and credit registries). - Recommendation: Remove the recently introduced income tax deduction for interest on mortgages. - Recommendation: Press ahead with comprehensive fintech supervisory oversight using a “substance over form” approach (based on activity rather than type of entity). - Welcome initiatives that strengthen data gathering and enhance “know your customer” requirements. - Support policies that foster open networks and competition while maintaining financial stability. - The PBC’s announcement in March outlining market entry requirements for foreign companies in the domestic digital payments market is a welcome step. - Encourage efforts that leverage fintech to bolster greater financial inclusiveness, including greater internet penetration in rural areas. - Recommendation: Address AML/CFT shortcomings identified by FATF, including: - Increase transparency of beneficial owners of legal entities operating in China, - Introduce a comprehensive legal framework to implement UN-based targeted financial sanctions requirements, - Improve financial sector supervision and preventive measures (e.g., customer due diligence and politically exposed persons). ### Credit allocation, SOEs, and private sector financing - Finding: To improve credit allocation and efficiency, policies to increase lending to the private sector should be complemented with policies that reduce the share of credit to SOEs. - Recommendation: Remove pervasive implicit guarantees and other advantages (e.g., endowed land) enjoyed by SOEs to foster debt and regulatory neutrality and promote higher-quality deleveraging. - Recommendation: Develop a comprehensive and well-sequenced plan to remove implicit guarantees in the medium-term. Near-term options include: - Require corporates that receive implicit advantages to explicitly pay the cost to the budget (in addition to standard targeted transfer of SOE profits to the fiscal budget). - Penalize SOEs that fail to meet the dividend payout target of 30 percent of profits (e.g., reduce access to loans or increase credit spreads). - Increase banks’ risk weights on loans to corporates receiving such guarantees to correct underpricing of risk. - Other financial regulatory options: - Gradually tighten caps on banks’ exposure limits on SOE loans to equalize application of large and related-party limits on lending to SOEs and private enterprises in the medium-term. - Harmonize regulation in the segmented bond market to increase liquidity and price discovery. - Drop the requirement that medium-term notes and commercial paper obtain an AA rating or higher to encourage more issuance by smaller firms while allowing investors to bear risks and bonds to default. - SME financing recommendations: - Expedite payments to SMEs (especially from SOEs). - Increase use of alternative forms of collateral, such as moveable assets and accounts receivable, rather than lowering risk weights for SMEs or expanding public credit guarantees. - Recommendation: Increase transparency on SOE/private enterprise credit, for example by publishing the share of bank credit to each group. - Recommendation: Encourage more equity financing, for example through an Allowance for Corporate Equity that provides an income tax deduction for the normal rate of return on equity, while monitoring impact on tax collection. - Recommendation: Strengthen overall credit culture by developing a more comprehensive credit registry and encouraging operation of more foreign ratings’ agencies to improve bond ratings. ### Authorities’ views on deleveraging, household debt, fintech, and AML/CFT - Finding: Authorities agreed bank capital needs to be strengthened, particularly for small banks, and recognized the rapid rise in household debt. - Finding: Authorities viewed Baoshang Bank as an isolated case and considered contagion risk to be low and manageable; the PBC is ready to provide sufficient liquidity to mitigate funding problems. - Finding: Authorities agreed on the need to establish a well-functioning resolution regime. - Finding: Authorities plan to enhance the role of DSTI limits as a macroprudential tool going forward but emphasized the need to improve information on all household debt obligations. - Finding: Authorities see merits of a unified credit registry but favor having credit information collected and shared by different registries, including market-based ones. - Finding: Authorities agreed on the need to promote a personal bankruptcy regime, improve enterprise bankruptcy law, establish a universal property registration and reporting system, further develop social security framework, and address moral hazard concerns regarding personal insolvency. - Finding: On fintech, authorities recognized dominance of a few market leaders could amplify risks and are formulating rules establishing principles for innovative fintech products, new financial services channels, administrative and safety rules for banks’ APIs, data protection, and regulation of key technologies such as cloud computing; a comprehensive oversight plan of fintech firms is expected. - Finding: On AML/CFT, authorities are preparing a plan to address FATF-identified shortcomings, aim to submit it to the State Council as soon as possible, have adopted regulations requiring financial institutions to obtain beneficial ownership information for new clients with timetables for existing clients, and have adopted new standards to identify non-complying financial institutions and impose sanctions. ### Progress and stance on SOE deleveraging - Finding: Authorities highlighted success in deleveraging. The requirement that SOEs decrease their leverage (liability-to-asset ratio) by 2 percentage points by 2020 has yielded positive results. - Finding: Authorities implemented a pilot program requiring banks to jointly decide on whether to lend to highly indebted SOEs. - Finding: Authorities viewed lower cost of capital for SOEs as reflecting market perceptions of SOEs being less risky. - Finding: Authorities committed to further deleveraging of SOEs but stressed the process should be gradual and balance deleveraging, risk prevention, and economic stability, while encouraging lending to the private sector, particularly SMEs, following market principles. - Finding: Authorities agreed credit allocation to SMEs could be improved by finding alternatives to collateral, including using fintech for creditworthiness assessment. ### External imbalances and boosting consumption - Finding: China has made welcome progress in reducing external imbalances over several years. - Finding: The external position in 2018 was broadly in line with medium-term fundamentals and desirable policies. - Projection/Risk: The current account (CA) is projected to remain close to balance over the medium-term, but risks exist that an excessive surplus could reemerge should consumption fail to rise as quickly (e.g., due to high household debt) or investment fall faster than expected (e.g., due to further credit tightening). - Recommendation: Achieving a durable balance in the external position requires continued progress in addressing distortions that encourage excessive household savings and further boosting consumption. - Finding: Increasing consumption will also increase the welfare of Chinese citizens, who spend less on consumption than those in other similar income-level countries. *Source: PEOPLE’S REPUBLIC OF CHINA — INTERNATIONAL MONETARY FUND (content unit 33–45).* ### 46. Continued progress in addressing distortions that encourage excessive household ### 46. Continued progress in addressing distortions that encourage excessive household ### Consumption rebalancing and fiscal reforms - Continued progress in addressing distortions that encourage excessive household savings and boosting consumption would help achieve a durable external balance. - China’s savings rate is projected to fall over time due to demographic changes, but targeted fiscal reforms can also help boost consumption and reduce inequality. - Structural reform priorities: - Enhance the social safety net to lower precautionary savings by increasing spending on social welfare including healthcare, education, and pensions, and improving access to social services by accelerating hukou reform. - Shift certain spending responsibilities (e.g. health and education) to the central government to ensure a minimum level of service and reduce the large disparity between urban and rural public service provision. - Make the tax system more progressive by: - Reducing the personal income tax threshold and widening the tax base. (Contrast noted with the recent PIT reform which raised the taxable income threshold sharply and introduced a wide range of deductions, benefiting the better-off and narrowing the tax base.) - Removing minimum social security contributions for low income households which result in prohibitively high effective tax rates for the lowest earners. - Accelerating the introduction of a nationwide recurrent property tax to provide an important source of local government revenue and contribute to curbing property speculation. - Imposing a substantial carbon or coal tax to tackle air pollution and climate change; such a tax would also help generate revenue to offset higher social spending, as well as save almost four million lives by 2030. - Specific household and tax datapoints cited: - Average monthly wage of urban non-private enterprise employees, RMB 7358 - Average monthly wage of urban private enterprise employees, RMB 3613 - PIT reform: new regime effective October 1, 2018 ### Financial system preparedness and capital flow volatility - The financial system and policy framework should prepare for greater capital flow volatility. - Key measures: - Strengthen the financial system through continued de-risking and improved FX risk management. - Complement greater exchange rate flexibility with steps to deepen the FX market and improve transparency. - Develop markets and tools for risk management (e.g. bond futures) given the growing importance of benchmark-driven foreign portfolio flows. - Regulatory reforms should adhere to international standards to encourage investment by institutional and long-term investors and deepen RMB internationalization. - Over the medium term, capital flow management measures (CFMs) should be gradually phased out in a sequence consistent with greater exchange rate flexibility and other supporting reforms. - Authorities expect the current account to remain in surplus over the medium term and foresee the income deficit narrowing as foreign direct investment (ODI) proportion increases, leading to higher return on overseas earnings. - Inclusion of Chinese domestic debt and stock markets in international indices is expected to provide a stable source of inflows despite possible short-term market sentiment changes in 2019. ### Productivity slowdown, structural causes, and reform priorities - Key issues: - China’s productivity growth has declined steadily since the GFC, driven by declining returns on infrastructure investment and worsening resource misallocation related to the increasing role of the state. - TFP growth since the GFC, at 2¼ percent, is about half of its average in the decade before the GFC; the decline in TFP explains most of the fall in GDP growth between the two periods. - The incremental capital-output ratio has been rising, reflecting diminishing returns to capital accumulation. - Reform priorities to boost long-term productivity and income convergence: - Increase the role of the market by unifying product markets to raise firm entry across sectors and regions, and increase labor market flexibility. - Further liberalize markets, particularly in services dominated by the public sector. - Remove local protectionism (e.g. requirements to use designated service providers, local registration requirements) following the government’s Work Plan for Dismantling Barriers to Competition. - Amend the bankruptcy law to improve the quality of exits, restrain local government intervention, and expand the use of specialized bankruptcy courts and administrators. - Accelerate hukou reform, enhance access to social services, and increase pension portability to boost labor market flexibility. - Accelerate opening up: - China remains less open than other G20 emerging market economies in services and FDI; further opening of the service sector and simplifying approval of inward investments is recommended. - The new foreign investment law and recent changes to the negative list are positive steps and should be implemented consistently across localities. - Unilaterally eliminating tariffs on goods imports could increase China’s real GDP level by about 3 percent in the long term, while liberalizing FDI could increase GDP by a further 6 percent; lowering non-tariff barriers (NTB) on services has a further estimated impact of 0.4 percent on GDP. - Scenario impacts on GDP (reported): Goods tariff, 3.0; Services NTBs, 0.4; FDI, 6.0. - Accelerate and intensify SOE reform to achieve competitive neutrality and improve performance: - Limit SOE use of credit advantages by hardening budget constraints and increasing dividend payments to the budget; set deleveraging goals in terms of SOE debt/GDP ratio. - Support removal of implicit guarantees by allowing SOE and LGFV bonds to default. - Complete classification/identification/zombie exit with published classifications (competitive, social, strategic) and timetables for moving SOEs out of competitive sectors. - Ensure zombie exits do not reduce competition via top-down mergers; instead release resources to the private sector and facilitate exits by strengthening the social safety net. - Increase competition by opening non-strategic sectors to private and foreign enterprise, strengthen the State Administration for Market Regulation, and submit a high-quality revised offer to join the WTO Agreement on Government Procurement. - Improve SOE governance by increasing transparency at the group level and promoting appointment of managers with international and private sector experience (e.g. follow 2015 OECD guidelines on corporate governance of SOEs). ### Policy frameworks, governance, and macro policy tools - Managing an increasingly systemic and complex economy requires modernizing policy frameworks and improving governance to favor market-based, transparent frameworks and reduce vulnerabilities to corruption. - Monetary policy recommendations: - Phase out benchmark deposit and lending rates while developing a market-based loan pricing mechanism. - Clarify that the PBC’s reverse repo rate is the one key policy rate; move corridor ceiling and floor rates in tandem with the policy rate. - Base pricing and access to PBC lending facilities on clearly defined collateral rules and not supervisory criteria. - Gradually phase out new facilities (e.g. TMLF) and central bank lending (re-lending/discounting) used to respond to slowdowns, simplifying the operating framework to improve effectiveness. - Give the PBC greater accountability and operational independence around a clear inflation objective. - Financial regulation and supervision: - Give the Financial Stability and Development Committee (FSDC) full macro-prudential authority with a clearly defined policy process and toolkit including the counter-cyclical capital buffer. - Clearly communicate division of responsibility across agencies, decision-making processes, roles, and coordination mechanisms to the public. - Fiscal reforms and governance: - Establish a macro-fiscal unit in the Ministry of Finance to estimate China’s fiscal policy stance and macro impact. - Recognize and dismantle implicit guarantees on off-budget investment; non-commercial debt should be recognized and estimates of general government deficit and debt improved by following international standards and including off-budget borrowing. - Reduce misalignment of center-local fiscal responsibilities; key reforms include accelerating a nationwide recurrent property tax and having the central government take over certain expenditure responsibilities (pensions, employment insurance, health, and education). - Increase the size of equalization grants to support least-developed and vulnerable regions. - Improve pension system sustainability through parametric reforms such as gradually increasing the retirement age, indexing benefits to prices, and modifying benefit formulas. - Enhance fiscal transparency by publishing general government accounts and balance sheets, the Executive’s budget proposal in line with international best practice, information on quasi-fiscal operations of SOEs and extrabudgetary funds, producing a fiscal risk statement, and improving the framework for non-tax revenues (e.g. land sales). - Improving transparency and statistics: - Monetary policy and financial stability communication improvements include a new PBC website in English, regular press conferences, expanded Q&As, and publishing stress test results in the annual financial stability report. - Fiscal accounts should be made more transparent and data brought more in line with international standards. - Address longstanding data gaps in national accounts and sparse labor market data to improve policymaking, credibility, IMF surveillance, and G20 commitments. *People’s Republic of China — Chapter/Section content (IMF).* ### Box 4. Improving Governance in Administering Land Transfer Fees ### Box 4. Improving Governance in Administering Land Transfer Fees ### Context - China mobilizes substantial amounts of government revenue by selling land user rights (LURs) to entities and individuals. - In 2017, land transfer fees from LUR sales accounted for around 7 percent of GDP and 39 percent of LG revenue. - Land transfers have also been a critical factor in China’s economic growth and urban development. - Proper governance of land transfer fees is key to ensuring sufficient funding for LGs as well as promoting economic efficiency and fairness in land allocation. ### Current practices - Urban land is owned by the state and rural land is owned by collective organizations. - Individuals and entities can use land by acquiring LURs, either for free (or at low cost) if used for public purposes, or for a fee if used for private (profit) purposes. - Since 2007, for profit LURs have been granted through a bidding process instead of direct negotiation and land transfer fees have been turned over to LG treasuries and reported in their budgets. ### Existing vulnerabilities and recent improvements - A 2014 National Audit Office report found that about 20 percent of the RMB13 trillion (3 percent of GDP) in audited land transfer fees were either under-collected, inappropriately spent, or improperly accounted. - Recent reforms initiated by the authorities: - An online Public Resources Transactions Platform has been deployed on which all land auctions and tenders are now executed. - The MOF has issued new procedural guidelines for collecting and using land transfer fees. ### Good international practices — Collection of land transfer fees - The Land Administration Law, which is currently undergoing revision, could be amended to include a section on land transfer fee administration. This section could include the most crucial provisions governing land auctions/tenders and collection of land transfer fees while still providing flexibility to LGs on other, less critical features of fee administration. Regulations—which are currently scattered across various decrees and instructions--could be consolidated. - An appropriate division of collection responsibilities across agencies is needed to provide checks and balances. The responsibilities for key collection functions (e.g., preparing auction and tender documents, establishing reserve prices, evaluating the tenders and selecting the winning bids, handling payments) should be split across government agencies to avoid undue concentration of authority. - Competitive bidding processes should include features that ensure fairness and transparency. This could be promoted by requiring tenders and reserve prices to be submitted in sealed envelopes, secured in a locked tender box, and opened in the presence of and evaluated by officers from multiple agencies. There is also evidence that single-stage auctions are less vulnerable to manipulation than two-stage auctions. Auctions and tenders could be conducted on-line using an electronic bid submission system with a secure log book. Both winning and losing bids should be published. - Internal controls need to be designed to promote integrity in administration. The Ministry of Finance and Ministry of Natural Resources could issue internal control guidelines on segregation of duties within agencies, establish multiple levels of review for key decisions, and require reconciliation of accounting information (e.g., to ensure the agreed contract price matches the amount actually paid). Information systems should grant access rights to authorized officials in line with their responsibilities and include activity logs and exception reports for identifying unusual system usage for follow up. - External supervision and investigation should be guided by modern risk management methods. Those categories of land transfer fee administration that are perceived to have the highest risk of violations should be assigned a national risk manager who is responsible for overseeing a national strategy for mitigating the risk. The National Audit Office could conduct a targeted land administration audit to follow-up on its 2014 comprehensive audit. - Land administration officials should be bound by a public service code of conduct. The standard code of conduct could be extended for land officials by requiring them to file a financial disclosure declaration each year and a confidentiality of information form for each auction/tender. A comprehensive and continual awareness program should be implemented to ensure that land officials understand the code of conduct, how to comply with it, and the consequences of violations. ### Good international practices — Use of land transfer fees - There are clear benefits in bringing all land expenditures (and revenues) under a unified budget and subjecting them to legislative scrutiny. Mechanisms that earmark revenue and expenditures to specific purposes limit policy flexibility to allocate resources to higher priorities. They also impede the legislature’s fiscal oversight. Good practice is to include all land sales revenues and expenditures in the annual general budget of the concerned local government. - If a separation cannot be avoided, then the planned uses of the fees (and expected collections) should be fully disclosed as part of budget documentation for information purposes, under the same classification standards and granularity as the general budget. Existing regulations may need strengthening to ensure the resources are efficiently managed and are carried out in accordance with acceptable standards of accounting and reporting, internal control, internal and external audit, and meets basic transparency requirements. The regulations may also need clarity on the accountability for the use of these resources. - Central oversight of the use (and collection) of land transfer fees should be supported by well-designed IT systems. Local accounting IT systems should ideally be harmonized across local governments and follow similar timelines to ensure the rapid and timely consolidation of information at the central level. At least, IT systems should be designed to allow for some degree of dialogue between one another, so that the information can be easily translated and exploited for consolidation purposes. ### Authorities’ Views - The authorities pointed out several initiatives implemented in recent years to improve land transfer fee administration: an online Public Resources Transactions Platform has been deployed on which all land auctions, tenders, and listings are now executed; new guidelines have been issued on the collection and uses of land transfer fees; investigations of land administration violations were increased, resulting in more prosecutions. - The authorities are of the view that these and other initiatives have had a significant impact on improving land transfer fee administration and reducing corruption, but saw value-added in considering further some of the good international practices identified by the mission. *Prepared by J. Brondolo, F. Gonguet, and S. Saxena* ### 73. It is proposed that the next Article IV consultation with China take place on the ### 73. It is proposed that the next Article IV consultation with China take place on the standard 12-month cycle. ### Recent Developments: Weaker Growth Momentum - Growth moderated in 2018, particularly in the second half of the year. - Demand side: - Consumer spending remained relatively robust (excluding tax-affected auto sales). - Figure caption: Contribution share to real GDP: demand side (In percent). Series labels shown: Net export, Investment, Consumption, Real GDP growth. - Time markers and labels present: 2013Q1, 2014Q3, 2016Q1, 2017Q3, 2019Q1. - Retail and auto indicators: - Retail sales, auto sales and urban disposable income shown (In percent, year-on-year, 3mma). - Time markers: 2014M3, 2015M7, 2016M11, 2018M3, 2018M10, 2019M5. - Legend entries: 2019M5, Non-auto retail sales, Auto sales, Retail sales, Urban disposable income (rhs). - Investment and financing: - Growth of investment and total social financing (In percent, year-on-year). - Series include Infrastructure investment, Manufacturing investment, Real estate investment. - Time marker: 2019M5. - Supply side and business surveys: - Survey indicators weakened significantly, especially for export orders. - PMI: Manufacturing (SA, 50+=Expansion). Time markers: 2014M1, 2015M2, 2016M3, 2017M4, 2018M5, 2019M6. Source: Haver Analytics. - Export orders, New orders, Production series shown. - Profitability and prices: - Profitability has fallen as PPI inflation moderates. - Industrial profit growth (Percent change, 3mma year-on-year). Time markers include 2013M1, 2014M3, 2015M5, 2016M7, 2017M11, 2019M1, 2019M5. - Series labels: Downstream profits, Upstream profits; PPI (rhs, percent change yoy). - Property market: - Property sales have weakened. - Residential House Price and Floor Space Sold (In percent, year-on-year, 3mma). - Time markers: 2012M1, 2013M3, 2014M5, 2015M7, 2016M9, 2017M11, 2019M1, 2019M5. - Series labels: Floor space sold, Residential house price. ### Rebalancing: Continued but Uneven Progress - Real-side rebalancing: - Internal rebalancing towards consumption in real terms accelerated. - Internal rebalancing towards services stalled as a share of GDP. - Contribution share to real GDP: demand side (In percent) with time span 2011–2018 and series Net export, Investment, Consumption. - Supply-side structure: - Contribution share to real GDP: supply side (In percent) with time span 2011–2018 and series Tertiary, Secondary, Primary. - Sectoral employment (In percent of total employment) with time markers 2000, 2003, 2006, 2009, 2012, 2015, 2018. Series: Primary industry, Tertiary industry, Secondary industry. - Labor reallocation from agriculture and industry to services continued. - Credit dynamics: - After improving in 2017, credit intensity stabilized in 2018. - Credit intensity defined as credit to economy divided by nominal GDP. - Chart elements: Change in credit, Change in nominal GDP, Credit intensity (rhs). Time markers: 2005, 2007, 2009, 2011, 2013, 2015, 2017. Units: In RMB trillions; ratio. - Annotation: 2018 — Worse credit intensity. - Environment and inequality: - Most cities saw continued declines in air pollution. - The rural-urban aspect of inequality improved somewhat in 2018 but remains high. - Additional figure elements and numeric markers present across panels: - Numeric labels appearing in figures and captions: 61.9, 54.9, 47.0, 48.8, 59.7, 66.5, 57.6, 76.2, 46.2, 43.4, 55.3, 46.9, 41.6, 43.1, 33.8, 32.4, -8.1, 1.7, -2.3, 4.3, -1.3, -9.6, 8.6, -8.6. - Other numeric timelines and markers appear: 4.1, 5.0, 4.2, 4.6, 4.5, 4.1, 4.8, 4.2, 52.0, 50.0, 48.5, 47.9, 42.5, 38.2, 35.7, 36.1, 43.9, 45.0, 47.2, 47.5, 53.0, 57.7, 59.6, 59.7. *Source: CEIC; CEIC and IMF staff estimates; Haver Analytics.* ### 2.5 in 74 cities ### 1chnea2019003 - 2.5 in 74 cities ### Air quality (2.5 in 74 cities) - Chart title: "2.5 in 74 cities (μg/m³, bubble size proportional to city usual residence population in 2016)". - Time windows compared: - Oct. 2017 to Mar. 2018 average - Oct. 2018 to Mar. 2019 average - Note: December excluded due to data availability. - Source: CEIC and IMF staff estimates. - Visual distinctions noted: "Worsened in 2019" and "Improved in 2019" categories shown in the figure. ### External: Shrinking Current Account Surplus - China’s CA surplus declined by 1 percentage point in 2018. - Drivers highlighted: - Structural factors and a jump in oil and semiconductor prices. - Trade tensions introduced volatility in targeted commodity exports but affect "10 percent of china’s exports so far". - RMB trends: trade tensions played a role in reversing the RMB’s appreciating trend against the USD; RMB remained stable against the basket. - Capital flows and reserves: - Capital inflows moderated during the year, turning into outflows in Q4, but "there were no significant outflow pressures." - "Reserves remain adequate and there were no indications of large scale FXI despite RMB depreciation against the USD." - Current account and balances (figure notes): - Series shown: Income balance, Service balance, Goods balance, Current account balance (In percent of GDP, 4qma). - Specific decomposition: China petroleum and integrated circuits import growth decomposition (In percent, 12mma). - U.S. import targeting lists shown by year-on-year change with categories: "$34bn list", "$16bn list", "$200bn list", "Other". - RMB exchange rates vs. USD and CFETS index: CFETS currency basket index (Dec. 31, 2014 = 100); onshore RMB/USD spot rate (rhs). - Net capital flows (financial account excl. E&O, asset/liability/financial account in USD billions) shown with observations to 2019Q1. - Foreign exchange reserves: FX reserve position (in USD trillions, rhs) and change in FX reserve position (In USD billions) with observation to 2019M5. ### Fiscal: Continued Loosening - "The augmented deficit expanded further in 2018." - Infrastructure: - "Infrastructure investment stabilized." - Financing gap for infrastructure investment is presented as percent of GDP. - Debt projections: - "Official and especially augmented debt is projected to rise further." - Narrow and broad government debt (In percent of GDP) with projection path. - Note: "Large jump in 2014 reflects official recognition of 22 percent of GDP in LGFV debt." - Government balances: - Government balance under different definitions (In percent of GDP) shown; on-budget and augmented were compared. - Estimates of local government off-budget spending shown. - Bond yields and market signals: - "Government bond yields have moderated somewhat from recent highs." - Primary market bond yields (In percentage points) for central government, LGFV, local government; data to 2019M6. - Land sales and local fiscal gaps: - "Land sale revenues contracted in recent months." - "Local government revenue-expenditure gap remains wide." - Landsales revenues growth (In percent, year-to-date) shown to 2019M5. - Local government on-budget spending and revenues (In percent of general government spending) shown to 2019M5. ### Monetary: Inflation Contained Amid Policy Easing - Inflation dynamics: - "Core CPI inflation fell in the second half of 2018; changes in headline inflation were driven by food prices." - "PPI inflation moderated through 2018, falling sharply at the end of the year." - CPI inflation series (Headline; Core CPI excl. food and energy; Food (rhs)) with observations to 2019M5. - PPI and its components (Consumer goods; Producer goods) with observations to 2019M5. - Expectations and policy: - "Inflation expectations remained anchored." - "The PBC cut the RRR in each of quarter from 2018Q2-2019Q1 and increased medium term liquidity." - Liquidity and rates: - 7-day reverse repo and interbank rates: "7-day reverse repo rate for deposit institutions fell by about 25 basis points following the July RRR cut and has hovered near the bottom of the corridor." - Other interbank interest rates fell more and have stayed low. - Monetary instruments presented with labels and note: “PSL” = pledged supplementary lending facility; “MLF” = medium-term lending facility; “SLF” = standing lending facility; "TMLF" = targeted medium-term lending facility. - Interest rate corridor and wholesale market funding costs shown with observations to 2019M6. ### Credit Growth and Debt Dynamics - Credit growth: - "Credit growth stabilized at the end of 2018 but recently picked up." - Shadow banking "continues to contract." - Total Social Financing (TSF) composition and contributions: - Contribution series include: Others, Special purpose bonds, Non-financial enterprise equity, Net corporate bond financing, Shadow banking, Bank loans. - Note: Since January 2017, ABS, loan write-offs, and special purpose bonds are included. TSF stands for total social financing. - Lending composition and borrowers: - Banks expanded loans strongly; momentum shifted from household to corporate lending. - Lending to small firms decelerated sharply. - Growth rate of bank loans by borrower and maturity (Loans to corporates; Loans to households; Total loans) with observation to 2019M5. - Loans to enterprises by size (Total loans; Small and micro) with 2018Q4 reference. - Debt levels: - "Debt levels remain high as corporate deleveraging was more than offset by rising public and household debt." - Household debt levels now exceed the EM average. - Domestic non-financial sector debt (In percent of GDP) for Households, Corporates 1/, Government debt (augmented definition) from 2014–2018. - Household debt to GDP comparisons across countries and changes 2008-18 (bars for USA, JAP, IND, RUS, IDN, BRA, MAL, HKG, KOR, CHN, AEs, G20, World, EMs). ### Banking Sector: Asset Growth, Profitability, Capital Constraints - Bank asset growth and composition: - "Bank asset growth has stabilized in recent months, except for rural financial institutions, where the decline continues." - City commercial banks, Joint-stock commercial banks, Large commercial banks, Rural financial institutions growth rate (In percent, year-on-year) to 2019M5. - Contribution to bank asset growth by Other Assets and Bank loans (In percent, year-on-year). - Contribution to bank asset growth by claims on banks, NBFIs, households, corporate, governments (In percent, year-on-year) to 2019M5. - Profitability and capital: - "Further downsizing of shadow activity and bank reintermediation could be hampered by declining profitability..." - Net interest margin series from 2010–2018 by bank type (Rural banks; State-owned banks; City banks; JSBs). - Tier 1 capital ratio: Big 5 vs Small and medium-sized (2014–2018). - Non-performing loan ratio series for Big 5 and Small and medium-sized (2012–2018). - "Tighter capital constraints, particularly in small and medium-sized banks," and "rising NPL ratios" noted. ### Financial Market Funding Conditions - Bond and market funding: - "Increased liquidity boosted bond financing particularly for short to medium-term notes issuers." - Corporate bond gross issuance by type (Short and medium term notes; Enterprise and private placement bonds; Corporate bonds; Asset-back securities; Others) in RMB billions to 2019M6. - Interbank and funding structure: - "Banks’ reduced reliance on interbank borrowing limits the benefits of lower interbank rates." - Interbank borrowing to total liabilities of banks (In percent) by bank type; 1-month SHIBOR shown. - Credit spreads and credit events: - "Credit spreads remained mostly elevated despite lower rates." - Credit spread of corporate and LGFV bond issuers (In percent, 3-year, AAA versus AA-) shown to 2019M7. - "Credit events have been rising, mainly for privately-owned enterprises." - Credit events by bond issuer (FOEs, POEs, SOEs) (In RMB billions) to 2019Q2. - Small enterprises and informal lending: - "Small enterprises still face high borrowing costs and reduced their issuance." - Private placement notes by small and medium sized enterprises (In RMB billions; issuance rate in percent) shown. - "Informal, private sector lending rates – Wenzhou and P2P – remain high." - Private lending rates and yields: Yield of P2P products; Trust product yield; WMP expected yield; Private lending rate in Wenzhou (rhs) shown to 2019M6. ### Key Macroeconomic and Financial Indicators (select figures from Table 1 and Tables) - Real GDP (base=2015): 2014–2024 row: 7.3, 6.9, 6.7, 6.8, 6.6, 6.2, 6.0, 6.0, 5.7, 5.6, 5.5 (annual percent change by year). - Consumption growth (2014–2024): 7.2, 8.3, 8.6, 7.4, 9.4, 8.0, 7.2, 6.6, 6.3, 6.2, 6.0. - Investment growth (2014–2024): 7.1, 6.1, 6.5, 5.1, 4.8, 3.8, 5.0, 5.8, 5.6, 5.4, 5.2. - Consumer prices (average): 2.0, 1.4, 2.0, 1.6, 2.1, 2.2, 2.4, 2.8, 2.9, 3.0, 3.0. - Household debt (percent of GDP): 35.8, 38.7, 44.8, 49.7, 54.0, 56.2, 59.1, 61.1, 63.2, 65.4, 67.9 (annual series through 2024). - Total social financing (TSF): 14.3, 12.4, 16.7, 13.4, 9.8, 10.5, 10.5, 10.0, 9.5, 9.2, 8.7 (levels and percent of GDP: 190, 198, 216, 224, 226, 232, 238, 242, 245, 247, 249). - General government (official) net lending/borrowing (percent of GDP): -0.9, -2.8, -3.7, -3.9, -4.8, -6.1, -5.7, -5.6, -5.6, -5.5, -5.4. - Augmented net lending/borrowing (percent of GDP): -7.2, -8.4, -10.4, -10.8, -11.2, -12.7, -12.2, -11.9, -11.6, -11.5, -11.4. - Augmented debt (percent of GDP): 52.3, 56.6, 62.0, 67.3, 72.7, 80.2, 86.2, 91.1, 95.6, 99.3, 101.5. - Current account balance (percent of GDP): 2.2, 2.7, 1.8, 1.6, 0.4, 0.5, 0.4, 0.2, 0.1, 0.0, -0.1 (2014–2024). - Gross official reserves (bn US$): 3,899; 3,406; 3,098; 3,236; 3,168; 3,167; 3,174; 3,177; 3,179; 3,182; 3,189 (annual series). - Nominal GDP (bn RMB): 64,718; 69,911; 74,563; 81,526; 88,702; 95,539; 103,084; 111,560; 120,546; 130,318; 140,613. ### External and Financial Sector Indicators (select from Tables 2–4) - Current account and trade: - Current account balance (percent of GDP) 2014–2018: 2.2, 2.7, 1.8, 1.6, 0.4. - Exports (percent of GDP) 2014–2018: 21.3, 19.1, 17.7, 18.4, 18.0. - Imports (percent of GDP) 2014–2018: 17.2, 14.0, 13.4, 14.4, 15.1. - International investment position (percent of GDP asset/liability/net): Asset 61.1, 54.8, 58.0, 59.3, 54.6; Liability 45.9, 39.9, 40.6, 41.9, 38.7; Net international investment position 15.2, 14.9, 17.4, 17.4, 15.9 (2014–2018). - Reserve adequacy and external debt: - Total external debt (percent of GDP) 2014–2018: 17.0, 12.3, 12.6, 14.6, 14.8. - Short-term external debt by remaining maturity (billion US$) 2014–2018: 1,311; 887; 871; 1,099; 1,234. - Coverage in months of imports and in percent of broad money provided in Table 3. - Monetary and credit indicators (Table 4 highlights): - Broad money (M2: annual percentage change) 2014–2018: 11.0, 13.3, 11.3, 9.0, 8.1. - TSF (annual percent change) 14.3, 15.0, 19.8, 14.4, 10.2. - Bank loans (contribution to TSF) 9.2, 8.8, 8.5, 8.1, 7.9. - Shadow banking (contribution to TSF) 2.3, 0.6, 0.9, 2.1, -1.5. - Nonperforming loans ratio: 1.3, 1.7, 1.7, 1.7, 1.8. - Capital adequacy ratio: 13.2, 13.5, 13.3, 13.7, 14.2. - Tier 1 capital adequacy ratio: 10.8, 11.3, 11.3, 11.4, 11.6. *Source: CEIC; Haver Analytics; Bloomberg; WIND; PBOC; China National Bureau of Statistics; IMF staff estimates and projections.* ### 1. External rebalancing ### 1. External rebalancing ### External indicators - Contribution of net exports to GDP growth: %0.4-0.1-0.60.6-0.6 - Current account balance: 2.22.71.81.40.4 - FX reserve coverage: 22.118.218.620.017.6 - National saving rate: 49.047.545.946.044.6 ### Rebalancing Score Card Summary Indicators (notes on coding) - Color coding based on change in each indicator from 2017 to 2018: - Red if changes go in the opposite direction of rebalancing. - Yellow if some progress was observed. - Green if there was substantial progress in rebalancing. - For ratio indicators, changes measured in simple differences and considered substantial if larger than 0.5 percentage points. - For indices and credit indicators, changes measured in annual percent change and considered substantial if larger than 5 percent. - Framework reference: Zhang, L. (2016), "Rebalancing in China—Progress and Prospects,” IMF Working Paper No. 16/183. ### 2. Internal rebalancing ### Demand side - Growth contribution of consumption vs investment: %1.01.41.51.72.4 - Share of private consumption (Nominal): 37.538.039.439.040.0 - Share of investment (Nominal): 46.844.744.144.644.2 ### Supply side - Growth contribution of Tertiary vs Secondary sector: %1.01.31.51.71.2 - Share of Tertiary sector (Nominal): 48.050.551.851.951.9 - Share of Tertiary sector in total employment: %40.642.443.545.246.8 ### Credit side - Private credit: 149159181180178 - Credit intensity: 3.34.06.43.13.0 - Return on asset: SOE - private% -7.1-7.7-7.7-5.6-2.9 ### 3. Environmental rebalancing - Energy intensity of output: 86.283.082.179.979.8 - PM 2.5 (Weighted by usual residence): ...55.949.848.044.6 ### 4. Income distribution - Gini: 0.4690.4620.4650.467... - Labor income: 60.460.561.060.460.0 - Urban/rural income gap: 2.752.732.722.712.69 - Real disposable income growth: Median – Mean% 4.42.32.00.02.1 ### Table 8. China: SOE Performance (selected indicators) - Profitability - Return on assets SOEs: 2.21.81.61.91.9 - Return on assets industrial SOEs: 3.92.93.03.94.2 - Return on assets industrial private: 9.28.78.98.56.9 - Efficiency - Cost per unit of income - SOE: 95.497.394.897.197.1 - Leverage - Debt to equity SOEs: 183192190192183 - Central: 192213217213210 - Local: 176175171174165 - Debt to asset SOE: 64.765.765.565.764.7 - Central: 65.768.168.468.067.7 - Local: 63.863.763.163.562.2 - Debt to Asset - Industrial: 57.256.655.956.056.5 - Debt to asset industrial SOEs: 62.061.961.660.558.7 - Debt to asset industrial private: 54.153.252.353.055.2 - Number of zombies (legal entities of central SOEs): 1/2041841141 - Number of Bankruptcies: 203135685665954218823 - Corporate governance - Central SOEs with board of directors: 74.085.085.087.094.0 - Number of Central SOEs: 2/112.0106.0102.098.096.0 - Dividend payments to budget: 10.311.910.17.67.4 - SOEs share in the economy - Employment: 16.115.414.914.3 - Industrial Sales: 23.721.820.623.426.8 - Asset (industrial SOEs/total industrial): 38.838.838.539.238.8 - Liability (industrial SOEs/total industrial): 42.142.542.442.440.3 *Sources: CEIC and IMF staff estimates and projections; CEIC, NBS, Ministry of Finance.* ### Appendix I. Debt Sustainability Analysis ### Appendix I. Debt Sustainability Analysis ### Overview - The debt sustainability analysis (DSA) assesses government debt under both official “budgetary” and staff’s estimated general government “augmented” definitions. - Comprehensive fiscal measures implemented to mitigate the 2018–19 slowdown have worsened debt dynamics compared to last year. - Official budgetary government debt remains low, but “augmented” debt and associated gross financing needs are high; debt under both definitions is on an upward trajectory. - Continued efforts are important to reduce off-budget investment spending of local governments. ### Debt definitions and coverage - Two definitions of public debt are used: - “Budgetary” coverage: - Includes central government debt and “on-budget” local government debt identified by the authorities. - For 2004–13, general government debt includes central government debt and local government bonds (issued by the central government). - From 2014, general government debt includes central government debt and explicit local government debt (local government bonds and other recognized off-budget liabilities incurred by end-2014) following 2/3 of LGFV debt recognition. - “Augmented” debt (broad coverage): - Adds other types of local government borrowing, including off-budget liabilities borrowed by Local Government Financing Vehicles (LGFVs) via bank loans, bonds, trust loans and other funding sources, estimated by staff. - Covers debt of government-guided funds and special construction funds (quasi-fiscal activities). - Augmented deficit is the flow counterpart of augmented debt; augmented data are staff’s best estimate of general government data. - Data limitations: some nongovernment activity may be included; some LGFVs and funds may have substantial revenues; some government activity (e.g., PPPs) may be outside the augmented definition. ### Macroeconomic and fiscal assumptions - Real GDP growth: - Gradual slowdown to 5.5 percent y/y by 2024; projections list year values such as 6.2, 6.0, 6.0, 5.7, 5.6, 5.5 in figures. - GDP deflator growth: about 2.3 percent. - Fiscal assumptions differ by coverage scenario: - Budgetary coverage scenario: - Assumes all spending is done within the budget and off-budget public investment is sharply reduced. - Primary fiscal deficit assumed to rise from 3.8 percent of GDP in 2018 to 5.0 percent of GDP in 2019, then gradually decline to 4.0 percent of GDP in 2024. - Special purpose bond quota increases from RMB 1350 billion RMB in 2018 to RMB 2150 billion RMB in 2019 (about additional 0.7 percent of GDP). - Augmented coverage scenario: - Off-budget local government spending assumed to decline marginally. - Augmented primary deficit projected to rise from around 8.0 percent of GDP in 2018 to around 9.0 percent of GDP in 2019, then gradually decrease to 6.4 percent of GDP in 2024. - Local government financing: - Past reliance on net revenue from land sales and LGFV borrowing; DSA assumes future financing needs increasingly met by bond issuance. - Interest rates and amortization: - Interest rates for central and local government bonds assumed about 3–4 percent (historical average). - Interest rates for off-budget borrowing (augmented scenario) assumed about 6-7 percent (based on yield differential between sovereign bonds and LGFV bank loans and short-term instruments). - Staff assume all maturing debt will be rolled over. ### DSA results — Budgetary (narrow) coverage - Government debt path: - Budgetary government debt at 38 percent of GDP in end-2018, increasing to 51 percent of GDP in 2024. - Faster increase relative to last year’s DSA as fiscal stimulus relies more on-budget items. - Debt dynamics and risks: - Budgetary government debt remains relatively low and manageable in standard stress tests except for contingent liability shocks. - Contingent liability shock scenario: - A contingent liability shock in 2020 would increase budgetary debt from about 38 percent of GDP in 2018 to about 67 percent of GDP in 2020. - Footnote describes standard contingent liability shock: assumes 10 percent of non-government banking system assets turn into government liabilities; non-government banking system assets were about 220 percent of GDP in 2016; assumes real GDP growth in 2019 and 2020 would be 2–2.5 percent lower (one standard deviation shock). - Even if budgetary debt remains manageable, gross financing needs could increase and be sensitive to market financing conditions and rollover risks. ### DSA results — Augmented (broad) coverage - Debt path: - Augmented debt rises from 73 percent of GDP in 2018 to 101 percent of GDP in 2024. - Debt-stabilizing primary balance: - Estimated to be -2.3 percent of GDP in the medium term—almost 7 percentage points of GDP stronger than the projected 2019 level. - Sensitivity: - Augmented debt is sensitive to macro-fiscal shocks; combined macro-fiscal shocks would push debt above 110 percent of GDP in 2024. - Composition and financing needs (figures highlight): - Nominal gross public debt, public gross financing needs, real GDP growth, inflation, nominal GDP growth, and effective interest rate series are presented in the figures for 2017–2024. - Figure 2 and accompanying charts show composition by maturity and currency and alternative scenarios (Baseline, Historical, Constant Primary Balance). ### Stress tests and risk assessment - Augmented debt stress tests: - Scenarios include Primary Balance Shock, Real GDP Growth Shock, Real Interest Rate Shock, Real Exchange Rate Shock, Combined Shock. - Examples of underlying projected values in stress tests: - Baseline primary balance: -9.0 (2019), -8.1 (2020), -7.4 (2021), -6.9 (2022), -6.6 (2023), -6.4 (2024). - Baseline real GDP growth series: 6.2, 6.0, 6.0, 5.7, 5.6, 5.5. - Effective interest rate series under various shocks listed (e.g., 5.4, 5.5, 5.6, 6.2, 6.6, 6.9, 7.0 in some scenarios). - Combined macro-fiscal shock pushes gross nominal public debt and gross financing needs significantly higher in charts. - Budgetary debt stress tests: - Scenarios include Primary Balance Shock, Real GDP Growth Shock, Real Interest Rate Shock, Real Exchange Rate Shock, Combined Shock, Contingent Liability Shock. - Baseline primary balance for budgetary government: -5.0 (2019), -4.5 (2020), -4.3 (2021), -4.2 (2022), -4.1 (2023), -4.0 (2024). - Contingent liability shock scenario also assumes that 10 percent of banking assets would turn into government liabilities. - Risk assessment heat maps and indicators: - Gross financing needs and other vulnerability indicators are compared to benchmarks (e.g., gross financing needs benchmark of 15 percent of GDP; bond spread benchmarks 200 and 600 basis points; external financing requirement benchmarks 5 and 15 percent of GDP). - Specific indicators shown for 2018 include: bond spread EMBIG (bp) 77; gross financing needs roughly 22–23 percent of GDP for augmented; public debt held by non-residents and foreign-currency debt shares are plotted in figures. ### Policy implications and recommendations - China’s debt profile depends on implementation of fiscal measures and willingness to reduce public investment and support macroeconomic rebalancing. - If off-budget investment is strictly reduced and carried out on commercial terms, debt dynamics are more likely to follow the narrow-coverage scenario; continued off-budget liabilities by local governments would move the profile toward the broad-coverage scenario with rapidly rising debt-to-GDP ratios in the medium term. - Fiscal risks also arise from newer borrowing avenues, such as less supervised PPPs and government-guided funds. - Given weak overall SOE profitability and about a third of SOEs being loss making, fiscal risks from SOE debt warrant caution in the medium-term debt profile, particularly as SOE assets may not be liquid and SOE debt (in terms of GDP) is on the rise. ### Key statistics and exact figures highlighted in the DSA - Budgetary government debt: - 38 percent of GDP in end-2018 → 51 percent of GDP in 2024. - Augmented (broad coverage) debt: - 73 percent of GDP in 2018 → 101 percent of GDP in 2024. - Augmented primary deficit: - Around 8.0 percent of GDP in 2018 → around 9.0 percent of GDP in 2019 → 6.4 percent of GDP in 2024. - Budgetary primary fiscal deficit: - 3.8 percent of GDP in 2018 → 5.0 percent of GDP in 2019 → 4.0 percent of GDP in 2024. - Special purpose bond quota: - RMB 1350 billion in 2018 → RMB 2150 billion in 2019 (about additional 0.7 percent of GDP). - Interest rate assumptions: - Central/local government bonds: about 3–4 percent. - Off-budget borrowing (LGFVs, etc.): about 6-7 percent. - Contingent liability shock mechanics: - Assumes 10 percent of non-government banking system assets turn into government liabilities; non-government banking system assets were about 220 percent of GDP in 2016. - Debt-stabilizing primary balance (augmented): -2.3 percent of GDP in the medium term (about 7 percentage points stronger than projected 2019 level). *Source: IMF staff.* ### Appendix II. Risk Assessment Matrix ### Appendix II. Risk Assessment Matrix ### Short-term risks: likelihood, impact, and policy responses - High likelihood — Rising Protectionism - Risk: "A re-escalation in tensions could result in higher tariffs, disruptions in supply chains, and weaker confidence and investment." - Impact/Policy response: "High. Mitigate trade tensions by seeking a durable settlement and continue to support multilateralism and the global trading system." - Medium likelihood — A downturn in the property market - Risk: "A sudden correction in property prices could have significant adverse impact on financial sector stability and the real economy." - Impact/Policy response: "High. Macroprudential policies for the property market can curb excessive risk taking and be eased in the event of a sharp downturn." - Low likelihood — Sharp tightening of global financial conditions - Risk: "The tightening could be a result of market expectation of tighter U.S. monetary policy triggered by strong wage growth and higher-than-expected inflation. Pressure on the exchange rate could resume because of capital account pressures. Higher debt service and refinancing risks could put stress on leveraged firms." - Impact/Policy response: "Medium. Move toward effectively floating exchange rate, and limit intervention to mitigate disorderly market conditions." - Medium likelihood — Cyber-attacks - Risk: "Financial, transport or communication infrastructure could be affected triggering systemic financial instability or widespread disruptions in socio-economic activities." - Impact/Policy response: "High. Put in place adequate firewalls and security measures. Enhance crisis preparedness for cyber-attacks." - Medium/High likelihood — Weaker-than-expected global growth - Risk: "The global growth slowdown could be synchronized as weakening outlooks in the U.S. (medium), Europe (high) and China (medium) feed off each other and impact on earnings, asset prices and credit performance. In China, in the short term, intensification of trade tensions and/or a housing market downturn could prompt a slowdown, which is not fully offset by policy easing. Deleveraging may be delayed, and financial stresses could emerge including capital outflow and exchange rate pressures." - Impact/Policy response: "Medium. Engage partners to sustain and build a stronger rules-based multilateral trading system. Make sufficient progress in rebalancing and ensure that credit flows to the productive private sector." ### Medium-term risks: likelihood, impact, and policy responses - Medium likelihood — A comprehensive reform package (upside) - Risk/Opportunity: "Reforms that increase the role of markets, aided by greater openness could significantly boost productivity and potential growth." - Impact/Policy response: "High. Implement a high-quality comprehensive reform package based on market-oriented policies." - Medium likelihood — A more dynamic private sector (upside) - Risk/Opportunity: "China’s booming fintech sector and digital economy could present an upside potential to growth as commercialization of digital business models could proceed rapidly." - Impact/Policy response: "High. Support the development of fintech while ensuring financial stability through proper regulation and supervision." - Medium likelihood — Rising protectionism and retreat from multilateralism - Risk: "Geopolitical competition and fraying consensus about the benefits of globalization lead to economic fragmentation with adverse effects on growth and stability." - Impact/Policy response: "Medium. Adopt competitive neutrality policies that will help mitigate tensions with foreign firms." - Medium likelihood — Increasing role of the state - Risk: "With a slowdown in growth, the role of the state has been increasing which could weigh on potential growth especially if combined with a reliance on debt to hit short-term growth targets." - Impact/Policy response: "Medium. Stay the course on rebalancing and deleveraging. Improve credit allocation to the private sector while maintaining credit quality." - Medium/High likelihood — Weaker-than-expected global growth (medium-term) - Risk: "In China, over the medium term, insufficient progress in deleveraging and rebalancing could reduce growth and raises the probability of a larger disruptive adjustment. There would be negative spillovers on the global economy through trade volumes, commodity prices, and financial markets." - Impact/Policy response: "Medium. Engage partners to sustain and build a stronger rules-based multilateral trading system. Make sufficient progress in rebalancing and ensure that credit flows to the productive private sector." ### Notes on the RAM methodology and likelihood language - The RAM shows events that could materially alter the baseline path. - Likelihood definitions: "low" = probability below 10 percent; "medium" = probability between 10 and 30 percent; "high" = probability of 30 percent or more. - "Short term" = within 1 year; "medium term" = within 3 years. - Green upward and red downward arrows denote upside and downside risks respectively. --- ### Appendix III. AML/CFT Assessment — findings and ratings ### Overview and general findings - "China’s AML/CFT system is relatively young (China only joined FATF in 2007)." - Assessment scope: measures effectiveness across 11 immediate outcomes and technical compliance against the FATF 40 Recommendations. - Effectiveness: "China substantially meets 3 of the 11 immediate outcomes; however, the other 8 outcomes are assessed as insufficiently effective." - Technical compliance: "China is compliant or largely compliant with 22 Recommendations, while 18 Recommendations were rated partially or non-compliant." ### Key assessment points - Domestic coordination: "Domestic AML/CFT cooperation and coordination is well established and could be a good starting point to develop an improved risk understanding, and subsequently, take appropriate risk mitigation measures." - Main predicate crimes: "illegal fundraising, fraud, trafficking in illicit drugs, corruption and bribery, tax crimes, counterfeiting of products, and illegal gambling." - Financial Intelligence Unit (FIU): "consisting of two separate units at the national level and 36 separate regional branches, has the potential to produce financial intelligence that supports the operational needs of competent authorities. But the current incomplete access of all parts of the FIU to all data, leads to a fragmented analysis and disseminations." - Law enforcement: "have access to and actively use a wide range of financial information to identify and trace proceeds. However, their focus is mainly on proving predicate offences and on confiscating assets, and to a lesser extent on financial investigations related to money laundering and terrorist financing." - Targeted financial sanctions: "Implementation of UN-mandated targeted financial sanctions related to terrorist financing and proliferation financing related to Iran and the DPRK, is suffering from fundamental shortcomings in legislation and in implementation by banks." - Beneficial ownership and legal entities: "Hiding the persons who ultimately own or control a legal entity, is made exceedingly easy through a lack of an understanding of the risks of legal entities..., a lack of legal requirements, and a lack of implementation, including by banks and other financial institutions." - Financial institutions (FIs): "While FIs have a satisfactory understanding of their AML/CFT obligations, they have not developed a sufficient understanding of risks, and measures implemented to mitigate risk are generally not commensurate with different risk situations." - Supervision and sanctions: "The supervision of FIs is not sufficiently risk-focused and sanctions applied by supervisors are not effective, proportionate and dissuasive." - Designated non-financial businesses and professions (DNFBPs): "Implementation of measures for designated non-financial businesses and professions is for most sectors still pending." ### Ratings key (as presented) - 11 Immediate outcomes: High level of effectiveness; Moderate level of effectiveness; Substantial level of effectiveness; Low level of effectiveness. - 40 Technical Recommendations: Compliant; Largely compliant; Partially compliant; Non-compliant. - Listed Immediate Outcomes (IO.1 through IO.11) and Technical Recommendations (R.1 through R.40) are provided in the assessment matrix. --- ### External Sector — key background, assessments, and policy responses ### Net International Investment Position (NIIP) and foreign assets/liabilities (2018) - Background: "The NIIP remains positive but declined to 15.9 percent of GDP by end-2018 after peaking at 30.2 percent of GDP in 2008." - Drivers of deterioration: "a reduction in the CA surplus, valuation changes, and sustained high GDP growth." - Gross foreign assets: "55 percent of GDP by end-2018" (dominated by foreign reserves). - Gross liabilities: "40 percent of GDP" (mainly inward FDI). - Reserves: "Reserve assets were stable and stood at US$3.1 trillion by end-2018 (about 24 percent of GDP)." - Assessment: "The NIIP-to-GDP ratio is expected to remain strong, with a modest decline over the medium term, in line with the projected CA. The NIIP is not a major source of risk at this point..." ### Overall assessment of the external position (2018) - "The external position in 2018 was broadly in line with the level consistent with medium-term fundamentals and desirable policies." - Note: "This represents a change from earlier assessments when the external position was judged to be moderately stronger." - Policy response priorities: "gradual closing of domestic policy gaps in fiscal and credit areas... improving the social safety net; SOE reform and opening markets to more competition; creating a more market-based and robust financial system; taking steps to attract more inward FDI... and moving more to a flexible, market-based exchange rate." ### Key numerical indicators (2018, as presented) - NIIP: 15.9 - Gross Assets: 54.6 - Res. Assets: 23.6 - Gross Liab.: 38.7 - Debt Liab.: 13.0 ### Current Account (2018) - Background: "The CA surplus declined further in 2018, reaching 0.4 percent of GDP in 2018, about 1 percentage point lower than in 2017." - Drivers: "a shrinking trade balance (driven by high import volume growth) and a continued increase in the services deficit (mostly driven by tourism), as well as higher commodity and semiconductor prices." - Assessment and EBA metrics: - Actual CA: 0.4 - Cycl. Adj. CA: 0.3 - EBA CA Norm: –0.4 - EBA CA Gap: 0.8 - Staff Adj.: 0.0 - Staff CA Gap: 0.8 - Staff view: "Consistent with the EBA CA methodology... staff assesses the CA to be broadly in line with fundamentals and desired policies with a CA gap range of –0.7 to +2.3 percent." ### Real Exchange Rate (REER) - Background: "In 2018, the average REER appreciated by about 1.4 percent relative to 2017, driven by the appreciation in the NEER (1.5 percent). Estimates through May 2019 show that the REER has depreciated by about 0.2 percent relative to the 2018 average." - Assessment: "The 2018 EBA REER index regression estimates China’s REER to be at the same level as warranted by fundamentals and desirable policies—compared with 5.3 percent lower in 2017." - REER gap range as assessed by staff: "Overall, staff assesses the REER gap to be in the range of –11.5 to 8.5 percent." - Technical note: "The staff assessed REER gap of –1.5 percent is within the (± 5 percent) interval generally described as broadly in line with fundamentals." ### Capital and Financial Accounts: flows and policy measures - Background on flows: "Overall, China registered a small net capital inflow of US$30 billion in 2018, compared with net capital outflows of US$103 billion in 2017, and down significantly from the record outflows of US$647 billion in 2015 and US$646 billion in 2016." - Policy measures: "a 20 percent reserve requirement on FX forwards, a CFM, was reintroduced, and the authorities reimposed administrative measures to control the exchange rate in August 2018." - Assessment: "Over the medium term, the sequence of capital control loosening that is consistent with exchange rate flexibility should carefully consider domestic financial stability... prioritizing the shift to an effective float (while using FX intervention to counter disorderly market conditions) and strengthening domestic financial stability prior to a substantial further liberalization of the capital account." - Recommendation: "Efforts should be stepped up to encourage inward FDI, which would generate positive growth spillovers and improve corporate governance standards." ### FX intervention and reserves level (2018) - Background: "FX reserves declined modestly by US$67 billion in 2018, after rising by US$129 billion in 2017." - Assessment of reserves adequacy: - Reserves stood at "90 percent of the IMF’s composite metric unadjusted for capital controls at end-2018 (down from 106 percent and 97 percent in 2016 and 2017, respectively)." - Relative to the metric adjusted for capital controls, "reserves stood at 145 percent (down from 156 percent in 2017)." - Staff view: "Given that the capital account is considered only partially open, reserves would be considered adequate in the range indicated by the adjusted and unadjusted metrics. Overall, staff assesses the current level of reserves to be adequate." - Policy guidance: "As the transition to greater flexibility advances, intervention should be limited to smooth excessive volatility." *Source: Appendix II. Risk Assessment Matrix; Appendix III. AML/CFT Assessment; External Sector Report excerpts (people’s republic of China), as contained in the supplied IMF content unit.* ### Appendix V. Implementation of Main Recommendations of the ### Appendix V. Implementation of Main Recommendations of the 2018 Article IV Consultation ### Continue to rein in credit growth / De-emphasize growth target - The 2019 growth target was lowered from 6.5 percent in 2018 to 6-6.5 percent. (Mar 2019) ### Corporate deleveraging - The government aims to lower SOE leverage by 2 percentage points by 2020 from the 2017 level. - A dynamic leverage management system is set: 5 percent above the average leverage ratio of enterprises above designated size in a certain industry is a warning line; 10 percent above would lead to strict supervision. (Sep 2018) ### Tackling local government debt - MOF tightened control on PPPs: - If a government’s fee payment to PPP project exceeds 5 percent of fiscal spending, it cannot launch any new fee-paid-by-government project; - if more than 7 percent, the central government will warn the local government on the risk; - if more than 10 percent, no new project will be accepted into MOF’s database. (Sep 2018) ### A more holistic approach towards financial regulation - CBIRC released administrative measures on asset management for commercial banks. (Dec 2018) - CBIRC released administrative measures on asset management for commercial bank subsidiaries. (Oct 2018) - PBC, CBIRC and CSRC jointly released a guideline to improve supervision of Systematic Important Financial Institutions. (Nov 2018) ### Overcapacity cut / Zombie exit - The government reaffirmed that no new production capacity would be allowed in the cement and the sheet glass industry. Government agencies shall conduct rigorous review for capacity replacement proposals. (Sep 2018) - NDRC and other agencies urged local governments and State-owned asset management departments to define the first lists of zombie companies. With the disposal of zombie companies set to be completed by 2020. (Dec 2018) ### Accelerating rebalancing efforts — Promoting lending to small and private firms - PBC launched Target Medium-term lending facility (TMLF) to provide financing support for small and micro enterprises and private firms. (Dec 2018) - PBC and CSRC introduced credit risk mitigation (CRM) tools to allow investors to hedge default risks associated with private corporate bonds. (Oct 2018) ### Accelerating rebalancing efforts — Promoting consumption - The State Council published a comprehensive strategy to boost consumption. (Oct 2018) - NDRC released plans for consumption upgrading, mainly targeting cars, home appliances and electronic products. Key measures include lifting purchase and driving restrictions on new energy cars. (Oct 2018; Jun 2019) ### Poverty reduction and reducing urban-rural gap - The State Council issued guidelines on the Three-Year “Action to Win the Strong Battle against Poverty”, setting a goal of eliminating absolute poverty in rural areas by 2020. (Jun 2019) - China released a new guideline on rural digitalization, which aims to expand the 4G coverage, modernize agriculture and public services in rural area, and close the urban-rural digital gap. (Jun 2018; May 2019) ### Tackling pollution - Target to reduce the level of PM 2.5 pollution by around 3 percent in the cities around the Beijing-Tianjin-Hebei region between October 2018 and March 2019; remove industrial production controls and grant localities more autonomy in deciding the scale of production suspensions. (Jun 2018) ### Fostering greater openness — Opening-up measures - The National People’s Congress adopted the foreign investment law, which grants foreign investors pre-establishment national treatment and negative list management; forbids local government from forced technology transfer; and codifies equal treatment of foreign companies in public procurement. (Mar 2019) - CSRC announced to allow majority shareholding by foreign investors in futures companies. (Aug 2018) - CBIRC announced to allow foreign investors to operate insurance appraisal and agency business in China. (Mar 2019) - MOF granted a three-year tax exemption on interest income on bond investment by foreign institutions. (Nov 2018) ### Fostering greater openness — Capital account liberalization - The quota for Qualified Foreign Institutional Investors (QFII) was doubled from $150 bn to $300bn. (Jan 2019) - PBC and SAFE issued guidelines on funds involved in stock incentives for foreign employees of listed companies. Once registered at SAFE, relevant fund transfer will not require prior approval. (Feb 2019) - The Shanghai-London Stock Connect was officially launched. At the initial stage, the quota is set at 300 bn RMB for Shanghai Stock Exchange listed companies’ issuance on the London Stock Exchange, and 250 bn RMB for London Stock Exchange listed companies’ issuance in Shanghai. (Jun 2019) ### Fostering greater openness — Tariff reductions - China announced to raise export tax rebates for products such as mechanical and electrical goods as well as cultural products, effective September 15th. (Sep 2018) - The State Council cut tariffs on a wide range of industrial products and raw materials beginning in November 1. The move targets 1585 tariff code categories, including textiles, metals, electromechanical equipment and other raw materials and products, about 19 percent of the total number of Chinese tax items. (Nov 2018) - The State Council announced to cut the MFN tariff rate of 298 IT products from July 1st, 2019 and adjust the provisional tax rate of some IT products accordingly. (Dec 2018) - The State Council eliminated export tariff on 94 commodities and set provisional tariff on more than 700 import items, effective January 1st. (Jan 2019) ### Increasing the role of market forces — SOE reform - More than 2000 hospitals affiliated to SOEs will be separated from parent entities, ready for group management or restructuring. (Jun 2018) - SASAC issued guidelines on the accountability of SOE managers and employees. Loss of more than 5 million RMB will be regarded as Large Loss (loss above 50 million RMB as Major Loss), which will lead to demotion or deposition of SOE managers. (Jul 2018) - The government approved the fourth batch of pilots for SOE mixed-ownership reform, including 107 central SOE subsidiaries and 53 local SOEs or subsidiaries. (May 2019) - NDRC released a guideline to strengthen information disclosure of local SOEs’ external bond issuance and ban local governments from providing implicit guarantees. (Jun 2019) ### Increasing the role of market forces — Business environment - China’s ranking in the World Bank’s doing business index advanced from 78 in 2017 to 46 to 2018, reflecting progress in business registration, building permit, property registration, getting electricity, tax payment and cross-border trading etc. (2017-2018) ### Modernizing policy frameworks - CSRC published revised governance rules to standardize the operation of listed firms. (Sep 2018) - MOF published guidelines on promoting the third-party performance evaluation of government procurement service. (Aug 2018) - MOF started to implement a unified government accounting standard since Jan. 2019, a step towards a modern fiscal system and more efficient performance budgeting and management. (Jan 2019) - The State Council issued a new guideline on the division of responsibility between the central and local governments on education. For compulsory education, the central government will shoulder 50-80 percent of cost, depending on the regional income level. (Jun 2019) ### Enhancing data transparency and communication - The People’s Bank of China set up a new working group to translate policy statements and news releases into English to better provide information to international investors. (End 2018) - The National Statistical Bureau increased the publication frequency of the survey-based unemployment rate from quarterly to monthly. (Jan 2019) - The State council announced the revised version of "Regulations on the Openness of Government Information of the People's Republic of China", which would take effect on May 15, 2019. (Apr 2019) - The government intensified its efforts in cracking down data falsification at local level. (2018-2019) *Appendix V. Implementation of Main Recommendations of the 2018 Article IV Consultation* ### Appendix VI. Implementation of Main Recommendations from ### Appendix VI. Implementation of Main Recommendations from China’s 2017 FSAP ### Macroeconomic recommendations - Recommendation: De-emphasize relatively high GDP growth projections in national plans; these higher projections motivate the setting of high growth targets at the local level. - Priority: H - Time-frame: NT - Measures adopted: - China’s GDP growth target is an indicative target determined based on comprehensive consideration of domestic and foreign economic situations rather than a binding target. - The indicative target for GDP growth in 2019 was set at 6-6.5 percent. - Rationale cited: adjust forecasts based on instability/uncertainty; use interval indicative targets to increase elasticity; maintain reasonable growth to satisfy demand for new employment and support high-quality development; match current economic growth potential and industry-level indicative targets. ### Systemic risk, macroprudential policy, and strengthening supervision - Recommendation: Create a new financial stability sub-committee with the sole function of maintaining financial stability. - Priority: H - Time-frame: NT - Measures adopted: - Establishment of the Financial Stability and Development Committee (FSDC); periodic special meetings on preventing and defusing financial risk—since 2018, more than ten special meetings convened. - Office of the FSDC installed at the People’s Bank of China (PBC); PBC established internal secretariat to coordinate supervision, information sharing, policy linkage, draft major financial reform/development plans, and coordinate central-local cooperation mechanisms. - Recommendation: Establish robust mechanisms for cooperation, coordination, and exchange of information—including granular financial data—with domestic and foreign safety-net participants. - Priority: H - Time-frame: NT - Measures adopted: - State Council Financial Stability and Development Committee established in November 2017; interdepartmental coordination mechanisms created. - PBC and CBIRC established mechanisms for regular, comprehensive information sharing: off-site supervision indicators, central bank rating results, onsite deposit insurance inspection findings. - Data-sharing mechanisms established among CSRC, PBC, CBIRC, SAFE, NBS, and State Administration for Market Regulation for securities and futures market statistics. - In 2018, CBIRC convened joint meeting of core regulators of four G-SIBs and engaged in bilateral consultations with foreign supervisors to share information on operations, governance, risk management. - Recommendation: Trigger the countercyclical capital buffer, and review banks’ capital requirements with a view to targeted—and in some cases substantial—increase in capital. - Priority: H - Time-frame: MT - Measures adopted: - Macroprudential capital adequacy ratio indicator in the macroprudential assessment (MPA) used as a core indicator; reflects countercyclical capital buffer concept from Basel III. - Departments are studying and formulating countercyclical capital supervision standards and have begun continuous supervision of bank capital adequacy ratios. - Recommendation: Amend primary laws to strengthen the operational and budgetary autonomy of the PBC and the regulatory agencies, and increase their resources. - Priority: H - Time-frame: MT - Measures adopted: - PBC intends to promote amendment of the Law of the People’s Republic of China on the People’s Bank of China to improve finance and accounting systems and enhance budgetary autonomy. - Example budget change: 2018 CBIRC budget approved by the Ministry of Finance increased by 49.3 billion yuan over 2017, a year-on-year increase of 7.13 percent. - Regulatory agencies have intensified team-building, grassroots supervisory capacity, and training. - Recommendation: Address data gaps that impede systemic risk monitoring and effective financial regulation and supervision. - Priority: H - Time-frame: MT - Measures adopted: - March 2018: General Office of the State Council published the Opinion Concerning Comprehensive Promotion of Integrated Statistics for the Financial Industry. - PBC, CBIRC, CSRC, and SAFE jointly published Statistical System and Statistical Templates for asset management products to create a full-life cycle, full-funding chain statistical system by product. - CBIRC improved offsite supervisory reporting; CSRC developed nearly 500 securities industry core indicators, a central database and a central monitoring system for abnormal trading and cross-border/cross-exchange activity. - Recommendation: Assess purposes and structure of the PBC’s MPA to simplify and use it solely as input to FSS-C deliberations. - Priority: M - Measures adopted: - PBC emphasizes MPA as an important macroprudential tool; MPA also used to support monetary policy objectives (M2 and aggregate financing). Consensus formed among regulatory agencies on strengthening macroprudential framework. ### Bank regulation and supervision - Recommendation: Enhance supervision of financial holding group risk and increase the ability to supervise banks and their affiliated financial groups, including identification of ultimate beneficial owners. - Priority: H - Time-frame: MT - Measures adopted: - Strengthened supervision of controlling shareholders; improved qualification requirements and emphasis on identification of ultimate beneficial owners. - Joint Guiding Opinion on Strengthening Supervision of Non-Financial Enterprise Investment in Financial Institutions issued; Provisional Measures on Administration of Commercial Bank Equity and Measures on Administration of Insurance Company Equity introduced. - Launched simulated supervision pilot for financial holding companies with five enterprises (China Merchants Group, Shanghai International Group, Beijing Financial Holdings Group, Ant Financial, Suning Holdings). - Formulation of Provisional Measures for the Supervision of Financial Holding Companies underway; emphasis on "substance over form", look-through consolidated supervision, shareholder qualification, capital authenticity, capital adequacy supervision, related-party transaction controls and risk firewalls. - Recommendation: Discontinue consideration of collateral in loan classification; constrain banks’ ability to roll over credit to non-SME corporate borrowers; classify all loans overdue >90 days as nonperforming. - Priority: H - Time-frame: MT - Measures adopted: - April 30, 2019: CBIRC published Provisional Measures for the Risk Classification of Commercial Bank Financial Assets (Public Comment Draft) requiring focus on debtor performance capacity; restructured assets rules; principal, interest or income payments past due in excess of 90 days (including after rollovers) to be classified as nonperforming even when collateral is sufficient. - Recommendation: Strengthen enforcement of the “look-through” principle. - Priority: M - Measures adopted: - April 27, 2018: New Asset Management Rules published requiring look-through management (upward identification of final investors, downward identification of underlying assets), risk isolation, end of rigid redemption, full disclosure. - Onsite inspections enforce look-through in corporate governance, shadow banking and interbank wealth/asset management operations. - Recommendation: Increase liquidity coverage ratio (LCR) requirements for interbank products and off-balance-sheet WMPs. - Priority: M - Measures adopted: - China’s LCR requirements for interbank products consistent with Basel standard. - May 23, 2017: CBIRC published Administrative Measures on Commercial Bank Liquidity Risk increasing erosion rate for off-balance sheet WMPs from 2.5 percent to 5 percent. - Recommendation: Enhance regulatory reporting requirements; collect more granular supervisory data including bank investment information and provisioning. - Priority: M - Measures adopted: - CBIRC optimized offsite supervision report forms; strengthened routine monitoring of large risk exposures, interest rate risk, related party transactions, liquidity, trading counterparty credit risk. - Asset quality monitoring refined to include impairment allowances, delinquency information, restructuring and upward adjustment details; improved collection of investment operation information. - Recommendation: Enhance forward-looking integrated risk analysis to identify vulnerabilities, challenge banks, and facilitate ex ante intervention. - Priority: M - Measures adopted: - Development and upgrading of risk identification and early warning systems (REASS and others); comprehensive offsite and onsite data collection and analysis; monthly/quarterly operational analyses; regular situation analysis meetings, supervision interviews, prudential and triparty conversations. - Use of stress testing and ICAAP; annual supervision ratings; targeted intervention plans; in 2018 more than 150 supervision interviews, risk bulletins, and special risk guidance projects initiated. - Emphasis on monitoring product innovation and ex ante intervention to halt noncompliant products. ### Stress testing - Recommendation: Significantly enhance data/information sharing across PBC and the three regulatory agencies and use more granular supervisory data in stress tests. - Priority: H - Time-frame: MT - Measures adopted: - State Council FSDC (July 2017) enhances planning and coordination including information sharing. - Regulatory agencies share aggregate financing, monetary credit, banking industry operations and securities/futures statistics; close communications on stress test scope, scenarios, methodology, and results. - 2019 PBC stress testing to examine banks under scenarios: macroeconomic downturn, deterioration in key fields, increased liquidity stress, interbank counterparty defaults; use internal bank data and supervisory data with increased granularity for NPL trends, asset/liability classifications, and bond investment types. - CBIRC uses look-through data in bank stress testing (underlying assets, invested industry, size and non-performing assets; bond principal, duration, type). - CSRC and PBC enhanced cooperation; CSRC required industry-wide stress tests for futures companies and directed China Futures Association to publish Futures Company Stress Testing Guide (Provisional). - Recommendation: Expand coverage of nonbanks and correlations in systemic risk assessments; develop and integrate stress testing of collective investment schemes (CIS). - Priority: M - Measures adopted: - 2019 PBC bank stress testing uses network analysis models to assess contagion between banks and nonbanks; tests consider non-standard credit investments and off-balance sheet operations; liquidity stress testing considers WMP redemptions. - CBIRC stress testing accounts for asset management product losses and WMP redemptions (open vs closed), requires banks to establish wealth management product stress testing systems: minimum once quarterly for publicly-offered WMPs. - Stress testing of trust company liquidity and real estate-related credit risk conducted since end-2017; Administrative Measures for Trust Company Capital (Provisional) being accelerated. - CSRC’s uniform scenario stress testing covers securities companies, fund companies and subsidiaries; stress testing of CIS included. - Recommendation: Enhance inter-agency coordination and analytical capacity of stress testing teams. - Priority: M - Measures adopted: - PBC and CBIRC maintain close communications on stress testing design and methodology; cross-departmental use of PBC Research Bureau macroeconomic models in scenario design. - Stress testing teams with personnel from headquarters, branches, sub-branches, and commercial banks established; CBIRC-led training with IMF participation; participation in Basel Committee Working Group on Stress Testing. - CSRC developing a stress testing model case database and work manuals; deepening data sharing with PBC and CBIRC. ### Shadow banking and implicit guarantees - Recommendation: Amend laws/regulations to ensure bankruptcy remoteness of CIS (including WMPs) in event of manager/custodian bankruptcy. - Priority: H - Time-frame: MT - Measures adopted: - New Asset Management Rules (April 27, 2018) require separation of asset management operations and independence of client operations from proprietary operations. - September 2018: CBIRC Administrative Measures for Supervision of Commercial Bank Wealth Management Operations clarify WMP assets are independent from manager/custodian proprietary assets; in event of liquidation, WMP assets are not liquidated property and cannot be offset. - CBIRC Notice (Trust Letter (2018) No. 37) requires trust operations initiated during transition to implement independent custodianship, separate books/accounting, no fund pooling with rolling issuance characteristics. - CBIRC promoting Provisional Measures on Administration of Funding Trusts: funding trust property independence; required independent custody accounts; separate books/accounting; no fund pooling. - Supreme People’s Court judicial interpretation work on Trust Law recommended to clarify mutual independence of trust and inherent property. - Securities Investment Fund Law (Article 5) and related measures affirm fund property independence and protections in securities investment funds and asset management plans. - Recommendation: Move towards eliminating limits on lending to specific sectors, conditional on eliminating implicit guarantees. - Priority: M - Measures adopted: - PBC guiding financial institutions to apply differentiated treatment: support transformation of steel and coal where appropriate; orderly withdrawal from non-viable industries. - CBIRC guidance: banks to implement differential credit policies and control credit for projects expanding capacity illegally or failing environmental/safety requirements. - Cooperation with Ministry of Finance to strip local government financing platforms of government financing functions; local governments no longer permitted to use financing platforms to raise debt or provide guarantees by law. - 2018 Guiding Opinion Concerning Maintaining the Intensity of Correcting Infrastructure Shortcomings (Guo-Fa-Ban (2019) No. 101) requires lending to financing platforms that have “exited to become ordinary companies” be reviewed according to ordinary enterprise standards. - Recommendation: Limit interventions in asset markets (real estate and equity) to episodes of systemic risk. - Priority: M - Measures adopted: - CBIRC urging banks to strengthen compliance and real-estate risk prevention; onsite inspections and enhanced monitoring. - CSRC monitoring implementation of New Asset Management Rules; established monitoring mechanisms for transition; exchanges monitoring stocks/bonds of listed companies involved with debt risk and daily monitoring of stock pledging; use market and legal means to prevent and defuse related risks. ### Securities market regulation and supervision - Recommendation: Improve disclosure of CIS; prohibit specifying expected returns in WMP prospectuses. - Priority: H - Time-frame: NT - Measures adopted: - September 2018: CBIRC Administrative Provisions for Supervision of Wealth Management Operations require disclosure frequency for net values: daily for publicly-offered open products; at least once a week for publicly-offered closed products; monthly statements for publicly-offered; privately-offered must disclose net values at least once a quarter; banks must publicly disclose overall wealth management operations twice a year; banks not permitted to publicize expected returns. - CSRC: 2018 Administrative Measures for the Privately-Offered Asset Management Operations of Securities and Futures Dealers (Article 51) prohibit forecasts of investment performance, publicizing expected returns, promise of no loss, exaggeration of past performance in asset management plan disclosures. - November 2018 Operations Manual requires large collective asset management operations of securities companies to target publicly-offered fund standards by end-2020. - Recommendation: Introduce functional supervision to ensure similar products by different institutions are supervised similarly. - Priority: H - Time-frame: MT - Measures adopted: - New Asset Management Rules (April 2018) set uniform supervision standards. - PBC, CBIRC, CSRC coordinated to implement functional supervision and equal access/uniform regulation across institutions. - CBIRC New Wealth Management Rules published and implemented on September 28, 2018 setting requirements: control maturity mismatching, limit multi-layer nesting, control leverage and concentration, strengthen investor suitability and sales compliance. - CSRC published measures on privately-offered asset management operations (October 22, 2018) to unify supervision and eliminate regulatory arbitrage. - Recommendation: Tighten eligibility and enhance haircut methodology for repo collateral. - Priority: M - Measures adopted: - October 2018: PBC notice introduced triparty repo transactions on interbank market; third-party institutions, trading platforms, and CCPs to set rules for qualified collateral and haircuts. - CSRC instructed CSDC to strengthen monitoring of bond collateral risk, develop dynamic management, internal rating and market-implied rating mechanisms to adjust discount coefficients or revoke repo eligibility. - CSDC working on standard bond haircut methodology, autonomous valuation and risk-adjusted valuation schemes for CCP risk management. - Recommendation: Strengthen systemic risk monitoring to view interconnectedness between securities markets and other financial sectors. - Priority: M - Measures adopted: - PBC and CSRC measures: strengthen uniform supervision of credit rating industry (2018 Notice Number 14); establish uniform bond market enforcement mechanism (Opinion on Further Strengthening Bond Market Enforcement Work, October 2018). - CSRC established cross-market risk monitoring systems for stock, bond, futures, money, FX markets; quarterly Leading Group on Stock Market Risk and Response meetings; central supervisory information platform for securities and futures industries; phase II of centralized capital market monitoring system underway. ### Insurance regulation and supervision - Recommendation: Develop plans for risk-based supervision, bringing together insurer issues and actions, including market conduct. - Priority: M - Measures adopted: - Solvency supervision under “Solvency 2” framework with quarterly comprehensive risk ratings. - Assessment of life insurance liability supervision initiated; policy registration management platform development; actuarial supervision strengthened; revision of Actuaries Report rules advanced. - Early 2019: system to strengthen business management of insurance intermediary channels formulated; emphasis on clear authorities, compliance monitoring, forbidding illegal intermediary activities. - Recommendation: Formulate plans to gradually move valuation methods to be more market-oriented. - Priority: M - Measures adopted: - Current GAAP+ valuation system under China’s Solvency 2 conforms to Chinese market realities and is a solvency valuation method permitted by ICP. ### Supervision of financial market infrastructure (FMIs) - Recommendation: Adopt full delivery-versus-payment (DVP) in the CSDC. - Priority: H - Time-frame: NT - Measures adopted: - CSDC currently uses non-standard DVP: “T+0 securities delivery and T+1 transfer of funds” due to paperless securities and payment system constraints. - CSRC included reform of the A-share DVP clearing model among key tasks; CSRC arranging for CSDC to formulate a reform plan based on FMI Principles. - Recommendation: Strengthen resilience of FMIs through full implementation of CPSS-IOSCO Principles and strengthening legal framework. - Priority: H - Time-frame: MT - Measures adopted: - PBC pushing amendment of People’s Bank of China Law to improve payment, clearing, settlement provisions. - PBC promoted phase II of CIPS; developed fund settlement models for DVP and PVP. - PBC published Notice on Strengthening Administration of Cross-Border Financial Network and Information Services; promoted establishment of wholly-owned SWIFT subsidiary in China; formulating specialized measures on FMI supervision in compliance with PFMI. - CSDC measures: front-end funds control system; amendment of Measures on Administration of Securities Clearing Risk Funds; agreements on liquidity support for clearing banks signed with five largest state-owned banks; development of uniform risk monitoring and stress testing systems. - Futures exchanges: CSRC cooperating on Futures Law legislation; self-assessments for QCCP status and in January 2019 affirmed all futures exchanges as qualified central counterparties. - Recommendation: Expand provision of central bank services to all systemically-important CCPs. - Priority: M - Measures adopted: - PBC studying improvements to central bank account settlement service scheme to support 24/7 use of central bank currency settlement. - PBC currently offers settlement services to China Central Depository & Clearing Corporation and Shanghai Settlement House; considering expanding to CSDC and four futures exchanges. - Noted concerns: access to central bank liquidity could raise moral hazard/ethical risk; system modifications and operating logic changes required. ### Anti-money laundering and countering the financing of terrorists (AML/CFT) - Recommendation: Mandate enhanced customer due diligence (CDD) for domestic political public figures on a risk-sensitive basis. - Priority: M - Measures adopted: - January 2013: PBC Guidelines for Financial Institutions on Money Laundering and Terrorist Financing Risk Assessment and Customer Classification Management require risk ratings and enhanced CDD for high-risk customers, including domestic political dignitaries. - Enhanced CDD measures include senior management approval for establishing/maintaining relationships, deepened knowledge of assets/sources of funds, increased transaction monitoring. - Financial institutions advised to verify high-risk customers through databases, official websites, photographs, and other identifying information. - Recommendation: Ensure self-laundering is more effectively investigated and prosecuted as a standalone offense. - Priority: M - Measures noted: - In China, self-laundering by upstream offenders is not prosecuted as standalone offense due to legal principles; money laundering considered an inclusive offense absorbed into the upstream graver offense. - Chinese courts may impose heavier penalties for self-laundering under Article 61 and Article 5 principles; judicial practice includes adjudicated self-laundering cases (example: Wei case, 2015). ### Crisis management - Recommendation: Clarify triggers for activating government-led crisis response and limit to systemic events requiring public resources. - Priority: H - Time-frame: NT - Measures adopted: - PBC promoted revision of Regulations on the Resolution of Commercial Bank Bankruptcy Risk. - CSRC emphasizes market mechanisms and would intervene only where systemic risk of collapse exists; CSRC will define crisis response triggers as clearly as possible. - Recommendation: Formulate special resolution mechanisms for banks and systemically-important insurance companies. - Priority: H - Time-frame: MT - Measures adopted: - November 27, 2018: PBC, CBIRC, CSRC published Guiding Opinion on Improving Supervision of Systemically-Important Financial Institutions requiring PBC to lead crisis management groups, establish special resolution mechanisms, formulate recovery and resolution plans, and initiat e resolvability assessments. - December 4, 2018: cross-border crisis management meeting for ICBC, ABC, BOC, CCB reviewed recovery/resolution plans and resolvability. - PBC studying administrative measures for early correction and risk resolution for deposit insurance; joint “consultations and investigations” working mechanism with CBIRC established. - Recommendation: Develop a formal framework for emergency liquidity assistance by the PBC. - Priority: H - Time-frame: MT - Measures adopted: - PBC and relevant agencies formulated and continue to improve liquidity risk emergency response plans covering risk identification, prevention, response, and division of responsibilities. - Recommendation: Improve design of protection funds to limit moral hazard. - Priority: MT - Measures adopted: - Deposit insurance: continue premium collection and fund management; improve risk-differentiated premium mechanisms; monitor insured institutions quarterly; explore early correction role. - Securities investor protection funds: Administrative Measures published June 30, 2005 and amended April 19, 2016, restrict purposes and scope, clarify review/approval and punishments to limit ethical risk. - Trust protection funds: ex post assessments deepened; proposals to include prevention of ethical risk in institutional framework; supervisors issuing risk alerts to trust protection fund companies. ### Financial inclusion and fintech - Recommendation: Enhance legal, regulatory, and supervisory frameworks for fintech. - Priority: M - Measures adopted: - Basic supervision rules for AI, blockchain, biometric recognition formulated; improved supervision rules for financial technology. - PBC and agencies studied long-term supervision mechanisms adapted to internet finance; established supervision systems for internet lending, centralized deposit of non-bank payment reserves, clarified supervisory red lines for internet asset management, virtual currency exchanges, ICOs, equity crowdfunding, internet insurance. - Infrastructure: migration of payment operations processing to NetsUnion and UnionPay clearing platforms; achieved centralized deposit of 100 percent of customer reserve deposits with the central bank. - National Internet Finance Association of China improved registration disclosures and statistical monitoring. - Baihang Credit established with personal credit information system for non-traditional and internet finance. - CBIRC amending Provisional Measures for Supervision of Internet Insurance Operations. - CSRC drafting Guiding Opinion on Promoting Healthy Development of Financial Technology in the Securities and Futures Industry. *Source: Appendix VI. Implementation of Main Recommendations from China’s 2017 FSAP (as reported by the authorities, with IMF staff providing translation).* ### 1. This statement contains information that has become available since the staff report ### 1chnea2019003 - 1. This statement contains information that has become available since the staff report ### Recent data and near-term activity - Q2 GDP growth was 6.2 percent (y/y), in line with staff projections and marginally lower than 6.4 percent in Q1. - Services contribution to growth: 3.6 percentage points. - Industry contribution to growth: 2.3 percentage points. - Consumption contribution to growth: 3.4 percentage points. - Investment contribution to growth: 1.6 percentage points. - Net exports contribution to growth: 1.2 percentage points (positive contributor due to weak import growth). - Nominal GDP growth: 8.2 percent (y/y) in Q2, up from 7.8 percent in Q1. - High-frequency indicators for June: - Industrial value-added: 6.3 percent (y/y) in June, up from 5.0 percent in May. - Fixed asset investment growth: 6.3 percent (y/y) in June, up from 4.3 percent in May. - Total social financing growth: 10.9 percent (y/y) in June, up from 10.6 percent in May (driven by a slower contraction in shadow banking). - Inflation: - Headline CPI inflation: 2.7 percent (y/y) in June. - Core CPI inflation: 1.6 percent (y/y) in June. - PPI inflation: 0.0 percent (y/y). ### Financial sector opening measures (Financial Stability and Development Committee announcements) - Eleven measures to improve foreign access to the bond market, asset management, insurance, securities, and ratings industries, specifically allowing foreign financial institutions to: 1. rate domestic bonds; 2. establish and invest in wealth management subsidiaries of commercial banks; 3. establish controlling stakes in wealth management companies; 4. invest in pension management companies; 5. establish and participate in currency brokerage companies; 6. increase ownership in life insurance companies from 51 to 100 percent as of 2020 (advanced from 2021); 7. own more than 25 percent of the total shares of insurance asset management companies; 8. no longer be required to operate for over 30 years (for foreign-funded insurance companies); 9. own 100 percent of securities companies, fund management companies, and futures companies by 2020 (advanced from 2021); 10. obtain Class-A primary underwriting licenses in the interbank bond market; and 11. invest more easily in the interbank bond market. ### Market developments since July 12 - RMB movements since July 12: broadly stable, appreciating by 0.4 percent against the CFETS basket and depreciating by 0.1 percent against the US dollar. - Equity market: fell by ¼ percent. - Central government bond yields: - 3-month yield: rose by 15bps to 2.2 percent. - 5-year yield: essentially unchanged at 3.0 percent. ### Statement by Executive Director for People’s Republic of China (Jin Zhongxia) — Recent developments and outlook - GDP: slowed from 6.4 percent in Q1 to 6.2 percent in Q2; major indicators within a reasonable range. - Inflation: CPI increased by 2.2 percent in the first half. - Employment: surveyed urban unemployment rate at 5.1 percent in June. - Structural shifts: - Consumption contribution to GDP growth: raised to more than 60 percent. - Service sector share: 52.2 percent. - Manufacturing sector share: 40.7 percent. - Growth expectation: potential to achieve sustainable growth within an expected range of 6 to 6.5 percent in 2019. - Productivity and potential: - China’s R&D expenditure: 2.18 percent of GDP (noted as higher than EMs’ average and close to OECD’s average of 2.37 percent). - Number of college graduates in 2018: 8.2 million, with STEM majors accounting for more than 50 percent of total graduates. - FDI and portfolio flows: - UNCTAD World Investment Report 2019: China remained the second largest FDI recipient, with new FDI inflow increasing by 4 percent in 2018. - 2018 experienced a record level of portfolio inflows. ### Fiscal policy - Continued proactive fiscal policy focusing on large cuts in taxes and fees totaling nearly 2 trillion yuan (equivalent to US$280 billion). - Tax cuts targeted at small- and medium-sized companies, middle- and low-income brackets, and R&D in the corporate sector. - Authorities expect positive impact of fiscal stimulus to be further felt in the latter half of 2019. - Authorities concur with staff that there is no need for a further large-scale fiscal stimulus at this moment since trade tension effects are factored into this year's budget. - Views on debt dynamics and analysis: - Acknowledgement that debt dynamics have worsened compared to last year, posing risks to debt sustainability. - Authorities view the recent rise in the debt ratio as a short-term response and are committed to stabilizing overall leverage. - Suggestion that debt dynamics should be examined in the context of China’s high savings rate and that measures like Debt Service/GDP ratio and Debt/National Wealth ratio may provide more accurate analysis than Debt/GDP. ### Monetary policy - Continued prudent monetary policy with data-dependent adjustments. - Use of a combination of monetary policy instruments to keep liquidity appropriate and money supply reasonably sufficient. - People’s Bank of China (PBC) to further deepen market-based interest rate liberalization and shift from a quantity-oriented to a price-oriented monetary policy framework. - PBC noted to have had little FX interventions in recent years. ### Financial stability and banking sector - Authorities emphasize safeguarding financial stability; measures taken to prevent and mitigate risks in banking, securities, and insurance sectors. - Small- and medium-sized banks required to raise more capital from markets. - Recent interventions: takeover of Baoshang Bank and participation of strategic investors in Jinzhou Bank highlighted as part of efforts to clean up, consolidate, and strengthen smaller banks. - Majority of small and medium banks strengthened via capital raises, disposal of non-performing loans, and sharp increase in provisioning, consistent with FSAP recommendations. ### State-owned enterprises (SOEs) and small- and medium-sized enterprises (SMEs) - Supply-side structural reform deepening: - 95 percent of central zombie firms disposed; authorities aim to tackle remaining firms by end of this year. - Of disposed zombie firms, more than one-third via bankruptcy; the rest via mergers and acquisitions and internal restructuring. - New policy by NDRC and 12 ministries to facilitate zombie SOEs declaring bankruptcy and exiting market; central and local governments prohibited from providing subsidies or loans to prop up non-viable SOEs. - Private sector: - Domestic privately owned firms account for over 60 percent of GDP and over 80 percent of employment. - Domestic private firms and foreign invested firms account for more than 90 percent of China’s exports. - Authorities committed to a level playing field and implementing Competitive Neutrality. - Comments on IMF staff’s treatment of implicit guarantees: - Authorities caution against defining and quantifying “implicit guarantees” based on conjecture. - Note that many SOE bonds have defaulted in recent years, and in certain periods SOE defaults exceeded private enterprise defaults. - Encourage more comprehensive cross-country analysis before concluding on implicit guarantees. ### Trade - Trade tensions have affected the Chinese economy but impact considered manageable. - China has become the world’s largest market in terms of total retail sales. - Continued opening of markets, improved investment environment, and strengthened intellectual property protection cited as reasons multinational companies will not give up the Chinese market. - Acknowledgement that technology transfer barriers and embargoes could weigh on short-term technological development and innovation, but supplier countries may also be affected. - Potential for domestic investment to develop substitutes for imports, offsetting external demand declines. - Support for cooperative, constructive, rules-based multilateral dispute settlement and WTO reform. - Rejection of “managed trade” approaches characterized by discrimination and distortion; emphasis that China’s market opening and tariff reductions are results of China’s own policies, not conditional on bilateral agreements. ### Overseas lending and Belt and Road Initiative - Efforts to improve monitoring, coordination, and transparency of overseas lending. - Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative has borrowed from IMF methodology and benefited from staff consultation. - Authorities issued early warnings to Chinese creditors based on staff monitoring and IMF Executive Board discussions, yielding positive results. *Statement by Executive Director for People’s Republic of China, Jin Zhongxia — July 31, 2019* --- _Source: https://www.imf.org/-/media/files/publications/cr/2019/1chnea2019003.pdf_