## _cr16271

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---

### Definition and framework
- Rebalancing contains four elements: external, internal, environmental, and distributional.
- Internal rebalancing includes: shifting from investment to consumption (demand side), transitioning from industry to services (supply side), reducing credit intensity of output, and improving resource allocation efficiency.
- Environmental rebalancing: reduce carbon intensity of output and make growth more environment-friendly.
- Distributional rebalancing: increase share of labor income in GDP and reduce income inequality.

### Progress to date
- External rebalancing
  - Current account surplus fell from a peak of 10 percent of GDP in 2007 to around 2–3 percent in recent years.
  - Contribution of net exports to growth has fluctuated around zero (from 2 percentage points of GDP annually in the pre-GFC peak).
- Internal rebalancing — demand side
  - Since 2012, demand-side rebalancing from investment to consumption advanced, with a notable acceleration in 2015 and 2016:Q1 (consumption contributing two thirds of overall growth).
  - Investment ratio elevated at 43 percent of GDP; private consumption accounts for only 38 percent of GDP.
- Internal rebalancing — credit side
  - Credit intensity of output doubled compared to the pre-GFC period and continued to rise.
  - Credit misallocation driven by financing of nonviable firms, especially state-owned firms in overcapacity sectors (construction and steel).
  - Since 2016, early signs of improving credit structure with lending shifting toward the “new economy,” but overall misallocation remains significant.
- Internal rebalancing — supply side
  - De-industrialization began at an income level of about US$9,000 (1990 international prices); industrial share of output peaked in 2011.
  - Since 2012, nominal share of industry has been on a steady decline; real share decline has been more muted so far.
  - Industrial employment share peaked in 2012 and has declined steadily since then.
- Environment and inequality lagging
  - Some reduction in energy and carbon emission intensity of GDP, but PM 2.5 indexes remain very high (Beijing PM 2.5 Index: Very High).
  - Gini index rose from 0.3 in the 1980s to 0.53 in 2013; recent progress with labor income gaining share, but fiscal redistribution remains limited.

### Staff baseline projections and key quantitative forecasts (medium term, to 2021)
- Household saving rate: projected to fall from 24 to about 20½ percent of GDP by 2021.
  - Drivers: rapid ageing (old-age dependence ratio forecast to double from its current level by 2030) and stronger social safety net.
  - Government health spending projected to rise from current 1.5 percent of GDP to 2.1 percent by 2021.
  - Lifting of the one-child policy may induce faster decline in saving rate depending on fertility response.
- Investment ratio: gross fixed asset formation in GDP projected to fall gradually to 40 percent of GDP by 2021.
- Current account surplus: projected to remain low and decline further to less than 1 percent of GDP in the medium term.
- Private consumption share of GDP: projected to rise from around 38 percent in 2015 to 43 percent in 2021.
- Private credit (excluding LGFVs): expected to approach 200 percent of GDP by 2021, up from about 160 percent in 2015.
- Credit intensity: forecast to fall modestly but remain high.
- Services sector:
  - Nominal share of services projected to rise from current 50 percent to 55 percent by 2021.
  - Share of service employment forecast to rise to 51 percent by 2021.
- Key rebalancing interactions noted: asynchronous declines in investment and saving, premature deindustrialization, and continued debt overhang could derail rebalancing.

### Analytical findings and illustrative metrics (selected staff estimates — preserve exact values)
- National saving rate (% of GDP): 2015 = 47.9; 2016 = 46.3; 2017 = 44.9; 2018 = 44.1; 2019 = 43.2; 2020 = 42.4; 2021 = 41.6.
- Share of private consumption (Nominal, % of GDP): 2015 = 38.0; 2016 = 39.1; 2017 = 40.2; 2018 = 41.1; 2019 = 41.9; 2020 = 42.6; 2021 = 43.2.
- Share of investment (Nominal, % of GDP): 2015 = 45.0; 2016 = 43.9; 2017 = 43.3; 2018 = 42.8; 2019 = 42.2; 2020 = 41.6; 2021 = 41.0.
- Share of Tertiary sector in GDP (Nominal, % of GDP): 2015 = 50.2; 2016 = 51.9; 2017 = 52.9; 2018 = 53.7; 2019 = 54.5; 2020 = 55.0; 2021 = 55.4.
- Share of Tertiary sector in total employment (%): 2015 = 42.4; 2016 = 44.1; 2017 = 45.7; 2018 = 47.2; 2019 = 48.5; 2020 = 49.6; 2021 = 50.6.
- Private credit (% of GDP): 2014 = 148; 2015 = 158; 2016 = 169; 2017 = 179; 2018 = 187; 2019 = 192; 2020 = 195; 2021 = 199.
- Credit intensity (unitless series): 2010 = 2.2; 2011 = 1.5; 2012 = 2.6; 2013 = 2.8; 2014 = 2.9; 2015 = 3.7; 2016 = 4.1; 2017 = 4.0; 2018 = 3.7; 2019 = 3.4; 2020 = 3.1; 2021 = 2.9.
- Current account balance (% of GDP): 2010 = 3.9; 2011 = 1.8; 2012 = 2.5; 2013 = 1.5; 2014 = 2.6; 2015 = 3.0; 2016 = 2.4; 2017 = 1.6; 2018 = 1.3; 2019 = 1.0; 2020 = 0.8; 2021 = 0.6.
- FX reserve coverage (months of imports): 2010 = 34.0; 2011 = 28.3; 2012 = 22.3; 2013 = 24.0; 2014 = 22.1; 2015 = 18.1; 2016 = 18.7; 2017 = 18.4; 2018 = 16.8; 2019 = 15.3; 2020 = 14.1; 2021 = 13.0.
- Gini index: rose from 0.3 in the 1980s to 0.53 in 2013.
- Beijing PM 2.5 Index: characterized as “Very High”.

### Environmental rebalancing — supply-side indicators and scorecard
- Energy intensity of output (per unit of output): 102, 105, 103, 104, 100, 92, 89, 87, 86, 84, 83, 82.
- Carbon emission intensity (kg CO2 per output): 0.17, 0.19, 0.18, 0.17, ... ...
- PM 2.5 (mcg per cubic metre): ... ..., ... ..., 67.4, 64.1, 55.0.
- Rebalancing Scorecard heat map descriptors list thresholds for multiple indicators (examples preserved exactly as presented): Growth contribution of consumption vs investment Level: >0.5; 0.2-0.5; <0.2; Contribution of net exports to GDP growth Level: >3.2; 2.5-3.2; <2.5; Current account balance Level: >30; 20-30; <20; FX reserve coverage Level: >50; [45,50]; <45; National saving rate Level: <1; [1-1.2]; >1.2; Share of investment (nominal) — Level: >45; [40,45]; <40; Private credit — Annual change: >5; [0,5]; <0; Credit intensity — Annual change: >0.05; [0,0.05]; <0.

### Income distribution and labor share indicators
- Gini index number: 0.54, 0.53, 0.53, 0.53, 0.47, 0.46.
- Labor income (% of GDP): 58.5, 58.3, 60.1, 60.7, 61.7, 62.5, 63.2, 63.6, 63.9, 64.2, 64.2, 64.2.
- Urban/rural income gap (income ratio): ... ..., 2.8, 2.7, 2.9.

### Shadow credit products, wholesale funding, and interbank vulnerabilities
- Scale and growth of shadow products
  - Volume grew by 48 percent in 2015, to RMB 40 trillion, equivalent to 40 percent of banks’ corporate loans and 58 percent of GDP.
  - RMB 19 trillion—nearly half of total shadow products—have either NSCA or equities as underlying and appear high-risk relative to corporate loans.
  - Shadow products with yields of 11‒14 percent, compared with 6 percent on loans and 3‒4 percent on bonds.
- Risk characteristics and loss potential
  - About half of shadow credit products appear to pose elevated risk of default and loss.
  - Products with NSCA underlying assets are probably of lowest quality; equity-based shadow products also risky.
- Banks’ exposures and incentives
  - At end-2015, banks held RMB 15.2tn of shadow products—equivalent to 8 percent of banks’ assets and 92 percent of capital buffers, and up 58 percent year-on-year for listed banks.
  - “Big four” banks have small exposures; several other listed and unlisted banks have exposures several times their capital.
  - Repacking deteriorating loans into investment securities to avoid recognizing and providing for NPLs likely skewed exposures toward riskier products.
- Wholesale funding and interbank risks
  - From 2010 to 2015, total financial system assets grew by 5½ times more than GDP.
  - Financial system assets relative to stable bank deposit funding rose from 163 percent in 2010 to 193 percent in 2015; for banks, from 130 to 143 percent.
  - Wholesale sources as a percent of total bank funding essentially doubled from 15 to 34 percent over 2013–2015 (counting banks’ principal-protected WMPs as quasi-deposits lowers dependence to 30 percent at end-2015).
  - Banks source about 16 percent of their total funding from the interbank market, up from 8 percent at end-2010; interbank market accounts for about half of bank wholesale funding.
  - Interbank funding providers are investment vehicles, mostly WMP-structured, sourcing funds mostly with tenor less than three months.
  - Increasing use of pledged repo and low-quality collateral (e.g., Trust Beneficiary Rights) increases stress-transmission risk.
- Supervisory implications and recent steps
  - Call for a holistic, system-wide oversight approach with harmonized treatment of similar institutions and products.
  - Recent regulatory steps (Document 82) appear to close major regulatory arbitrage opportunities but may not compel recognition of impaired assets in existing positions; immediate recognition would imply substantial provision charges for some banks.
- Liquidity and funding policy recommendations (preserved wording)
  - Review implementation of Liquidity Coverage Ratio (LCR) framework with focus on designation of High-Quality Liquid Assets (HQLA) and ‘outflow’ assumptions applied to wholesale and interbank elements of banks’ funding.
  - Revisit and tighten mechanisms that allow participants to generate leverage within the interbank system (consider stricter limitations on use of pledged repo; reconsider allowing relatively low-quality assets like Trust Beneficiary Rights as collateral).
  - Monitor shift toward wholesale and interbank funding; continued increases may merit comprehensive frameworks to limit liquidity risk.

### Outlook for net capital flows and capital account risks
- 2015 net capital outflows: 6.2 percent of GDP (US$ 673 billion).
- Drivers and dynamics
  - Recent outflows started in early 2014 reflecting repayment of foreign liabilities and acquisition of foreign assets.
  - Increased foreign asset acquisition (mainly “Other Investment” abroad) explains about 70 percent of deterioration in 2014 but only roughly 15 percent in 2015; in 2015 rapid reduction of nonresident claims on China was dominant driver.
  - Foreign loans and nonresident deposits rose from 200 billion to a peak of 1.1 trillion in four years since 2008, roughly 10 percent of GDP.
  - External debt is now quite low at 12 percent of GDP.
  - Expected slowing of external debt repayment could reduce outflow pressure by $100–125 billion per quarter.
  - Additional drivers: surge in overseas direct investment (ODI) and increases in errors and omissions; ODI increases partly reflect intra-company loans and use of direct investment channels to reduce net exposure to Chinese assets.
- Two primary capital account risks
  - Uncertainty about flow and stock of China’s FDI.
  - Speed at which Chinese investors will acquire foreign assets and reduce home bias.
- Staff judgment: rising current account surplus, low external debt, large reserves, and a still relatively controlled capital account should support stabilization of outflows.

### Global spillovers from China’s rebalancing (findings and magnitudes)
- Rebalancing reduces longer-term tail risks but a near-term slowdown has strong global spillovers because of China’s size, openness, high investment rate, and high import content.
- Trade spillovers
  - Value added in exports related to final demand in China was relatively high (more than 4 percent of GDP) for Australia, Korea, Malaysia, Singapore, Taiwan Province of China, Thailand, and Vietnam.
  - Staff analysis suggests a 1 percentage point investment-driven drop in China’s output growth would reduce G20 growth by ¼ percentage point.
  - Duval and others (2014) estimate a growth spillover effect of about 0.3 percentage points for the median Asian economy.
  - Cashin, Mohaddes, and Raissi (2016) find similar estimates for ASEAN-5 and a twofold increase in effects between 1992 and 2012 for the median country.
- Heterogeneous exposure
  - “Unitary” rebalancing (1 percentage point reduction in investment growth combined with 1 percentage point increase in consumption growth) is broadly growth-neutral for China but weighs more on countries exposed to China’s investment.
  - Most adversely affected Asian economies: Korea and Taiwan Province of China; New Zealand benefits more due to consumption-exposed exports.
- Commodity and financial channels
  - China accounted for about 40 percent of total global demand for metals.
  - Metal prices have fallen by almost 60 percent on average since early 2011.
  - China’s rebalancing accounts for between one-fifth and one-half of the declines in broad commodity price indices.
  - Financial spillovers and co-movement with China have increased, particularly since the global financial crisis; financial sensitivities likely to rise further with renminbi internationalization and capital account liberalization.

### Resolving China’s corporate debt problem — diagnosis and strategy
- Diagnosis
  - Corporate credit growth averaged around 20 percent per year between 2009 and 2015.
  - Nonfinancial private credit-to-GDP ratio rose from around 150 percent to over 200 percent; gap 15–25 percentage points above the level consistent with historical trend at end-2015.
  - Credit boom tied to post-GFC investment surge; investment efficiency has fallen and corporate financial performance deteriorated.
  - SOEs more leveraged and less profitable than private sector; implicit guarantees estimated to upgrade ratings by 4–5 notches and lower borrowing costs by about 1‒2 percentage points.
  - Reported NPLs and special mention loans: about 5½ percent of total loans.
  - Staff estimate potential “debt-at-risk” amounts to 15½ percent of the total corporate loan portfolio.
  - Applying a 60 percent loss ratio on these loans yields estimated potential losses of about 7 percent of GDP.
- Strategy and key elements
  - Identify companies in financial difficulties (triage) via market-based creditor-driven approach or a government-driven entity with legal/political powers and independent valuation.
  - Proactively recognize losses in financial system; introduce incentives to support restructuring.
  - Burden sharing among indebted firm, creditors, and local/central government; consider moral hazard and social consequences.
  - Corporate restructuring and governance reform—particularly in SOEs—to prevent recurrence.
  - Harden budget constraints and remove implicit guarantees; facilitate debt-equity conversions and other workouts.
- Illustrative macro scenario for proactive strategy
  - Growth temporarily dips to 6 percent by 2017 (5½ percent excluding some assumed high-quality fiscal stimulus).
  - Growth then picks up to and maintains 6½ percent in the medium term.
  - Credit/GDP ratio would stabilize short term and gradually decline to more sustainable levels in the medium term.
- Key statistics preserved exactly
  - Credit growth averaged around 20 percent per year between 2009 and 2015.
  - Nonfinancial private credit-to-GDP ratio rose from around 150 percent to over 200 percent.
  - Potential “debt-at-risk”: 15½ percent of the total corporate loan portfolio.
  - Estimated potential losses applying a 60 percent loss ratio: about 7 percent of GDP.

### SOE reforms, restructuring pilots, and potential gains
- Current SOE footprint and performance
  - SOEs’ share of value added has fallen to 16 percent from 40 percent over the past decade.
  - SOEs account for about 10-15 percent of urban employment.
  - SOEs account for about half of total bank credit and 40 percent of total industrial corporate assets.
  - Financing costs for listed SOEs tend to be about 40–50 basis points below the benchmark lending rate.
  - Distortions from credit pricing account for nearly half of estimated implicit support (or 1½ percent of GDP).
  - Adjusting for implicit support suggests SOEs’ return on equity would have fallen from an average of 8 percent to about -1 percent during 2011–15.
  - SOE credit ratings are about two to three notches above those of comparable private firms.
  - SOE leverage ratios have risen rapidly to around 200 percent on average, concentrated in overcapacity and heavy industries.
  - Returns on SOE assets have deteriorated to about 2‒3 percent; SOE productivity is about 30‒40 percent that of private enterprises.
- Reform measures and pilot approach
  - Reform principles: reposition state as capital investor not operator; mixed-ownership reforms; classify SOEs by function; resolve nonviable SOEs.
  - State Council committed to cutting aggregate SOE losses by 2017 and expediting exit of nonviable “zombie” SOEs (resolve near 350 central SOE subsidiaries and near 4,000 local SOEs).
  - Ten pilot programs in 2016 focus on mixed-ownership and professional management.
  - Pilot deployment recommended: out-of-court approach under a SOE Restructuring Task Force, independent valuations, sale of loans to AMC or creditor committees, creditor-led restructure/liquidation decisions, transfer of equity to private investors or SOEs with governance safeguards, use of RMB 100 billion restructuring fund for laid-off workers.
- Potential gains from reforms
  - Two-sector model suggests SOE reforms could raise level of output by 3–9 percent compared to baseline projections, or about 0.3–0.9 percentage points of growth a year if spread across a decade.

### Environmental policy analysis, carbon/coal tax and ETS scenarios (methodology and key results)
- Methodology
  - Practical spreadsheet model using IEA energy flow data projecting to 2030 with assumptions on GDP growth, energy intensity trends, future fuel prices, and exogenous technological change.
  - Behavioral responses based on surveys of empirical evidence.
  - Local air pollution deaths based on previous IMF estimates for China (Parry, Heine, Li, and Lis, 2014).
  - Incidence analysis links policy-induced energy price impacts to an input-output model and household spending surveys.
- Baseline projection (no new policies beyond 2013 observations)
  - Energy intensity of GDP projected to decline by 37 percent between 2015 and 2030.
  - CO2 per unit of energy projected to remain about constant.
  - Fuel shares in 2015: Coal accounts for 83 percent of CO2, natural gas 3 percent, and oil products 13 percent.
- Carbon tax scenarios and impacts
  - Carbon tax rising from 15 RMB per ton from 2017 to reach 230 RMB by 2030 reduces CO2 by about 20 percent below baseline levels in 2030, meeting China’s CO2 intensity target for Paris.
  - Carbon tax rising progressively to 455 RMB per ton by 2030 reduces 2030 emissions by 30 percent.
  - Taxing coal only at the same rate achieves around 95 percent of CO2 reductions under the carbon tax.
  - Approximately 95 percent of CO2 reductions under the carbon tax come from less coal use.
- ETS performance
  - An ETS (same emissions price trajectories as carbon tax scenarios) generates about half of the CO2 reductions of the carbon and coal taxes because it excludes coal use from small-scale users.
  - ETS to be introduced in 2017 for power sector and large industrial sources; will cover electricity, domestic aviation, iron and steel, chemicals, cement, paper and other sectors and will be about twice as large as Europe’s trading market.
- Fiscal revenues (exact estimates)
  - Carbon tax raises revenues of 1.7 percent of GDP in 2020 or 3 percent of GDP in 2030 for the RMB 230 and 455 tax scenarios, respectively.
  - Coal tax raises revenues of about 83 percent of those under the carbon tax.
  - ETS (if allowances are auctioned) and the electricity tax raise revenues of about 45 and 35 percent, respectively, of the revenues from the carbon tax.
- Health impacts (cumulative 2017–2030)
  - Higher carbon and coal tax scenarios save about 4 million lives.
  - ETS saves about 1.9 million lives.
- Net economic gains (aggressive/high tax scenarios)
  - Carbon and coal tax: economic costs about 0.7 percent of GDP but domestic environmental benefits exceeding 5.5 percent of GDP, leaving a net economic gain approaching 5 percent of GDP by 2030.
  - ETS: net economic gains of 2.15 percent of GDP.
- Administration and implementation recommendations
  - Preferred levy point: upstream at point of entry (mine mouth for coal; refinery or gas processing plants for petroleum products; imported fuel taxed at border) to leverage existing administrative structures (e.g., China’s Resource tax).
  - Note: about 11,000 coal mines in China (restructuring likely to close around 4,000 of them over the next few years); far fewer refineries and gas processing plants.
  - Levying tax on large emitters would miss about half CO2 emissions and measuring emissions is more technically challenging than measuring carbon content of fuels.
  - Facilitation: provide tax rebates for firms required to obtain emissions allowances so all emitters pay same unit price of carbon.
- Incidence and distributional considerations (exact findings)
  - Carbon or coal tax is disproportionately burdensome on low income households: 50 percent larger burden for the first income decile and 25 percent larger for the second decile relative to their consumption, compared with the tenth income decile.
  - Recycling about 5 percent of tax revenues can offset adverse impacts on the bottom two deciles (e.g., reduced social security contributions and increased welfare and social spending).
  - An ETS with auctioned allowances is somewhat more regressive than carbon and coal taxes, and dramatically more regressive if allowances are freely allocated.
  - Mitigating fiscal measures to support energy-intensive and trade-exposed industries would cost around 10 percent of revenues collected through the carbon or coal tax (assuming no mitigation actions in other countries).
- Policy sequencing and conclusions
  - Introduction of an ETS in 2017 should not preclude simultaneous introduction of an upstream carbon or coal tax.
  - China can move ahead unilaterally on Paris pledges and realize very large domestic benefits without waiting for others to act.
  - Using around 5 percent of revenue from carbon/coal taxes can fully compensate low income groups; using 10 percent could compensate vulnerable, trade-exposed firms.

### Policy implications and prioritized recommendations (synthesized from analysis)
- Advance pro-consumption and service-sector reforms to sustain demand- and supply-side rebalancing.
- Implement decisive SOE reforms and corporate restructuring to accelerate credit rebalancing and reduce credit misallocation.
- Harden budget constraints and accelerate loan write-offs to reduce systemic credit risk and slow private debt accumulation.
- Strengthen social safety nets (health spending increase from 1.5 percent of GDP to 2.1 percent by 2021) to lower precautionary saving and support consumption.
- Adopt proactive environmental policies (for example, carbon or coal taxes) to achieve Paris climate summit targets and hasten reduction in carbon intensity.
- Use redistributive fiscal measures to reduce income inequality and improve inclusiveness as labor income share rises with service-sector growth.
- Coordinate reforms across fronts to avoid asynchronous adjustments that could shift imbalances abroad or trigger disruptive corrections (key risks: rapid investment decline with still-high savings; premature deindustrialization; continued debt overhang).
- Strengthen system-wide financial oversight, tighten liquidity and collateral practices in the interbank market, and ensure immediate recognition of impaired assets where appropriate.

*Source: _cr16271 (IMF staff text).*

### References _____________________________________________________________________________ 11

### REBALANCING IN CHINA: ANALYTICS AND PROSPECTS

### Definition and framework
- Rebalancing contains four elements: external, internal, environmental, and distributional.
- Internal rebalancing includes: shifting from investment to consumption (demand side), transitioning from industry to services (supply side), reducing credit intensity of output, and improving resource allocation efficiency.
- Environmental rebalancing: reduce carbon intensity of output and make growth more environment-friendly.
- Distributional rebalancing: increase share of labor income in GDP and reduce income inequality.

### Progress to date
- External rebalancing
  - China’s current account surplus fell from a peak of 10 percent of GDP in 2007 to around 2–3 percent in recent years.
  - Contribution of net exports to growth has fluctuated around zero (from 2 percentage points of GDP annually in the pre-GFC peak).
- Internal rebalancing — demand side
  - Since 2012, demand-side rebalancing from investment to consumption advanced, with a notable acceleration in 2015 and 2016:Q1 (consumption contributing two thirds of overall growth).
  - China remains an outlier in demand structure: investment ratio elevated at 43 percent of GDP; private consumption accounts for only 38 percent of GDP.
- Internal rebalancing — credit side
  - Credit intensity of output doubled compared to the pre-GFC period and continued to rise.
  - Credit misallocation driven by financing of nonviable firms, especially state-owned firms in overcapacity sectors (construction and steel).
  - Since 2016, early signs of improving credit structure with lending shifting toward the “new economy,” but overall misallocation remains significant.
- Internal rebalancing — supply side
  - De-industrialization began at an income level of about US$9,000 (1990 international prices); industrial share of output peaked in 2011.
  - Since 2012, nominal share of industry has been on a steady decline; real share decline has been more muted so far.
  - Industrial employment share peaked in 2012 and has declined steadily since then.
- Environment and inequality lagging
  - Some reduction in energy and carbon emission intensity of GDP, but PM 2.5 indexes remain very high (Beijing PM 2.5 Index: Very High).
  - Gini index rose from 0.3 in the 1980s to 0.53 in 2013; some recent progress with labor income gaining share, but fiscal redistribution remains limited (small difference between gross and net Gini).

### Staff baseline projections and key quantitative forecasts
- Aggregate outlook (medium term, to 2021)
  - Household saving rate: projected to fall from 24 to about 20½ percent of GDP by 2021.
    - Drivers: rapid ageing (old-age dependence ratio forecast to double from its current level by 2030) and stronger social safety net.
    - Government health spending projected to rise from current 1.5 percent of GDP to 2.1 percent by 2021.
    - Lifting of the one-child policy may induce faster decline in saving rate depending on fertility response.
  - Investment ratio: gross fixed asset formation in GDP projected to fall gradually to 40 percent of GDP by 2021.
  - Current account surplus: projected to remain low and decline further to less than 1 percent of GDP in the medium term.
  - Private consumption share of GDP: projected to rise from around 38 percent in 2015 to 43 percent in 2021.
  - Private credit (excluding LGFVs): expected to approach 200 percent of GDP by 2021, up from about 160 percent in 2015.
  - Credit intensity: forecast to fall modestly but remain high; specific staff-projected path shows continued elevated levels in the medium term.
  - Services sector:
    - Nominal share of services projected to rise from current 50 percent to 55 percent by 2021.
    - Share of service employment forecast to rise to 51 percent by 2021.
- Rebalancing interactions highlighted: asynchronous declines in investment and saving, premature deindustrialization, and continued debt overhang could derail rebalancing.

### Analytical findings and illustrative metrics (selected values from staff estimates)
- National saving rate (% of GDP): 2015 = 47.9; 2016 = 46.3; 2017 = 44.9; 2018 = 44.1; 2019 = 43.2; 2020 = 42.4; 2021 = 41.6.
- Share of private consumption (Nominal, % of GDP): 2015 = 38.0; 2016 = 39.1; 2017 = 40.2; 2018 = 41.1; 2019 = 41.9; 2020 = 42.6; 2021 = 43.2.
- Share of investment (Nominal, % of GDP): 2015 = 45.0; 2016 = 43.9; 2017 = 43.3; 2018 = 42.8; 2019 = 42.2; 2020 = 41.6; 2021 = 41.0.
- Share of Tertiary sector in GDP (Nominal, % of GDP): 2015 = 50.2; 2016 = 51.9; 2017 = 52.9; 2018 = 53.7; 2019 = 54.5; 2020 = 55.0; 2021 = 55.4.
- Share of Tertiary sector in total employment (%): 2015 = 42.4; 2016 = 44.1; 2017 = 45.7; 2018 = 47.2; 2019 = 48.5; 2020 = 49.6; 2021 = 50.6.
- Private credit (% of GDP): 2014 = 148; 2015 = 158; 2016 = 169; 2017 = 179; 2018 = 187; 2019 = 192; 2020 = 195; 2021 = 199.
- Credit intensity (unitless series as reported): 2010 = 2.2; 2011 = 1.5; 2012 = 2.6; 2013 = 2.8; 2014 = 2.9; 2015 = 3.7; 2016 = 4.1; 2017 = 4.0; 2018 = 3.7; 2019 = 3.4; 2020 = 3.1; 2021 = 2.9.
- Current account balance (% of GDP): 2010 = 3.9; 2011 = 1.8; 2012 = 2.5; 2013 = 1.5; 2014 = 2.6; 2015 = 3.0; 2016 = 2.4; 2017 = 1.6; 2018 = 1.3; 2019 = 1.0; 2020 = 0.8; 2021 = 0.6.
- FX reserve coverage (months of imports): 2010 = 34.0; 2011 = 28.3; 2012 = 22.3; 2013 = 24.0; 2014 = 22.1; 2015 = 18.1; 2016 = 18.7; 2017 = 18.4; 2018 = 16.8; 2019 = 15.3; 2020 = 14.1; 2021 = 13.0.
- Gini index: rose from 0.3 in the 1980s to 0.53 in 2013.
- Beijing PM 2.5 Index: characterized as “Very High” (WHO standard exceedances shown in figures).

### Policy implications and recommendations (implied by analysis)
- Advance pro-consumption and service-sector reforms to sustain demand- and supply-side rebalancing.
- Implement decisive SOE reforms and corporate restructuring to accelerate credit rebalancing and reduce credit misallocation.
- Harden budget constraints and accelerate loan write-offs to reduce systemic credit risk and slow private debt accumulation.
- Strengthen social safety nets (health spending increase from 1.5 percent of GDP to 2.1 percent by 2021) to lower precautionary saving and support consumption.
- Adopt proactive environmental policies (for example, carbon or coal taxes) to achieve Paris climate summit targets and hasten reduction in carbon intensity.
- Use redistributive fiscal measures to reduce income inequality and improve inclusiveness as labor income share rises with service-sector growth.
- Coordinate reforms across fronts to avoid asynchronous adjustments that could shift imbalances abroad or trigger disruptive corrections (key risks: rapid investment decline with still-high savings; premature deindustrialization; continued debt overhang).

*Prepared by IMF staff as background documentation for the 2016 Article IV consultation with China.*

### 3. Environmental rebalancing

### 3. Environmental rebalancing

### Energy and emissions intensity
- Energy intensity of output (per unit of output): 102, 105, 103, 104, 100, 92, 89, 87, 86, 84, 83, 82
- Carbon emission intensity (kg CO2 per output): 0.17, 0.19, 0.18, 0.17, ... ...

### Air quality
- PM 2.5 (mcg per cubic metre): ... ..., ... ..., 67.4, 64.1, 55.0

### Rebalancing Scorecard: Heat Map Descriptors (Environmental and related indicators)
- Categories and benchmark levels shown in the Scorecard:
  - Growth contribution of consumption vs investment
    - Level: >0.5; 0.2-0.5; <0.2
  - Contribution of net exports to GDP growth
    - Level: >3.2; 2.5-3.2; <2.5
  - Current account balance
    - Level: >30; 20-30; <20
  - FX reserve coverage
    - Level: >50; [45,50]; <45
  - National saving rate
    - Level: <1; [1-1.2]; >1.2
  - Share of private consumption (nominal) — Annual change
    - <0; 0-1; >1
  - Share of investment (nominal) — Level
    - >45; [40,45]; <40
  - Real growth rate of tertiary vs secondary sector — Level
    - <0.9; [0.9, 1]; >1
  - Share of tertiary sector in GDP (nominal) — Annual change
    - <0; [0,0.5]; >0.5
  - Share of tertiary sector in total employment — Annual change
    - <0; [0,1]; >1
  - Private credit — Annual change
    - >5; [0,5]; <0
  - Credit intensity — Annual change
    - >0.05; [0,0.05]; <0
  - SOE share in credit stock — Annual change
    - >0; [-1,0]; <-1
  - Difference in return on asset — Level
    - >0; [-1,0]; <-1
  - (Additional indicators with annual change thresholds)
    - Annual change: >0; [-1,0]; <-1
    - Annual change: >0; [-0.1,0]; <-0.1
    - Level: >10; [5,10]; <5
    - Annual change: >0; [-0.1,0]; <-0.1
    - Annual change: <0; [0,0.2]; >0.2
    - Annual change: >0; [-0.1,0]; <-0.1

### Supply-side / Environmental indicators listed in Scorecard
- Energy intensity of output
- Carbon emission intensity
- PM 2.5

### Data sources for indicators
- CEIC Data Company Ltd.; and IMF staff estimates.

---

### 4. Income distribution (related social indicators)
- Gini index number: 0.54, 0.53, 0.53, 0.53, 0.47, 0.46
- Labor income (% of GDP): 58.5, 58.3, 60.1, 60.7, 61.7, 62.5, 63.2, 63.6, 63.9, 64.2, 64.2, 64.2
- Urban/rural income gap (income ratio): ... ..., 2.8, 2.7, 2.9

*PEOPLE’S REPUBLIC OF CHINA — Rebalancing Score Card data and Heat Map Descriptors as presented in the source.*

### 1.      The proliferation of “shadow” credit products and growing reliance on short-term,

### 1.      The proliferation of “shadow” credit products and growing reliance on short-term, wholesale funding, could pose substantial risks.

### Shadow credit products: scale and growth
- The volume of shadow credit products grew by 48 percent in 2015, to RMB 40 trillion, equivalent to 40 percent of banks’ corporate loans and 58 percent of GDP.
- RMB 19 trillion—nearly half of total shadow products—have either NSCA or equities as underlying and appear high-risk relative to corporate loans.
- Shadow products with yields of 11‒14 percent, compared with 6 percent on loans and 3‒4 percent on bonds, indicate materially higher return premia on risky structures.

### Risk characteristics and loss potential
- About half of shadow credit products appear to pose elevated risk of default and loss.
- Products whose underlying assets are ‘nonstandard credit assets’ (NSCA)—untradeable debt, typically loans—are probably of lowest quality; shadow products based on equities are also risky.
- Some shadow products appear benign, but others contain significantly higher default risk and loss potential than banks’ corporate loan portfolios.

### Banks’ exposures and incentives
- At end-2015, banks held RMB 15.2tn of shadow products—equivalent to 8 percent of banks’ assets and 92 percent of capital buffers, and up 58 percent year-on-year for listed banks. (Excludes Agricultural Bank of China due to data availability.)
- The “big four” banks have small exposures, but several other listed banks and the unlisted in aggregate have exposures that are several times their capital.
- Banks’ positions appear motivated in part by practices of repacking deteriorating loans into investment securities to avoid recognizing and providing for nonperforming loans (NPLs), likely skewing banks’ exposures toward riskier products (those with NSCA as underlying asset).

### Transmission risks distinct from loan losses
- Shadow products can generate transmission risks that are potentially less manageable than loan losses because they can more readily trigger system-wide risk-aversion and liquidity withdrawal.
- Vulnerable holders include:
  - ‘Collective’ instruments (RMB 10.9 trillion at end-2015);
  - Nonbank financial institutions (particularly investment funds), corporates, and individuals who have limited ability or incentive to support market liquidity in stress.
- The ‘high-transmission’ segment appears sufficient to potentially catalyze significant liquidity challenges.

### Wholesale funding and interbank vulnerabilities
- From 2010 to 2015, total financial system assets grew by 5½ times more than GDP, twice as much as total social financing and three times as much as loans.
- Financial system assets relative to stable bank deposit funding rose from 163 percent in 2010 to 193 percent in 2015; for banks, from 130 to 143 percent.
- Staff estimate that wholesale sources as a percent of total bank funding essentially doubled, from 15 to 34 percent, over the period 2013 to 2015. (Counting banks’ principal-protected wealth management products as quasi-deposits would lower wholesale funding dependence to 30 percent at end-2015.)
- Banks source about 16 percent of their total funding from the interbank market, up from 8 percent at the end of 2010; the interbank market accounts for about half of bank wholesale funding.
- Financial institutions, including banks, are in aggregate net borrowers in the interbank market.
- Interbank funding providers are investment vehicles, mostly structured as ‘wealth management products’, sourcing funds mostly with tenor less than three months from yield-seeking investors.
- Interbank market practices are shifting toward greater risk (e.g., increasing use of ‘pledged’ repurchase agreement contracts to increase leverage and investment returns).
- The use of relatively low-quality assets like Trust Beneficiary Rights as collateral in repo and pledged repo practices increases stress-transmission risk.

### Supervisory and regulatory implications
- Rapid expansion in size, interconnectedness, and complexity of the financial system calls for commensurate increase and coordination in oversight; a more holistic, system-wide approach with harmonized treatment of similar institutions and products is recommended.
- Recent regulatory steps (Document 82):
  - Constructively criticize opaque and nonstandard transaction structures and weak prudential supervision of capital adequacy and loss provisioning that enabled regulatory arbitrage.
  - Appear to close major regulatory arbitrage opportunities and should limit banks’ ability to engage in loan-repacking transactions in future if implemented strongly.
  - It is unclear that the new regulation compels recognition of impaired assets in existing positions; immediate recognition of asset impairment in the investment receivables book would imply substantial provision charges for some banks.

### Policy recommendations to strengthen liquidity and wholesale funding robustness
- Review implementation of Liquidity Coverage Ratio (LCR) framework with focus on:
  - Designation of High-Quality Liquid Assets (HQLA); and
  - ‘Outflow’ assumptions applied to wholesale and interbank elements of banks’ funding.
- Revisit and tighten mechanisms that allow participants to generate leverage within the interbank system:
  - Consider stricter limitations on the use of pledged repo to achieve leverage.
  - Reconsider allowing the use of relatively low-quality assets like Trust Beneficiary Rights as collateral for repurchase agreements.
- Monitor the overall shift of funding toward wholesale and interbank sources; continued increases may merit consideration of more comprehensive frameworks to limit liquidity risk.

---

### CHINA: Outlook for Net Capital Flows — key points
- In 2015, China experienced net capital outflows of 6.2 percent of GDP (US$ 673 billion).
- The recent bout of outflows started in early 2014 and reflected both repayment of foreign liabilities and acquisition of foreign assets.
- On an annual basis, increased pace of foreign asset acquisition, mainly “Other Investment” abroad, explains about 70 percent of the deterioration in the capital account in 2014 but only roughly 15 percent in 2015; in 2015 the more rapid reduction of nonresident claims on China was the dominant driver of outflows.
- The rapid reversal in foreign liabilities is driven by the change in appeal of the carry trade; foreign loans and nonresident deposits rose from 200 billion to a peak of 1.1 trillion in the four years since 2008, roughly 10 percent of GDP.
- External debt is now quite low at 12 percent of GDP.
- Expected slowing of external debt repayment could reduce outflow pressure by $100–125 billion per quarter.
- Additional drivers of outflows include a surge in overseas direct investment (ODI) and increases in errors and omissions, with ODI increases partly reflecting intra-company loans and firms using direct investment channels to reduce net exposure to Chinese assets.
- Discrepancies between customs trade data and SAFE foreign exchange data suggest an increasing desire of domestic enterprises to hold foreign exchange deposits due to depreciation expectations.

*Prepared by John Caparusso and Kai Yan (both MCM); Geoff Gottlieb (SPR). International Monetary Fund.*

### 10.      Nonetheless, there are still two primary risks to the capital account. First, there is a

### 10. Nonetheless, there are still two primary risks to the capital account. First, there is a question as to what happens to the flow and stock of China’s foreign direct investment.

### Capital account risks and outflows
- Two primary risks to the capital account:
  - Uncertainty about the flow and stock of China’s foreign direct investment (FDI).
  - The speed at which Chinese investors will acquire foreign assets and reduce a historically high home bias.
- On flows:
  - China’s slowing growth prospects may weigh on inward FDI in a way that helps offset the improvement from lower debt payment; lower inflows, in an accounting sense, are the same as a rise in outflows.
- On stocks:
  - Firms’ accumulated reinvested earnings, to the degree they are in liquid assets, could leave as dividends which are current account transactions that do not face capital controls.
- Staff judgment:
  - The combination of a rising current account surplus, low external debt, large reserves, and a still relatively controlled capital account should support a stabilization of outflows.

### External debt and financial indicators (figures and charts referenced)
- External Debt (Figure 13): totals and components shown in billion of US dollars (deposits, loans).
- External Debt (Figure 14): shown in percent of GDP, with China labeled as CHN15 among peers.
- Share of domestic value added exported for China's final demand (Figure 1): shown in percent of GDP across regions (World, Asia, Non-Asia, AE, EM-COM, EM-others).
- Real commodity import growth (Figure 4): year-over-year percent change of 12-month rolling sum for Copper, Iron ore, Crude oil.
- Asian market correlations with China (Figure 5): equity, bond, FX correlations shown for Pre-GFC, Post-GFC, Since June 2015.
- Post-GFC business cycle synchronization and equity return correlation with China (Figure 6): regression y=0.251x+0.183, R2=0.434.

### Global spillovers from China’s rebalancing — findings and mechanisms
- Rebalancing overview:
  - China’s transition to consumption- and services-driven growth is desirable and reduces longer-term tail risks, even if it entails a near-term slowdown.
  - Given China’s size, openness, high investment rate, and high import content of its investment and exports, a slowdown in China is likely to have strong global spillovers.
- Trade spillovers:
  - Negative trade spillovers will weigh on global growth, varying by country exposure to China.
  - Value added in exports related to final demand in China was relatively high (more than 4 percent of GDP) for Australia, Korea, Malaysia, Singapore, Taiwan Province of China, Thailand, and Vietnam.
  - Staff analysis (IMF, 2016d) suggests that a 1 percentage point investment-driven drop in China’s output growth would reduce G20 growth by ¼ percentage point.
  - Duval and others (2014) estimate a growth spillover effect of about 0.3 percentage points for the median Asian economy.
  - Cashin, Mohaddes, and Raissi (2016) find similar estimates for ASEAN-5 and a twofold increase in effects between 1992 and 2012 for the median country.
- Heterogeneous effects by exposure type:
  - “Unitary” rebalancing (1 percentage point reduction in investment growth combined with 1 percentage point increase in consumption growth) is broadly growth-neutral for China but weighs more on countries exposed to China’s investment; exposure to China’s consumption can buffer or boost exports.
  - Most adversely affected Asian economies: Korea and Taiwan Province of China (high integration via global value chains and exposure to investment); New Zealand benefits more due to consumption-exposed exports.
- Product mix and upstream competition:
  - China increasingly competes with upstream suppliers affecting Japan, Korea, Taiwan Province of China, Germany, and the United States, particularly in higher-technology products.
  - China is exiting some labor-intensive sectors, creating opportunities for frontier and developing economies in Asia (e.g., Cambodia, Lao P.D.R., Myanmar, Vietnam).
- Commodity market implications:
  - China accounted for about 40 percent of total global demand for metals.
  - Metal prices have fallen steadily since early 2011 by almost 60 percent on average.
  - China’s rebalancing accounts for between one-fifth and one-half of the declines in broad commodity price indices (range sensitive to analysis specifics).
  - For investment-related commodities, global consumption slowdown exceeded what can be attributed to China’s slowing GDP alone, reflecting rebalancing effects.
  - Consumption of food commodities has surprised on the upside (protein and vegetable oil) as per capita income rises; China’s demand for crude oil remained strong in 2015, partly due to accumulation of inventories.
- Financial spillovers:
  - Global and regional financial sensitivities to China have increased, particularly since the global financial crisis.
  - Co-movement and asset return correlations between Asian and Chinese markets have risen for equity and foreign exchange markets.
  - Countries with higher business cycle synchronization with China have, on average, seen their equity markets move more closely with China.
  - Financial spillovers likely to rise further with growing financial linkages, renminbi internationalization, and gradual capital account liberalization.

### Resolving China’s corporate debt problem — diagnosis and strategy
- Key summary points:
  - Corporate credit growth in China has been excessive in recent years.
  - The credit boom is largely related to the large rise in investment after the global financial crisis (GFC); investment efficiency has fallen and corporate financial performance has deteriorated, affecting financial institutions’ asset quality.
  - The corporate debt problem should be addressed urgently with a comprehensive strategy including: identifying companies in financial difficulties; proactively recognizing losses in the financial system; burden sharing; corporate restructuring and governance reform; removing debt overhang through workouts; and hardening budget constraints.
  - A proactive strategy trades off short-term economic pain for larger longer-term gain.
- Credit growth and leverage:
  - Credit growth averaged around 20 percent per year between 2009 and 2015—much higher than nominal GDP growth and the previous trend.
  - The (broadly defined) nonfinancial private credit-to-GDP ratio rose from around 150 percent to over 200 percent over the same period, and 15–25 percentage points above the level consistent with the historical trend at end-2015.
  - The gap is comparable to countries that experienced painful deleveraging (Borio and Drehmann, 2009).
- Corporate concentration and drivers:
  - Credit growth concentrated in the corporate sector; corporate credit-to-GDP ratio significantly higher than peers and typical for developed economies.
  - High corporate investment after the GFC financed scaling-up of infrastructure spending and real estate investment, supporting upstream industries (steel, cement, coal); corporate borrowing also increased due to growing payments arrears.
- Efficiency and profitability:
  - ‘Efficiency of credit’ (incremental GDP growth relative to incremental increase in credit) has been declining.
  - Growth payoffs from additional capital spending have been falling despite additional borrowing.
  - Corporate leverage ratio rising while return on assets has been steadily falling—most pronounced in real estate, construction, and related upstream activities.
- State-owned enterprises (SOEs) and distortions:
  - SOEs more leveraged and less profitable than the private sector; have acted partly as conduits for policy-driven investment.
  - Soft budget constraints and implicit government guarantees contributed to leverage buildup.
  - Staff estimates: implicit guarantees translate to a 4–5 notches upgrade in credit ratings, and appear to lower borrowing costs by about 1‒2 percentage points.
- Credit quality and potential losses:
  - Reported NPLs and special mention loans have been on the rise but remain relatively low (at about 5½ percent of total loans).
  - Staff estimates based on corporate data suggest potential “debt-at-risk” amounts to 15½ percent of the total corporate loan portfolio.
  - Applying a 60 percent loss ratio on these loans yields estimated potential losses of about 7 percent of GDP (IMF, 2016a).

### Key statistics and estimates (preserved exactly as in source)
- Credit growth averaged around 20 percent per year between 2009 and 2015.
- Nonfinancial private credit-to-GDP ratio rose from around 150 percent to over 200 percent.
- Gap: 15–25 percentage points above trend at end-2015.
- China accounted for about 40 percent of total global demand for metals.
- Metal prices have fallen by almost 60 percent on average since early 2011.
- A 1 percentage point investment-driven drop in China’s output growth would reduce G20 growth by ¼ percentage point.
- Duval et al. estimate: about 0.3 percentage points spillover for median Asian economy.
- Implicit guarantees translate to a 4–5 notches upgrade in credit ratings and lower borrowing costs by about 1‒2 percentage points.
- Reported NPLs and special mention loans: about 5½ percent of total loans.
- Potential “debt-at-risk”: 15½ percent of the total corporate loan portfolio.
- Estimated potential losses applying a 60 percent loss ratio: about 7 percent of GDP.
- China’s contribution to declines in broad commodity price indices: between one-fifth and one-half.

*Source: _cr16271 (IMF staff text).*

### 7.      The authorities recognize the problem and are developing plans to tackle it. They have

### _cr16271 - 7.      The authorities recognize the problem and are developing plans to tackle it. They have

### Recognition of the problem and current measures
- Announced reductions of 10–15 percent of existing capacity in coal and steel over the next 3–5 years.
- Announced a RMB 100 billion restructuring fund to absorb re-employment and resettlement costs for an expected 1.8 million laid-off workers.
- Current operational restructuring plan is narrowly focused on coal and steel; full extent of associated losses in the financial system has yet to be addressed.
- Overall progress in state-owned enterprise (SOE) reforms has been slow; implicit guarantees remain in place.
- Promoting mergers and acquisitions among stronger and weaker SOEs does not by itself impose financial discipline.
- Cases of “mini” or “near” defaults among Chinese corporates have been rising; corporate debt workouts are handled on a case-by-case basis and do not seem to promote corporate restructuring.
- Ad-hoc state intervention in SOEs without clear guidance on the state’s role does not provide an effective mechanism to harden budget constraints.

### Comprehensive proactive debt-restructuring strategy (key elements)
- Identifying companies in financial difficulties (triage):
  - Market-based approach (driven by creditors) or a separate government-driven entity with sufficient legal and political powers.
  - A transparent and standardized process, including external experts in valuation, to provide an independent basis for decision making.
- Loss recognition:
  - Proactively recognize losses in the financial system through an enhanced supervisory and regulatory framework.
  - Introduce positive and negative incentives (“carrots and sticks”) to support the debt restructuring process.
- Burden sharing:
  - Allocate recognized losses among the indebted firm, its creditors and local/central government.
  - Consider moral hazard, capacity to repay, and social consequences.
  - Develop mechanisms to facilitate debt workouts (e.g., debt-equity conversions).
- Corporate restructuring:
  - Include corporate restructuring and governance reform—particularly in SOEs—to prevent recurrence of losses.
- Hardening budget constraints:
  - Implement additional measures (e.g., regulatory reforms, particularly in the bond market) to harden corporates’ budget constraints and remove implicit guarantees.

### Supporting policies for successful restructuring
- Enhancing the legal framework:
  - Improve the legal system and institutional framework to handle insolvencies as a long-term goal.
  - Large-scale and expedited restructuring requires out-of-court mechanisms to complement the existing framework.
- Minimizing near-term growth and employment hit:
  - Recognize short-term economic costs of restructuring; offset over time by activity and employment in new sectors.
  - Supportive mechanisms needed: strengthening the social safety net, retraining, easing restrictions on migration.
- Improving local government fiscal discipline:
  - Boundaries between public and private debt are blurred; local governments have borrowed off-budget through local government financing vehicles.
  - The 2014 Budget Law regularized local government financing, but incentives for off-budget activity remain.

### Pilot deployment of enhanced debt restructuring strategy (proposed steps)
- Deploy on a pilot basis involving a small number of SOEs in a sector with clear overcapacity and diverse degrees of distress.
- Pilot features:
  - Predominantly out-of-court approach under oversight of a SOE Restructuring Task Force with relevant institutions and independent expert valuations.
- Sequential steps for the pilot:
  - Determining fair value of claims held by major creditors of the target enterprises by the China Banking Regulatory Commission.
  - Debt workouts: two alternative approaches:
    - Sale of the loans, at fair value, to a newly established asset management company (AMC); or
    - Establishment of a creditor committee by the relevant banks.
  - Restructuring or liquidation of target enterprises:
    - Decision to restructure or liquidate must be taken by creditors, based on market valuations, viability assessments, and restructuring plans prepared by independent experts.
  - Transfer of claims/ownership:
    - Equity acquired by banks in debt workouts could be sold to private investors or to SOEs with appropriate governance mechanisms.
  - Assistance to laid-off workers utilizing the restructuring fund.

### Scenarios and illustrative macroeconomic impact
- Short-term costs are expected but outweighed by longer-term gains from reallocation of labor and higher total factor productivity growth.
- Staff’s illustrative scenario results:
  - Growth in the proactive scenario will temporarily dip to 6 percent by 2017 (which would be 5½ percent excluding some assumed high-quality fiscal stimulus).
  - Growth then picks up and maintains a growth rate of 6½ percent in the medium term.
  - The credit/GDP ratio would stabilize in the short term, while gradually declining to more sustainable levels in the medium term.

### SOE status, reform plans, and potential gains
- Current SOE footprint and performance:
  - SOEs’ share of value added has fallen to 16 percent from 40 percent over the past decade.
  - SOEs account for about 10-15 percent of urban employment.
  - SOEs account for about half of total bank credit and 40 percent of total industrial corporate assets.
  - Financing costs for listed SOEs tend to be about 40–50 basis points below the benchmark lending rate.
  - Distortions from credit pricing account for nearly half of the estimated implicit support (or 1½ percent of GDP).
  - Adjusting for implicit support suggests SOEs’ return on equity would have fallen from an average of 8 percent to about -1 percent during the period 2011–15.
  - SOE credit ratings are about two to three notches above those of comparable private firms.
  - SOE leverage ratios have risen rapidly to around 200 percent on average, concentrated in overcapacity and heavy industries.
  - Returns on SOE assets have deteriorated to about 2‒3 percent, well below those of private enterprises.
  - SOE productivity is about 30‒40 percent that of private enterprises.
- Government SOE reform announcements and aims:
  - Reform principles include repositioning the state as a capital investor rather than operator; mixed-ownership reforms; classifying SOEs into categories (commercial strategic, commercial nonstrategic, SOEs with social functions); institutionalizing the leadership role of the communist party; resolving nonviable SOEs.
  - The State Council committed to cutting aggregate SOE losses by 2017 and expediting the exit of nonviable “zombie” SOEs, including resolving near 350 subsidiaries of central SOEs and near 4,000 local SOEs.
  - Ten pilot programs with selected SOEs started in 2016 focusing on mixed-ownership reforms and professional management.
- Measures to improve efficiency and resource allocation:
  - Triage SOEs to (i) identify fundamentally sound firms; (ii) liquidate nonviable SOEs; (iii) establish restructuring plans for viable but insolvent SOEs.
  - Expedited out-of-court restructuring using independent experts; begin with a few high-profile pilot cases.
  - Transfer noncore social functions (e.g., hospitals, schools, utilities) to the fiscal budget with related assets and expenses accounted for.
  - Hardening budget constraints by removing implicit guarantees, allocating losses to owners and creditors, and increasing the transfer of SOE profit to the fiscal budget (target of 30 percent by 2020).
  - Introduce greater competition by reducing entry barriers and phasing out restrictions that give SOEs privileged roles; allow private entry in state-dominated services.
  - Provide on-budget fiscal social support to minimize social costs of layoffs; RMB 100bn restructuring fund for coal and steel noted as an important step.
  - Advance complementary reforms (household registration, rural land property rights, insolvency and resolution framework, fiscal reforms for social security portability and intergovernmental finance).
  - Improve coordination via a well-staffed high level group with a clear mandate to promote and implement practical restructuring of SOEs.
- Potential gains from SOE reforms:
  - A two-sector model suggests SOE reforms could raise the level of output by 3–9 percent compared to baseline projections, or about 0.3–0.9 percentage points of growth a year if the effect is spread across a decade.

*Source: IMF staff analysis and recommendations contained in the provided chapter.*

### References

### _cr16271 - References

### Methodology
- Model: Practical spreadsheet model using energy flow data for China from the International Energy Agency (IEA), projecting forward to 2030 using assumptions about GDP growth, trends in the energy intensity of GDP, future fuel prices, and exogenous technological change (Parry and others, forthcoming).
- Behavioral responses: Fuel use and energy efficiency assumptions based on surveys of empirical evidence.
- Local air pollution deaths: Based on previous IMF estimates for China (Parry, Heine, Li, and Lis, 2014).
- Incidence analysis: Links policy-induced impacts on energy prices from the spreadsheet tool to an input-output model to trace price impacts on industries and consumer goods; combined with survey data on spending for energy and other products by different household groups.

### Key findings: emissions, fiscal, economic, and health impacts
- Baseline projection (no new policies beyond 2013 observations):
  - Energy intensity of GDP projected to decline by 37 percent between 2015 and 2030.
  - CO2 per unit of energy projected to remain about constant.
  - Fuel shares in 2015: Coal accounts for 83 percent of CO2, natural gas 3 percent, and oil products 13 percent.
- Carbon tax scenarios:
  - Carbon tax rising from 15 RMB per ton from 2017 to reach 230 RMB by 2030 reduces CO2 by about 20 percent below baseline levels in 2030, meeting China’s CO2 intensity target for Paris.
  - Carbon tax rising progressively to 455 RMB per ton by 2030 reduces 2030 emissions by 30 percent.
  - Taxing coal only at the same rate achieves around 95 percent of CO2 reductions under the carbon tax.
  - Approximately 95 percent of CO2 reductions under the carbon tax come from less coal use.
- Emissions Trading System (ETS) performance:
  - An ETS (same emissions price trajectories as carbon tax scenarios) generates about half of the CO2 reductions of the carbon and coal taxes because it excludes coal use from small-scale users.
  - The ETS will be introduced in China in 2017 for the power sector and large industrial sources, building on seven regional pilot programs; it will cover electricity, domestic aviation, iron and steel, chemicals, cement, paper and other sectors and will be about twice as large as Europe’s trading market.
- Fiscal revenues:
  - Carbon tax raises revenues of 1.7 percent of GDP in 2020 or 3 percent of GDP in 2030 for the RMB 230 and 455 tax scenarios, respectively.
  - Coal tax raises revenues of about 83 percent of those under the carbon tax.
  - ETS (if allowances are auctioned) and the electricity tax raise revenues of about 45 and 35 percent, respectively, of the revenues from the carbon tax.
  - Other policies raise much smaller amounts of revenue, no revenue, or lose revenue in some cases.
- Health impacts (cumulative 2017–2030):
  - Higher carbon and coal tax scenarios save about 4 million lives.
  - ETS saves about 1.9 million lives.
  - Note: Analysis may overstate domestic health benefits as it assumes incremental benefits are the same regardless of pollution concentrations; recent evidence suggests a possible concave relation between mortality and pollution concentrations.
- Net economic gains (aggressive/high tax scenarios):
  - Carbon and coal tax: economic costs about 0.7 percent of GDP but domestic environmental benefits exceeding 5.5 percent of GDP, leaving a net economic gain approaching 5 percent of GDP by 2030.
  - ETS: net economic gains of 2.15 percent of GDP.
  - Other policies: much lower net economic benefits.

### Administration and implementation recommendations
- Preferred levy point:
  - Best administration is to levy upstream at the point of entry in the economy (e.g., at the mine mouth for coal; at the refinery or gas processing plants for petroleum products; imported fuel taxed at the border) to leverage existing administrative structures (e.g., China’s Resource tax).
  - There are currently about 11,000 coal mines in China (restructuring likely to close around 4,000 of them over the next few years); far fewer petroleum refineries and gas processing plants exist.
- Alternative approaches and challenges:
  - Levying tax on large emitters would miss about half the CO2 emissions and measuring emissions is more technically challenging than measuring carbon content of fuel combustion, requiring technical expertise not typically found in tax administrations.
  - A possible facilitation measure: provide some tax rebates for firms required to obtain emissions allowances to ensure all emitters pay the same unit price of carbon, enabling simultaneous introduction of an upstream carbon or coal tax alongside an ETS.

### Incidence and distributional considerations
- Households:
  - Carbon or coal tax is disproportionately burdensome on low income households: 50 percent larger burden for the first income decile and 25 percent larger for the second decile relative to their consumption, compared with the tenth income decile.
  - Recycling about 5 percent of tax revenues can offset adverse impacts on the bottom two deciles (for example, through reduced social security contributions and increased welfare and social spending).
  - An ETS with auctioned allowances is somewhat more regressive than carbon and coal taxes, and dramatically more regressive if allowances are freely allocated (rents accruing to owners of capital).
- Firms:
  - Carbon or coal tax imposes relatively large costs in industries closely associated with traditional growth engines (e.g., heavy manufacturing, construction).
  - Exporting sectors do not bear a disproportionate share of the tax burden compared with other sectors.
  - Mitigating fiscal measures to support energy-intensive and trade-exposed industries would cost around 10 percent of revenues collected through the carbon or coal tax (assuming no mitigation actions in other countries).

### Policy implications and conclusions
- Environmental and development objectives:
  - A carbon or coal tax can effectively address domestic environmental challenges and promote a more sustainable growth path, supporting rebalancing towards high value-added services and consumption-led growth.
  - These taxes also contribute to global mitigation efforts, reducing negative impacts of climate change in China (e.g., higher occurrence of natural disasters affecting coastal areas).
- Policy sequencing:
  - Introduction of an ETS in 2017 should not preclude simultaneous introduction of an upstream carbon or coal tax.
  - China can move ahead unilaterally on its Paris pledges and realize very large domestic benefits without waiting for others to act.
- Revenue recycling:
  - Using around 5 percent of revenue from carbon/coal taxes can fully compensate low income groups for increased energy prices.
  - Using 10 percent of revenues could compensate vulnerable, trade-exposed firms (less compensation needed if other countries also act on their Paris mitigation commitments).

*References and supporting citations appear in the source document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16271.pdf_