China's Economy
Published April 2006
Summary
- China's economy grew 10.2 percent in the first quarter of 2006, beating expectations and raising worries of overheating.
- In the lead-up to PRC President Hu Jintao's visit to the United States, the renminbi appreciated more rapidly than it had after China's mid-2005 revaluation. Analysts expect appreciation to resume at a more gradual pace through the rest of the year.
- China's global trade surplus was still high in the first quarter of 2006 after ballooning in 2005. Exports and investment are largely responsible.
- The government's new focus on balanced growth and its attempt to shift from an investment- and export-driven economy to a consumption-driven one will mean more policies to promote consumption.
- Sectors such as autos, steel, and aluminum face overcapacity, and the government will continue reining in high fixed-asset investment, which is leading to rising inventories and falling prices in certain sectors.
Overview
China's economy grew 10.2 percent in the first quarter of 2006. After a slight slowing in late 2005, investment and exports resumed strong growth in the first three months of 2006. Analysts still expect growth to moderate in the second half of 2006.
RMB and currency reform
After years of international debate, China in mid-2005 shifted its exchange rate regime to a currency-basket model and revalued the RMB against the dollar by 2.1 percent.
In the weeks leading up to PRC President Hu Jintao's recent visit to the United States, the annualized RMB appreciation rate reached 6-9 percent according to Deutsche Bank. This is a big increase over the 1-2 percent rate of August-December 2005. Analysts expect the RMB to appreciate at a more gradual rate of 4 percent for the rest of the year, which may not be enough to quiet critics.
Though initially praised for the move, China is facing pressure to reassure international markets that the revaluation and new basket regime is just the start of a shift toward a fully market-determined exchange rate. Indeed, China has introduced several mechanisms and instruments that are steps toward a more freely floating RMB, such as currency swaps and forwards, a market-making system, and over-the-counter trading of the RMB. China's top financial and political leaders have denied repeatedly in recent public statements that China will undertake another one-off revaluation, as some critics have demanded.
Economic Indicators
Trade: China's surplus is still strong
China's global trade surplus, which ballooned last year as domestic import demand slackened, grew just as strongly in early 2006, reaching $23.3 billion in the first quarter. Though imports picked up in the first quarter, up 24.8 percent, export growth was higher, at 26.6 percent year on year. UBS says that the strong surplus is due to lingering "overcapacity pressures"--reflected in weak imports of heavy industrial chemicals and raw materials, particularly steel. It is not due to weak domestic demand, according to UBS, which has apparently been gaining momentum in early 2006 (see China's Trade Performance).
Prices stay low
Consumer price inflation was 1.2 percent in the first quarter. Stiff competition in many industries has kept prices of consumer goods down despite high costs of raw materials. Producer prices rose 2.9 percent, and raw material and energy prices rose 6.5 percent.
The National Development and Reform Commission (NDRC) raised natural gas prices in late December and announced it would adjust prices annually, with raises not to exceed 8 percent, with the aim of eventually introducing market forces to gas pricing mechanisms. China also removed price controls on coal sold to state-owned power plants, which could signal higher electricity prices in future.
Consumption rises steadily
Consumption, measured by retail sales, grew steadily in 2005 and early 2006, boosted by low inflation and rising incomes, especially in rural areas. Retail sales rose 12.8 percent in the first quarter. Rural incomes grew nearly 12 percent in 2004 and 2005, after several years of growth of around 5 percent. In the first quarter of 2006, urban incomes rose 10.8 percent, and rural incomes were up 11.5 percent. The economic "blue book" released by the Chinese Academy of Social Sciences last December predicted slightly slower consumption growth in the near term, largely because rural incomes and prices of farm products rose more slowly in 2005 than in 2004 (though they still rose more quickly than in the 2001-03 period). Over the next few years, however, UBS expects urban consumption to slow as rural consumption picks up, with rising incomes from "structurally high food prices." Several new policies are aimed at keeping consumption strong in 2006 (see "What to Watch in 2006" below).
Output strong, overcapacity still a problem
Value-added industrial output in the first quarter was up 16.7 percent year on year. Heavy industrial output was up 17.8 percent, light industry up 14.7 percent, and raw material output (metals) rose 21.7 percent. Overcapacity, particularly in steel and other metals, is still a problem. In late 2005, NDRC identified 11 sectors facing overproduction: cement, aluminum, ferroalloy, calcium carbide, steel, autos, power, coal, copper, charcoal, and textiles. A glut of these products could lower producer prices.
Investment rebounds--too much
Fixed-asset investment picked up in the second half of 2005 and the first quarter of 2006 as the government's 2004 clampdown on overinvestment tapered off. Much of this investment was in the so-called bottleneck industries--power, coal, rail, and oil--where it was needed, though property construction did pick up again in the second half of the year. Deutsche Bank notes that "stubbornly high" fixed-asset investment may prompt the government to tighten credit by raising bank reserve requirements.
Fixed-asset investment in the first quarter was up 27.7 percent year on year, up nearly five percentage points over the first quarter of 2004.
Money supply and credit grow, interest rates stay low
M2 (cash and deposits) growth reached 18.8 percent in March, exceeding the 18 percent level of the end of 2005. The People's Bank of China's (PBOC) 2006 targets are 16 percent for M2 growth, 14 percent for M1 (cash) growth, and credit growth of RMB 2.5 trillion ($310 billion).
Interest rates are expected to stay low, but China may raise bank reserve requirements as a way to reduce lending (which was RMB 1.26 trillion in the first quarter) and money supply growth.
Forex reserves overtake Japan's
By the end of the first quarter, China's reserves stood at $875.1 billion, ranking China first in forex holdings worldwide. PRC authorities recently announced the relaxation of some forex controls and the introduction of the long-awaited qualified domestic institutional investor program. Such moves should encourage domestic foreign currency holders to move their holdings overseas. Though full capital account convertibility is still far off, these measures may somewhat help ease the forex buildup.
Government finances in good shape, but pensions loom
At the National People's Congress (NPC) meeting in March, Minister of Finance Jin Renqing delivered the Report on the Implementation of the 2005 Budget and the Draft 2006 Budget. The Ministry of Finance expects central-government revenue to grow 12 percent in 2006, from last year's RMB 1.72 trillion ($214 billion) to RMB 1.93 billion ($239 billion). The central government will seek to reduce its budget deficit by RMB 5 billion ($621 million) and lower the fiscal deficit-to-GDP ratio from 1.6 percent to 1.5 percent. The central government also plans to reduce government bond issuances by a quarter to RMB 60 billion ($7.5 billion) in 2006.
Tax revenue continues to grow strongly: In early January, the State Administration of Taxation announced that it had collected a record RMB 3.09 trillion ($382 billion) in 2005, up 20 percent from 2004. With growing tax revenues and fewer infrastructure bond issues, government finances are generally improving. The main problem is future pension liabilities, as local governments are raiding funds meant for future pensions to pay for current ones. A reform announced in December is aimed at expanding coverage to include more self-employed and other non-traditionally employed workers and introducing incentives (those who work longer and contribute more will receive more). In 2005, China paid about RMB 400 billion ($49 billion) to 43.5 million retirees. Eleven percent of China's population is more than 60 years old, and this percentage is expected to hit 24 percent in 2030. Illustrating the seriousness of pension shortfall, Vice Minister of Labor and Social Security Liu Yongfu noted that on average Chinese live 25 years in retirement, but that there is enough money to cover only 10 of those years.
Rural issues
Rural China is high on the government's agenda, and with good reason. The gap between rich and poor--in particular between rural and urban areas--is still growing, and many observers say it is threatening social stability. Though rural incomes grew slightly more quickly than urban incomes in the first quarter of 2006, they are still only a third of urban salaries. Average annual rural incomes in 2005 rose 6.2 percent to RMB 3,255 ($406.31) while average annual urban incomes, at RMB 10,493 ($1,309.82), rose 9.6 percent. Moreover, unlike urban residents, most rural residents do not receive subsidized health care or education, and only a small percentage participates in pension systems.
At the NPC session in March, the central government pledged to increase spending on the rural sector, from last year's RMB 297.5 billion ($40 billion) to RMB 339.7 billion ($42 billion), with a focus on the construction of rural infrastructure. Over the next five years, the central and local governments will apportion RMB 103 billion ($13 billion) annually to support lower-level government bodies and compulsory education in rural areas, with the central government funding 76 percent of the cost. By 2008, the central government said, it will abolish tuition fees for compulsory education in rural areas. The central government also plans to expand the pilot rural cooperative medical system to cover 40 percent of China's counties.
Rising numbers of protests and clashes between residents and local authorities in recent years signal frustration, resentment toward corrupt or heavy-handed officials, and in some cases, sheer desperation. This year the government reported 87,000 protests or clashes in 2005, up from 58,000 in 2003, though no rural/urban breakdown was given. Several of these have turned violent and have focused central-government attention on the problem (see China's Politics). Many of these incidents stem from the confiscation of land with little or no compensation. (In China, all land is owned by the state, and farmers may not voluntarily transfer their land-use rights. Involuntary "re-zoning" of agricultural land to industrial and real estate projects by local governments is the primary cause of farmers' dispossession. According to one press report, Chinese Academy of Social Sciences researchers say that more than half of farmers who have lost land see a drop in their standard of living.) Several disputes have stemmed from pollution so severe that a large number of people or even an entire village were sickened, yet the local government took little or no action.
Employment and labor issues
China's first-ever National Economic Census, released this past December, shows that the private and service sectors are leading sources of employment--by some estimates services account for 30 percent of new jobs created. By the end of 2005, consumer goods distribution employed 56 million, or 24 percent of the service sector. Unemployment is still a worry, however. Goldman Sachs, Inc. estimates urban unemployment, including those laid off from state-owned enterprises, at around 12 percent, while the official unemployment rate for 2005 was 4.2 percent.
Another worry is that adherence to labor regulations among small- and medium-sized private Chinese enterprises remains poor; many do not sign formal labor contracts with employees or pay the health insurance, pension, disability, and unemployment fund contributions as required by law. China recently released a draft Labor Contract Law for comment. The draft law is primarily aimed at putting protections in place for employees without written labor contracts and whose employers do not contribute to the government's social security systems.
What to Watch in 2006
RMB
Most analysts expect China to continue building the instruments and mechanisms needed to float the RMB, but also expect only a gradual appreciation of the currency in 2006. Several analysts predict a 4-5 percent appreciation by year's end.
Consumption-boosting policies
China has made several changes that should help boost consumption. First, the threshold at which income tax kicks in was doubled to RMB 1,600 ($200) per month, which means people at the lower end of the income scale, who spend more of their extra income, will have more to spend. Second, the elimination of the agricultural tax nationwide will likewise give rural residents more disposable income. Previously, rural residents had to pay the tax regardless of income or profit. Third, civil servant wages are expected to rise this year, in connection with reform of the civil servant pay system, according to Premier Wen Jiabao's Government Work Report. Finally, restrictions on low-emission, economical cars have begun to be eliminated in areas such as Shanghai, which should boost sales.
Still, the lack of a social safety net will keep the savings rate--currently nearly 50 percent--high, as Chinese worry about how to pay for education, healthcare, and survival in old age. In fact, economists at the Organization of Economic Cooperation and Development have suggested that China's high savings rate is not necessarily bad, because consumption will automatically increase as the population ages, and today's savings will pay for this future consumption.
How much consumption will rise depends largely on the direction of rural incomes, as rural consumption accounts for 40 percent of China's total, according to the Economist Intelligence Unit (EIU). EIU expects structural changes and government policies to strengthen rural consumption over the next five years, particularly at the lower end of the market. In urban areas, EIU expects consumption to grow more sophisticated, with higher sales of fashionable clothing, computers and other technology, and home improvement items.
Energy
China has accounted for roughly 40 percent of world oil demand growth over the past four years. China is also the world's largest consumer and producer of coal, which makes up about 65 percent of China's primary energy consumption. The country aims to diversify and expand its sources of petroleum abroad and diversify its energy mix at home. At a renewable energy conference in Beijing in late 2005, Vice Premier Zeng Peiyan told attendees that China aims to raise the use of renewable energy--including wind, geothermal, and nuclear--in its energy mix to 15 percent by 2020. At the National People's Congress meeting in March, Premier Wen Jiabao stated that China planned to lower its energy use per unit of GDP by 4 percent this year. This is the first time that China has designated energy efficiency as one of its major macroeconomic objectives, highlighting the government's focus on sustainable development.
- Power Though blackouts plagued most of China again last summer, power shortages were less severe than in 2004 and, with lots of new capacity coming online in the next few years, are expected to wane further in 2006, with a possibility of a glut in 2007. Incremental price reforms may also affect supply and demand. If retail prices rise in tandem with coal prices, demand could ease as consumers look for ways to boost efficiency.
- Oil Domestic supply of and demand for oil also depends somewhat on pricing policies. In 2005, Chinese refiners had to pay the going rate on the international market but sell in China at low, government-regulated prices. Forced to swallow the difference as a loss, they preferred to export refined products to get a better price. As a result, southern China suffered shortages until the government imposed limits on exports. Overall government policy encourages conservation: limitations on small, efficient, and non-polluting cars have begun to be lifted, and a fuel tax and new pricing mechanisms are also reported to be in the works.
- Conservation In line with its new focus on the environment, the government is calling for technology upgrades and lower energy consumption in energy-intensive sectors, such as steel, power generation, and building materials. It also plans to launch pilot recycling programs in key cities and industries next year and called for the development of new and renewable sources of energy.
Environment
One of the goals of the 11th Five-year Plan (FYP, 2006-10) is "building a resource-efficient and environmentally friendly society." Since October 2003, when the government began to call for more balanced economic growth, including taking the environment into consideration, several industrial accidents have underlined the need for massive efforts in this area. In November 2005, a toxic spill in northeastern China caused by a petrochemical explosion not only poisoned water supplies of Chinese towns and cities in the region, but also threatened water supplies in Russia. The South China Morning Post (SCMP) reported that before he resigned, Xie Zhenhua, former head of the State Environmental Protection Administration (SEPA), prepared a speech on China's environmental conditions in which he wrote: "The economic losses [in China] have been incalculable.... The damage includes 30 percent of the national territory polluted by acid rain, 300 million rural residents drinking unclean water, [and] 400 million city people breathing seriously polluted air, with 15 million of them developing bronchitis and respiratory cancers as a result." Though the SCMP report is unconfirmed, statistics on air and water quality on the SEPA website indicate that these numbers are likely accurate. At least three other toxic spills compromised water supplies in early 2006.
In early January, a water company in Baotou, Inner Mongolia, won compensation from two paper factories and an irrigation company responsible for a toxic slick that disrupted Baotou's water supply for four days in 2004. According to the Financial Times, this is the first time polluters of the Yellow River have been forced to pay compensation. Given the central government's new emphasis on the environment, such awards could become more common. For companies, the new focus on the environment and energy efficiency may mean better enforcement of environmental regulations and new opportunities for firms that produce environmentally friendly products and technology.
Before Xie's departure, he projected that China would invest more than RMB 1.3 trillion ($156.6 billion) in environmental protection between 2006 and 2010, equal to more than 1.5 percent of the country's GDP over this period. With reports indicating that more than 75 percent of China's urban water is not fit for drinking or fishing and that breathing in some cities amounts to smoking two packs of cigarettes a day, this investment cannot come soon enough.
| Economic Indicators | ||||
|---|---|---|---|---|
| 2005 Amount | % Change over 2004 | First-Quarter 2006 Amount | % Growth Year on Year | |
| GDP | RMB 18,232 billion | 9.9 | RMB 4,331.3 billion | 10.2 |
| Fixed-asset investment | RMB 8,860 billion | 25.7 | RMB 1,390.8 billion | 27.7 |
| Industrial value-added output* | RMB 7,619 billion | 11.4 | RMB 1,782.2 billion | 16.7 |
| Consumer price index | -- | 1.8 | -- | 1.2 |
| Retail sales | RMB 6,718 billion | 12.9 | RMB 1,844.0 billion | 12.8 |
| Per capita disposable income of urban households | RMB 10,493 | 9.6 | RMB 3,293 | 10.8 |
| Per capita net income of rural households | RMB 3,255 | 6.2 | RMB 1,094 | 11.5 |
| Registered urban unemployment | 4.2% | -- | NA | |
| M2 (Cash and deposits) | RMB 29,876 billion | 18.8** | ||
| Foreign exchange reserves | $819 billion | 34.3 | $ 875.1 billion | |
| Imports | $660 billion | 17.6 | $174 billion | 24.8 |
| Exports | $762 billion | 28.4 | $197.3 billion | 26.6 |
|
Note: * of enterprises with sales of more than RMB 5 million; NA = not available; **Growth rate in March 2006 Sources: National Bureau of Statistics, People's Bank of China, Reuters |
||||
Financial Reforms Press Ahead
Stock market reform
After years of delay, China in 2005 finally began addressing the nontradable share overhang that has been shadowing its stock markets. Nearly two-thirds of listed company shares are nontradable, and most of those shares are state owned. Fears that the conversion of nontradable shares would flood the markets, drive prices down, and dilute currently tradable shares have driven China's stock markets to record lows since the government first announced its intention to divest itself of nontradable shares in 2001.
The state wants to sell off these shares in part to cement its role as a regulator rather than an actor in the economy, and in part to relieve itself of the burden implied by its role as shareholder in listed PRC companies. Another goal of the reform is to make listed companies more accountable to smaller shareholders and, as a result, improve corporate governance and performance. In December, China exempted foreigners from capital gains tax, a move seen as an effort to shore up prices and improve governance of Chinese listed companies by attracting foreign investors. In early 2006 China went further, opening most of China's A-share companies to large-scale, strategic foreign investors. Previously, only foreign financial firms with qualified foreign institutional investor (QFII) status could invest in A-share firms. (Foreign investors may still not invest in firms in strategic industries.)
Bank reform
With the banking sector due to open fully to foreign participants by December 2006, China's regulators have been struggling to make the country's banks strong enough to compete with top international institutions. The biggest state banks are getting bailed out one by one, with tailored restructuring programs that aim to get them listed overseas. China Construction Bank listed on the Hong Kong Stock Exchange in October, Bank of China received approval to list this year, and the Industrial and Commercial Bank of China may list soon after. The entire industry is subject to various initiatives to improve lending practices and corporate governance and to prevent irregularities. Even so, some PRC officials appear to believe that China's banks need more time before being exposed to foreign competition.
Targeting corruption and improving governance
A series of banking scandals last year prompted authorities to tighten oversight and introduce rules to prevent fraud and corruption and reduce risk. The China Banking Regulatory Commission (CBRC) introduced anticorruption and disclosure measures and plans to introduce a risk-warning system that will reportedly monitor capital adequacy ratios and credit, market, operational, and liquidity risks. These reforms are sorely needed, as corporate governance in PRC banks still leaves much to be desired. Despite the government's recent attempts at systemic reform, interference by local officials remains widespread in China's banking system.
New instruments
As its economy matures and financial reforms gather steam, China is gradually introducing more sophisticated financial mechanisms and instruments. In recent years, several commodities futures markets have opened, and others will almost certainly follow in the next few years. In September, the head of the China Securities Regulatory Commission reportedly said China was considering introducing financial futures and other derivative products, though no timetable was given. And in December, a regulation allowing securitization of credit assets held by financial institutions took effect.
| GDP Growth Estimates, 2006 | |
|---|---|
| GDP (% growth) 2006 | |
| Official PRC government target | 8.0 |
| National Bureau of Statistics | 9.0 |
| Asian Development Bank | 9.5 |
| Deutsche Bank | 9.0 |
| International Monetary Fund | 9.5 |
| World Bank | 9.2 |
| Sources: Asian Development Bank, Bloomberg, Deutsche Bank, National Bureau of Statistics, 2006 PRC Government Work Report | |
The 11th Five-Year Plan
Premier Wen Jiabao outlined the 11th FYP in his government work report, delivered to the National People's Congress in March. Apart from the goals listed below, China plans to upgrade its industrial structure, develop the service industry, and balance regional development. The FYP also details specific transportation, high-tech, and energy projects that the government will undertake.
- China's GDP will double from the 2000 level of RMB 8.82 trillion ($1.07 trillion) to RMB 17.64 trillion ($2.14 trillion), with average per capita GDP reaching $1,600.
- The proportion of urban residents in the total population will reach 47 percent.
- The Engel Coefficient--the proportion of family income that is spent on food--will fall to 30 percent in urban areas and 40 percent in rural areas.
- The Gini Coefficient--a measure of income inequality where 0 is perfect equality and 1 is perfect inequality--will remain at 0.45 (already quite high).
- The adult literacy rate will reach 95 percent.
- Population growth will stay below 0.70 percent.
- Annual economic growth will average 7.5 percent.
- Energy consumption per unit of GDP will fall 20 percent by 2010.
- An increase of RMB 218.2 billion ($27 billion) in government spending on compulsory education.
- The government will invest RMB 20 billion ($2.5 billion) in the renovation of local hospitals.