China's Economy
Published February 2007
Summary
- China's economy grew 10.7 percent in 2006, the fastest pace in 11 years.
- China's trade surplus and foreign exchange reserves both hit new highs, putting more pressure on the RMB to appreciate.
- Rebalancing the economy--reducing the trade surplus and excessive fixed-asset investment, and boosting consumption--is moving up on the government's agenda.
- Bringing a halt to worsening income inequality and environmental degradation are also among the government's top priorities.
Economic Indicators
GDP
Expanding 10.7 percent, China's economy logged its fourth consecutive year of double-digit growth. Exports and fixed-asset investment were the main drivers of growth (see Table 1).
Trade surplus, forex reserves hit new highs
China's trade surplus surged 74 percent, hitting a record $177.5 billion (see China's Trade Performance). Because China's foreign exchange (forex) regime requires the central bank to use RMB to buy most forex earnings of Chinese companies, surging export earnings caused reserves to balloon to more than $1 trillion at the end of 2006, putting further upward pressure on the RMB exchange rate. Deutsche Bank expects export growth to slow to around 17 percent in 2007. But UBS notes that because of tighter liquidity at home (which would reduce import demand), the trade surplus will likely remain high, even if it does not grow much bigger.
Prices
Retail prices were steady in 2006, with the consumer price index (CPI) coming in at 1.5 percent. Most of the increases were in food prices, particularly grain. But the central government viewed the grain price rise of only 2.7 percent as a boon to farmers rather than a threat to urban stability. Purchasing prices of raw materials, fuel, and power rose 6 percent, producer prices 3 percent, and prices for investment in fixed assets 1.5 percent, all below 2005 increases. The CPI hit 2.8 percent in December, however, sparking concerns about higher inflation. Most analysts are predicting inflation of 2-3 percent in 2007.
Consumption rises steadily
Retail sales maintained the steady growth seen in the last few years, rising 13.7 percent in 2006. Sales in urban areas grew 14.3 percent, while those in rural areas rose 12.6 percent. Several analysts say rural consumption is where long-term growth opportunities lie, but in the shorter term, greater opportunities exist in urban areas where incomes are much higher. In the next year or so, strong consumption growth is likely in high-tech and luxury items and services, particularly healthcare and education. Deutsche Bank notes that healthcare coverage is about 45 percent in urban areas and 22 percent in rural areas--leaving lots of room for growth.
Output stays strong, analysts divided on overcapacity
Total value-added industrial output rose 12.5 percent. To this point, extra capacity built as a result of soaring fixed-asset investment in recent years seems not to be leading to excessive inventories. Some analysts argue that Chinese firms have been gaining market share both at home and abroad, reducing overcapacity in most sectors. Others--including respondents to USCBC's annual operating survey--counter that industrial overcapacity is leading to eroding margins and could undermine the economy.
Investment stays strong, but under control for now
Fixed-asset investment remained strong in 2006, growing 24 percent, down from 26 percent in 2005. After torrid growth of 31.3 percent in the first half, tightening measures, including hikes in interest rates and bank reserve requirements, as well as administrative measures in the property sector, kicked in to slow investment by the third quarter. Most economists agree at the moment that more tightening measures are unlikely to be needed in the next few months, but the government will no doubt be keeping a close eye on investment, particularly in the property sector. It should also be noted that some analysts suspect investment is being underreported and expect it to rebound in the first quarter of 2007.
Foreign investment rose 4.5 percent, excluding the financial sector (see Foreign Investment in China). Outbound investment, excluding the financial sector, jumped 32 percent in 2006 to $16.1 billion. The government is expected to further encourage outbound investment in 2007, in part to increase capital outflows and reduce pressure on the currency.
Money supply, credit, and interest rates climb
M2 (cash and deposits) grew 16.9 percent in 2006, slightly exceeding the 16 percent target (see Table 2). New credit hit RMB 3.18 trillion ($409.5 billion), 27 percent beyond target, according to a Xinhua report. Money and credit growth are already slowing to a more reasonable rate, according to UBS.
The People's Bank of China (PBOC) raised interest rates twice last year and in early January 2007 raised reserve rates for the fourth time in seven months. Many economists expect interest rates to rise, perhaps as early as April, as part of the continuing effort to curb lending and thus fixed-asset investment. Others point out that higher interest rates could boost capital inflows, putting more upward pressure on the RMB. Still others say that interest rate moves are largely symbolic. China will probably also keep raising bank reserve requirements, which appears to be the most effective method not only to drain liquidity from the system but also reduce pressure on the RMB to appreciate.
Other Issues of Concern
Income inequality: The gap widens further
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 the gap, particularly when combined with land grabs and other abuses by local officials, is threatening social stability. Rural incomes are still only one-third of urban incomes. Average annual rural incomes in 2006 rose 7.4 percent in real terms to RMB 3,587 ($462) while average annual urban incomes, at RMB 11,759 ($1,514), rose 10.4 percent. China still has an estimated 120 million surplus rural laborers, many of whom are migrating to cities to look for work. To help alleviate rural poverty, China will establish a national system of subsistence allowances. At the end of 2005, China had 23.7 million rural poor--defined as living on less than RMB 683 ($88) a year.
Unlike urban residents, few rural residents have received subsidized healthcare or education, and only a small percentage participates in pension systems. The government is trying to address these issues. Since 2006, rural children in western China have been entitled to free education for nine years; this will be extended to the rest of the country in the next few years. The government also aims to provide universal health coverage in the next five years, though previous attempts at reform in this area have not succeeded. The crux of the matter is money; local governments in poor areas simply do not have the resources to provide these services. China has acknowledged this problem and is working to ensure that local governments can fulfill their mandates. In the meantime, Beijing has pledged to allocate RMB 1 billion ($128.8 million) for healthcare in central and western China. The Chinese Academy of Social Sciences estimates that healthcare now accounts for nearly 12 percent of household consumption.
Perennial employment worries, new push on labor policies
The number of people graduating from institutes of higher education has more than tripled from 2000 to 2005, according to official statistics. As a result, competition for entry-level white collar and technical jobs is fierce. The National Development and Reform Commission's Economic Research Institute forecasts that there will be only 10 million vacancies for 25 million applicants this year.
For those lucky enough to have jobs, wages have been rising. According to a study by MRI Worldwide, salaries for regular staff at multinational corporations are rising 8-9 percent annually, while compensation packages at the high end of the scale are rising 31-33 percent. At the lower end of the scale, Xinhua reports that 29 of China's 31 provinces, municipalities, and autonomous regions raised minimum wages in 2006. At RMB 810 ($104) per month, Shenzhen has the highest minimum wage, while Jiangxi's is the lowest at RMB 270 ($35).
China has also been pushing labor contracts and unionization at foreign-invested and private enterprises. The All-China Federation of Trade Unions (ACFTU) has reportedly raised its target for unionization in foreign enterprises from 60 percent in 2006 to 70 percent this year. In late January 2007, the Guangdong ACFTU branch announced it aims to set up union branches at 80 percent of FIEs and 60 percent of private enterprises in the province, according to press reports. Xinhua also reports that nearly 84 percent of employees signed work contracts with their employers last year.
What to Watch in 2007
A stronger RMB
Most analysts expect China to continue building the instruments and mechanisms needed to float the RMB. China has recently indicated that it is willing to allow the currency to appreciate more quickly. Analysts are predicting a 4-6 percent appreciation by year's end, similar to the rise in 2006. A broader fluctuation band is also possible. Without faster appreciation, China runs the risk of significantly higher inflation, which would cause not only appreciation in real terms but hardship among China's low-income earners. Most analysts also expect further increases in reserve requirements and more vigorous promotion of outbound investment and other capital outflows to reduce the need for sterilization of forex inflows. UBS estimates that Chinese firms could make acquisitions abroad of $15-$20 billion a year for the rest of this decade.
Trade surplus
China has said it will take steps, such as reducing tariffs on certain imports and lowering value-added tax rebates on selected exports, to slow the growth of its trade surplus. The Ministry of Commerce predicts 15 percent growth in total trade in 2007. Several analysts expect China's surplus to remain high but steady.
Forex reserve management
China has for several years been saying it will diversify its forex holdings. In the run-up to this year's Financial Work Conference in early January 2007, there was much speculation in the press that China could form a state investment company, similar to Singapore's Temasek Holdings Pte Ltd. Though the government did not announce the formation of such a company following the conference, analysts are arguing that, structured correctly, it would be a way to not only maximize returns, but also raise capital outflows. Other analysts note that it would also raise China's political and economic influence around the world.
SOE dividends: A way to boost consumption and cut investment?
Analysts both inside and outside China have been calling for China to boost domestic consumption for several years, and China's leaders realize that stronger consumption is needed for balanced and sustainable long-term growth. Though consumption has been growing steadily, the need to save for healthcare, education, and retirement has kept savings rates higher than international norms--and curtailed consumption. Lack of consumer credit also keeps consumption low. Thus, before consumption can rival investment and exports as a driver of the economy, China must not only introduce more financial instruments and savings and investment options, but also fix its social safety net.
To this end, the World Bank, the International Monetary Fund, and other economic experts, are calling on China to force state-owned enterprises (SOEs) to pay dividends to the government. The logic goes like this: SOE profits are up significantly in the last few years. As a primary shareholder, the government should receive dividends from these profits. These dividends would go to the government budget, where they could be used to shore up the social safety net. This plan would help rebalance the economy in two ways. First, a stronger social safety net would reduce the need for precautionary savings and thus boost consumption. Second, diverting earnings away from the firms would also slow fixed-asset investment. Much of the overinvestment in recent years has come from firms with excess cash and nowhere to invest it, except in more capacity. This excess investment carries risks of inflation, stock and property market bubbles, and poor investment decisions, which in turn could lead to a rash of defaults, further weakening the banking system. Recent reports indicate that the government is planning to implement this idea.
Taxes
China is considering, or has decided on, several new taxes that will help achieve its policy goals. Chief among these is the unification of tax rates for foreign and domestic enterprises (see Foreign Investment in China). To reduce income inequality, China raised the threshold at which individual income tax kicks in as well as the rates for top earners. To promote conservation, the State Administration of Taxation (SAT) has also said it would try to push through the long-debated fuel tax this year.
The property sector has also been targeted to discourage speculative investments. SAT has already increased capital gains taxes on property and is considering a property tax on all owners. Press reports indicate that as of February 1, it will tax the profits of builders at rates as high as 60 percent. Though this tax has reportedly been on the books since 1993, it apparently has not been collected regularly.
Environment: SEPA flexes its muscles
According to the State Environmental Protection Administration (SEPA), 3 percent of China's 2004 GDP, or RMB 511.8 billion ($64 billion), was lost to pollution-related damage. Though the government is focused on this problem, SEPA has historically lacked the power to carry out its mandate effectively. A recent proposal by the China Council for International Cooperation on Environment and Development, an advisory body to the PRC government, to raise SEPA to full ministry status, may give it the clout it needs to make real progress. Several recent developments indicate that the PRC government's current emphasis on the environment may have emboldened SEPA to flex its muscles--and coordinate with other government bodies.
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The environmental watchdog in early January halted major projects by four large power companies and all power producers in Guizhou, Hebei, Shanxi, and Shandong--provinces with particularly poor environmental performance. SEPA also fined PetroChina Co. Ltd. RMB 1 million ($128,785), reportedly the highest possible amount for pollution under PRC law, for a spill at its Jilin plant that contaminated the Songhua River in 2005.
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In addition, PBOC announced that enterprises with poor environmental records will find it more difficult to obtain loans. PBOC is cooperating with SEPA to include environmental information in its national credit database.
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In late December, SEPA sharply criticized local governments for releasing false statistics on environmental pollution. To get local officials to take their stewardship of the environment more seriously, SEPA and the Ministry of Supervision issued a regulation laying out penalties for officials who fail to protect the environment. Environmental performance will be incorporated into regular evaluations of local governments and officials.
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In 2008, China will conduct its first national survey on sources of environmental pollution. Press reports indicate that once the survey is complete, the government will likely draft a list of products that cause severe pollution, which could serve as a basis for tax policies that discourage the manufacture of such products.
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In January, a deputy PBOC governor announced at the World Economic Forum that China would use environmental controls to restrain investment in particularly polluting industries.
Possible risks
The main risks to China's economy are a slowdown in the United States and a rebound in fixed-asset investment. Most analysts expect another year of strong growth, though perhaps slightly slower than this year (see Table 4).
Financial Reforms: A Progress Report
Stock market reform finally shows results
Until last year, as much as two-thirds of the shares of listed companies were nontradable and largely state-owned. The fear that the government would flood the market with these shares, diluting publicly held shares, led to a five-year slump. In 2005, the government finally released a viable plan to convert these nontradable shares. By the end of 2006, 95 percent of A-share listed companies had completed the conversion. After six years of losses, the A-share market made steady gains, then suddenly spiked in the last quarter of the year. Though some of the gains result from improved corporate fundamentals, there is increasing evidence of speculation. The government is taking steps to try to prevent a bubble, such as talking the market down. In late January, warnings of a bubble from one of China's top legislators caused the market to drop.
Bank reform: A focus on rural finance...
In the last few years, bank reform has made progress. Three of the big four state banks were cleaned up and listed, though they still have some way to go in terms of corporate governance, risk assessment, and transparency. The fourth bank, the Agricultural Bank of China (ABC), is slated for reform this year. The ABC will be harder to fix than any of the other three banks, tied as it is to China's dismally performing rural finance sector. In September, its nonperforming loan (NPL) ratio was 23.5 percent, down slightly from six months earlier. Contrary to earlier speculation, ABC will not be split up. Press reports indicate that it will, like the other banks before it, receive a capital injection from the government but, unlike the others, will not seek a foreign strategic investor and list abroad. Instead, it will likely list in Shanghai.
China began reforming rural cooperatives in 2003 and is seeking to revitalize the entire rural financial sector. Statistics show the rural sector to be underserved: only 60 percent of rural households have access to bank credit and farmers account for only 15 percent of bank loans and deposits, according to the Shanghai Daily. To encourage foreign and domestic banks to set up in rural provinces, the China Banking Regulatory Commission (CBRC) will likely reduce registered and operating capital requirements. CBRC has also said it will process applications to set up in Inner Mongolia, Jilin, Hubei, Sichuan, Gansu, and Qinghai more quickly than those to set up in other areas.
...and policy banks
The Financial Work Conference also set the China Development Bank on the road to reform. The bank will be the first of the three policy banks--established in 1994 to lend according to government policy rather than on a commercial basis--to engage in commercial lending.
A new lease on life for AMCs
In 1999, China set up four asset management companies (AMCs) to dispose of about RMB 1 trillion ($128.8 billion) in NPLs from the big four state banks. Widely considered to have done a poor job of disposing of these nonperforming assets, the AMCs have nevertheless reportedly been given the green light to become full-fledged financial service providers once they have fulfilled their original mandate. Accordingly, in early January 2007, the AMCs announced that they had disposed of their original NPLs, though press reports did not mention whether they had successfully disposed of other NPLs taken on since then. Restructuring plans for the AMCs along the lines of those of the big four are expected to be announced in the first half of 2007.
Market makers, Shibor, and other developments
China is doggedly attempting to bring its financial system up to international standards, particularly capital markets. Last January, it introduced a market maker system for the yuan market, with five foreign and eight domestic banks. (Market makers quote bid and offer rates, facilitating foreign exchange deals.) In December it expanded the program to encompass 21 banks, eight of which are foreign.
In early January 2007, PRC officials launched the Shanghai interbank offered rate, or Shibor, a set of market-determined interest rates, similar to Libor, the widely used London interbank offered rate. Shibor should provide a pricing benchmark for derivatives such as interest rate swaps, which China also introduced last January.
The introduction of new instruments and tools are steps toward a more flexible financial system and a prerequisite for removing capital controls and floating the RMB. China is still many years away from a free float, but these moves, and others like them, bring it a little bit closer.
| Table 1: General Economic Indicators, 2002-06 (All figures are in billions of RMB or percent unless otherwise indicated) |
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| Sources: PRC National Bureau of Statistics (NBS), China Statistical Yearbook 2006; NBS website; USCBC Notes: *All state-owned industrial enterprises and all non-state industrial enterprises with revenue from principal business of more than RMB 5 million. **According to official NBS figures |
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| Main indicators | 2002 | 2003 | 2004 | 2005 | 2006 |
| GDP | 12,033.3 | 13,582.3 | 15,987.8 | 18,308.5 | 20,940.7 |
| Real GDP growth | 9.1 | 10.0 | 10.1 | 10.2 | 10.7 |
| Consumer price index | -0.8 | 1.2 | 3.9 | 1.8 | 1.5 |
| Trade ($ billion) | 620.8 | 851.0 | 1,154.6 | 1,421.9 | 1,760.7 |
| % growth | 21.8 | 37.1 | 35.7 | 23.2 | 23.8 |
| Exports ($ billion) | 325.6 | 438.2 | 593.3 | 762.0 | 969.1 |
| % growth | 22.4 | 34.6 | 35.4 | 28.4 | 27.2 |
| Imports ($ billion) | 295.2 | 412.8 | 561.2 | 660.0 | 791.6 |
| % growth | 21.2 | 39.8 | 36.0 | 17.6 | 20.0 |
| Industrial value added output* | 3,299.5 | 4,199.0 | 5,480.5 | 7,218.7 | NA |
| % growth | 16.5 | 27.3 | 30.5 | 31.7 | 16.6 |
| Fixed-asset investment | 4,350.0 | 5,556.7 | 7,047.7 | 8,877.4 | 10,987.0 |
| % growth | 16.9 | 27.7 | 26.8 | 26.0 | 23.8 |
| Retail sales | 4,813.6 | 5,251.6 | 5,950.1 | 6,717.7 | 7,641.0 |
| % growth | 11.8 | 9.1 | 13.3 | 12.9 | 13.7 |
| Urban per capita disposable income (RMB) | 7,702.8 | 8,472.2 | 9,421.6 | 10,493.0 | 11,759.0 |
| % growth | 12.3 | 10.0 | 11.2 | 11.4 | 12.1 |
| Rural per capita net income (RMB) | 2,475.6 | 2,622.2 | 2,936.4 | 3,254.9 | 3,587.0 |
| % growth | 4.6 | 5.9 | 12.0 | 10.8 | 10.2 |
| Unemployment rate** | 4 | 4.3 | 4.2 | 4.2 | 4.1 |
| Table 2: China's Financial Indicators, 2002-06 | |||||
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| Notes: All figures in RMB billion unless otherwise indicated. *Over previous year. NA = not available
Sources: NBS, China Statistical Yearbook, 2006; The People's Bank of China; USCBC |
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| Financial indicators | 2002 | 2003 | 2004 | 2005 | 2006 |
| M0 supply | 1,727.8 | 1,974.6 | 2,146.8 | 2,403.2 | 2,707.2 |
| % growth* | 10.1 | 14.3 | 8.7 | 11.9 | 12.6 |
| M1 supply | 7,088.2 | 8,411.9 | 9,597.0 | 10,727.9 | 12,602.8 |
| % growth* | 16.8 | 18.7 | 13.6 | 11.8 | 17.5 |
| M2 supply | 18,500.7 | 22,122.3 | 25,410.7 | 29,875.6 | 34,557.7 |
| % growth* | 16.8 | 19.6 | 14.7 | 17.6 | 15.7 |
| Exchange rate (RMB/$) | 8.28 | 8.28 | 8.28 | 8.07 | 7.8 |
| Foreign exchange reserves ($ billion) | 286.4 | 403.3 | 609.9 | 818.9 | 1,066.3 |
| Government deficit | 315.0 | 293.5 | 209.0 | 228.1 | NA |
| Domestic debt | 567.9 | 615.4 | 687.9 | 692.3 | NA |
| Foreign debt ($ billion) | 171.4 | 193.6 | 228.6 | 281.0 | NA |
| Table 3: PRC Tax Revenue, 2005-06 (RMB million) | ||||
|---|---|---|---|---|
| Source: PRC State Administration of Taxation. Percentages calculated by USCBC. | ||||
| 2005 | 2006 | % Growth | % of Total | |
| Total Tax Revenue | 3,086,583 | 3,763,627 | 21.94 | 100.00 |
| National | 2,133,449 | 2,618,797 | 22.75 | 69.58 |
| Local | 953,134 | 1,144,830 | 20.11 | 30.42 |
| Domestic value-added tax | 1,069,829 | 1,289,460 | 20.53 | 34.26 |
| Consumption tax | 163,431 | 188,567 | 15.38 | 5.01 |
| Customs duties | 422,005 | 496,711 | 17.70 | 13.20 |
| Business tax | 423,143 | 512,889 | 21.21 | 13.63 |
| Company income tax | 436,313 | 554,588 | 27.11 | 14.74 |
| Foreign-invested enterprises and foreign enterprises income tax | 114,769 | 153,482 | 33.73 | 4.08 |
| Individual income tax | 209,391 | 245,232 | 17.12 | 6.52 |
| Resource tax | 14,263 | 20,726 | 45.31 | 0.55 |
| Urban maintenance and development tax | 79,602 | 94,023 | 18.12 | 2.50 |
| Property tax | 43,590 | 51,518 | 18.19 | 1.37 |
| Stamp duty | 22,675 | 37,659 | 66.08 | 1.00 |
| Urban land-use tax | 13,733 | 17,689 | 28.81 | 0.47 |
| Local value-added tax | 14,002 | 23,132 | 65.21 | 0.61 |
| Cargo tax | 3,889 | 4,996 | 28.47 | 0.13 |
| Vehicle purchase tax | 55,762 | 68,751 | 23.29 | 1.83 |
| Tobacco tax | 0 | 4,132 | NA | 0.11 |
| Other | 185 | 73 | -60.31 | 0.00 |
| Table 4: GDP Growth Estimates | |||
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| Note: NDRC = National Development and Reform Commission Sources: Associated Press, Deutsche Bank, Reuters, The Standard, UBS, Wall Street Journal, Xinhua News Agency |
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| GDP (% growth) | 2007 | ||
| Official PRC government target | 8.0 | ||
| National Bureau of Statistics | ~10 | ||
| Asian Development Bank | 9.5 | ||
| Deutsche Bank | 9.5 | ||
| UBS | 9.1 | ||
| State Information Center (NDRC) | 8.5-10.5 | ||
| People's Bank of China | 9.8 | ||
| CLSA Asia-Pacific Markets | 5-7 | ||
| World Bank | 9.6 | ||