China's Economy

Summary

• The economy grew 9.5 percent, pushed mainly by fixed-asset investment and exports.
• Government restrictions on lending and project approvals curtailed investment growth in overheating sectors such as aluminum, cement, and steel.
• Power and transportation bottlenecks also slowed the economy last year and are likely to continue to do so.
• Improving governance and other reforms continue in the financial sector. China's economic success in the long term depends on successful financial sector reform.
• Most analysts expect a soft landing in 2005, with growth "slowing" to around 8 percent.
• China's central bank forecasts 2005 CPI at about 3.3 percent. Producer price increases are likely to be higher.
• Administrative controls, rather than market levers, remain the main government tool for economic policy adjustments.
• Monetary pressures to adjust the RMB exchange rate continue to grow.

Economic Performance in 2004

As in 2003, China's economy grew robustly last year, boosted by strong fixed-asset investment and exports (see China's Trade Performance). China's National Bureau of Statistics announced a preliminary GDP growth estimate for 2004 of 9.5 percent, slightly higher than expected (see Table 2). This number masks a slight slowdown from 9.8 percent in the first quarter to 9.1 percent in the third quarter, though press reports indicate that growth edged up in the fourth quarter to 9.5 percent.

Growth in investment, production, and the money supply have all eased in recent months, signaling that China's economy is finally slowing, though admittedly not by much. Most analysts believe China is in the midst of a soft landing (a slowdown of about 2 to 3 percent in GDP growth), though some believe that China's current growth is sustainable. Anne Krueger of the International Monetary Fund (IMF) says it is too soon to tell, however, and Nicholas Lardy and Morris Goldstein of the Institute for International Economics argue that the slowdown will be gradual, but deeper than most observers expect—spread over several years instead of several quarters.

Overinvestment in certain sectors in the first quarter of 2004 spurred government administrative action last spring to curb lending and reduce the number of low-quality investment projects. Though the use of administrative fiat, rather than more subtle economic levers such as interest rate changes, was widely criticized by Western observers, it seems to be doing the job for the time being. Bottlenecks in the economy have also played a role in the slowdown: severe power shortages in nearly every province put factories on shortened work weeks, particularly over the summer; the rail system routinely turns away a substantial amount of prospective freight for lack of capacity; and a crackdown on overloaded trucks has made road transport more expensive.

Most observers expect investment and export growth to slow in 2005, reining in overall GDP growth somewhat, but predict that investment in real estate, infrastructure, energy, environment, and rural sectors will stay strong.

Inflation peaks and consumption stays strong

Spiking grain prices after a poor harvest in 2003 caused inflation to peak at just over 5 percent last summer. Inflation eased this fall when the 2004 harvest proved to be a good one, but rising energy and real estate prices may offset falling food prices in 2005.

Prices for recreation, education, cultural items, and housing rose slightly, while those for clothing, household items, medicine, and communication eased. The producer price index jumped 8.4 percent in October, fueled by high oil prices, but finished the year at 6.1 percent, perhaps indicating that high producer prices will not push consumer prices up significantly. The consumer price index (CPI) was 3.9 percent for 2004. With December inflation falling to 2.4 percent, PBOC forecasts 2005 CPI of 3.3 percent, down from its previous estimate of 3-4 percent. (Some economists warn that official CPI numbers may not be reliable because the composition of the basket has not been updated for years and official numbers reflect administrative price controls introduced in some provinces early last year.)

Retail sales grew 13 percent, to RMB 5.4 trillion ($652.6 billion) in 2004, boosted by strong sales of oil, communications equipment, autos, cultural items, furniture, cosmetics, and jewelry. Retail sales are expected to grow more than 10 percent in 2005. According to Qi Jingmei, a senior economist at the National Bureau of Statistics, growth of auto sales, which rose only 15 percent in 2004 after 75 percent growth in 2003, is expected to slow further this year because potential auto buyers are delaying their purchases until auto import tariffs fall to 25 percent in 2006. Also, high fuel prices are discouraging car purchases, and many of the people who can afford a car have already bought one. The property market is expected to keep growing strongly, however, further boosting consumption as people go about decorating their new homes. UBS Securities Asia Ltd. believes that higher growth in rural incomes will offset declining growth in urban incomes over the next few years, keeping consumption growth strong.

Output and investment growth eases

Value-added industrial output of industrial enterprises with sales of more than RMB 5 million rose 16.7 percent. Monthly figures show that growth eased slightly over the course of the year, however, from nearly 18 percent in the first half. Even so, output of tractors, ships, power generating equipment, fax machines, and semiconductor integrated circuits all leapt more than 50 percent (some as high as 99 percent) in the first 11 months of the year. Some analysts are taking this slightly slower growth as evidence that a soft landing is in the works. UBS forecasts that industrial value-added output will grow 11-12 percent in 2005. Total value-added industrial output grew 11.5 percent in 2004, to RMB 6,281.5 billion ($760 billion).

Fixed-asset investment grew 25.8 percent, to RMB 7,007.3 billion ($847.7 billion), down slightly from 2003. This number masks a distinct fall-off in investment growth from more than 40 percent in the first quarter to less than 30 percent in the third quarter and just over 20 percent in December. This drop is largely due to administrative controls in overheating sectors such as steel, aluminum, and cement and the winding-up of the government's fiscal stimulus measures that have been in place since 1998. Some analysts are forecasting investment growth to slow dramatically this year. Fixed-asset investment continues to grow faster than GDP, however, indicating that the economy may not be slowing as much as most analysts think.

In the first 11 months of the year, 58 percent of investment was in the state-owned and state-controlled sector; 85 percent of investment was at the local government level. Agriculture took in a miniscule 1 percent of investment, while industry and services absorbed 40 and 59 percent, respectively. Housing accounted for nearly 20 percent of all investment (see "Property Bubble—or Not?").

The most dramatic growth in the first 11 months of the year occurred in investment in ferrous metal mining (217 percent) and in fossil fuel and trash processing (104 percent and 131percent, respectively). Surprisingly, investment in railway transportation actually fell 2 percent, between January and November, though Xinhua News Agency reported in early January that investment in rail is to double in 2005.

Geographically, the eastern region took in just over half of all investment between January and November, with the remainder divided evenly between the central and western regions. The biggest jumps in investment, however, were in Inner Mongolia (up 64 percent), Liaoning (up 44 percent), and Chongqing (up 43 percent) compared to the first 11 months of 2003. By the end of 2004, investment in eastern China had risen 26 percent over 2003, while that in the central and western areas rose 33 and 29 percent, respectively.

Utilized foreign direct investment (FDI) grew 13 percent to $60.6 billion in 2004 (see Foreign Investment in China). Because it constitutes a fraction of overall investment, FDI has contributed little to overheating, though FDI in some of the overheated sectors such as aluminum and steel fell sharply after the government instituted controls.

Lending and money supply growth slow; interest rates inch up

To keep a lid on inflation, the People's Bank of China (PBOC) slowed broad money supply growth from nearly 20 percent at the end of 2003 to around 14.5 percent by the end of 2004. PBOC announced a target of 15 percent for M2 (currency in circulation and short-term deposits) growth in 2005, a slight easing of actual monetary policy from the second half of 2004, but lower than last year's target of 17 percent. According to Chen Dongqi, a senior National Development and Reform Commission researcher, the target of 15 percent "is designed to achieve comparatively fast growth while avoiding runaway growth...a hard landing [, or inflation]."

In October, PBOC raised interest rates for the first time in nine years, but not enough to slow the economy significantly. The main aim was to get real interest rates on deposits back into positive territory. With inflation easing, there is little incentive for steep rate hikes over the next year. A Bloomberg survey of economists indicates that most expect a quarter-point increase in the first quarter of 2005.

More important, PBOC lifted the ceiling on lending rates. This should allow banks to price for risk, enabling them to expand lending to private and smaller enterprises, which are now the main engines of job creation in China. Increasing lending to such underserved entities is a priority for PBOC. Banks have some way to go, however, to set up systems to evaluate potential lenders and determine appropriate interest rates. Thus, this type of lending may not expand until such systems are operational, which could take several years.

Lending slowed by RMB 500 billion ($60.5 billion), or 18.5 percent, in 2004 to RMB 2.2 trillion ($266.1 billion). PBOC also issued a target for lending in 2005: RMB 2.5 trillion ($301.9 billion), up nearly 14 percent over 2004.

Forex reserves jump again; the RMB holds steady for now

Foreign exchange reserves hit $609.9 billion at the end of 2004, up a significant 51 percent from the end of 2003. Yi Xianrong, a researcher at the Chinese Academy of Social Sciences, reportedly estimates that inflows of money speculating against the renminbi (RMB) account for a little over half of the rise in foreign exchange reserves. Concerned about such "hot money" inflows, China has tinkered around the edges of its forex regime to allow more money to leave the country. These measures, such as raising bank reserve requirements and allowing tourists and students to take more money abroad, have had little effect. In early January, China gave the go-ahead for China Ping An Insurance Co. to invest some of its forex reserves abroad. Allowing other financial companies to do the same could stem the tide of unwanted forex inflows, as could government support for non-financial companies to look for FDI opportunities abroad.

Despite the growing pressure that these large forex inflows exert on the currency, China has kept the RMB pegged at 8.28 RMB to the dollar. Though the country has promised to work toward a more flexible exchange rate regime, it has stated it will not change the RMB's value while speculators are waiting to cash in. Speculative inflows slowed in the second half of 2004, reflecting the fact that government controls have made the investment environment less attractive. Many economists think China will make a move this year—perhaps by broadening the narrow band within which the RMB fluctuates, or by tying it to a basket of currencies.

Government finances 2004: The year of tax reform

China collected a record amount of tax revenue last year, up 25.7 percent, and government spending, as of the end of November, was growing more modestly at 14.1 percent. At the end of November, China held a working fiscal surplus of RMB 283.7 billion ($34.2 billion), excluding bond issuances. Although tax chief Xie Xuren cautioned that such revenue growth would not be repeated in 2005, the successful tax collection effort gives the government a strong position to lead reforms in two directions: expanded social spending and changes to value-added tax rebates.

The government has already pledged that it will increase funding to rural infrastructure projects and large water projects. It has also earmarked another $120 million for grain subsidies and will award $460 million this year. Xie also announced that tax authorities may exempt more low-income households from taxes (the current cutoff is $100 per month). And the rollback of agricultural taxes continues: this year a total of 22 provinces will not impose agricultural taxes.

China also initiated a pilot tax reform in the Northeast in October 2004, which allows tax rebates for fixed investments in certain industries in Heilongjiang, Jilin, and Liaoning. While the pilot encourages investment in the Northeast, its real significance is that it may signal the start of broader tax reforms, including a possible shift toward a consumption-based tax system, and selective use of tax incentives to encourage investment.

Foreign companies can also breathe a sigh of relief: equalization of tax treatment, which was expected to be discussed at the March National People's Congress (NPC) meeting, will likely be delayed because MOFCOM voiced concerns on the effect of such a law on FDI. Analysts now expect tax equalization to start in 2007 at the earliest.

Finance Minister Jin Renqing indicated that he expected both tax revenues and expenditures to moderate in 2005, with a deficit target of RMB 300 billion ($36.1 billion), or 2 percent of GDP. China's budget deficits, including outstanding treasury bonds, has remained at that level for the past few years. (Including outstanding treasury bills, China will file a RMB 320 billion deficit for 2004). Though social expenditures will increase slightly, the government plans to issue fewer bonds for special construction and to limit expansion of general spending in 2005.

Finance Sector: Changes in 2004

Domestic banks—The clock is ticking

Foreign banks continue to expand their presence: HSBC took a 20 percent stake in Bank of Communications in August and Newbridge Capital finally landed its 18 percent controlling stake in Shenzhen Development Bank in October. Beijing continues to open the sector to foreign participation—it cut capital requirements and branching restrictions on foreign banks in September and went beyond its market-opening commitments to the World Trade Organization (WTO) when it opened RMB business in Beijing; Kunming, Yunnan; Shenyang, Liaoning; Xi'an, Shaanxi; and Xiamen, Fujian, to foreign banks in December.

With the full liberalization of China's banking sector due for 2006 under China's WTO commitments, China's domestic banks are faced with the need to increase their competitiveness. Domestic banks are reportedly improving management, particularly Bank of China (BOC) and China Construction Bank (CCB), which the government is preparing for listing as early as this year. Standard & Poor's Corp. noted that the two banks have centralized credit approval and are separating front office and risk management processes. Beijing set targets for the two banks early in 2004, covering nonperforming loan ratios, return on assets, and capital adequacy, among other indicators. Beijing has also provided more direct support to the banks: a $45 billion injection at the start of 2004 and a transfer of $34 billion in nonperforming loans (NPLs) to a state-owned asset management company. As a result, Standard & Poor's has upgraded the two banks to investment quality (BBB-). (NPLs at China's 16 largest banks dropped 4.6 percent to 13.2 percent of existing loans, while the Big Four banks cut their collective NPL ratio to 15.6 percent.)

The regulatory background is changing as well. Beijing issued administrative controls, including prohibitions on inside lending and a brief moratorium on lending to slow unprecedented money supply growth, as well as a broad slate of market-based measures. These included the first interest rate increase in nine years, two increases in the deposit reserve ratio, and adjustments to interbank lending rates. To help bring Chinese banks up to international standards, banking regulators also set capital adequacy requirements in March, with a compliance deadline of January 1, 2007.

Investors' receptivity to the eventual listings of BOC and CCB will be a litmus test for the direction and effectiveness of Chinese banking reforms. There are rumors of capital injections being prepared for the other two major state banks, the Industrial and Commercial Bank of China and the Agricultural Bank of China, and the validity of these rumors may depend on the success of the first two listings. As in 2004, the Big Four banks and other banks will continue to pay low dividends, plowing profits into writing off NPLs.

One initiative to watch is the national individual credit database, established among the Big Four banks and 12 joint-stock and city commercial banks in December on a pilot basis. For the first time, banks will share loan repayment, credit card, and loan guarantee information on individuals and compile personal credit histories for them, which could then be used to guide lending and reduce risk more effectively. The success of this program will greatly help in due diligence and the spread of consumer credit. Another step forward expected in 2005 is the long-awaited bankruptcy law. The law, which has already been reviewed twice by the NPC Standing Committee, will set consistent rules on shareholder exits and payment to creditors for failing companies.

Securities—An exercise in misery

The PRC government announced new initiatives at the end of January to encourage investment in capital markets—including a reduction in transactional charges, new listing procedures, and plans to audit securities firms. Investors were not reassured. At press time, China's moribund markets are at five year lows. The Shanghai market for A shares lost 15.2 percent in 2004 and the Shenzhen market 16.5 percent, the latest in a series of steady losses.

Though China's stockmarkets suffer from problems ranging from poor monitoring to ineffective listing procedures, these pale beside the uncertainty surrounding disposal of government-held shares, estimated at two-thirds of total shares. The Shanghai and Shenzhen stock markets' decline dates from June 2001, when the government announced its intention to unload some of its shares. The market has never recovered. The markets will not function normally until the government specifies how it will float these shares and when.

The poor health of China's stock markets continues to damage the Chinese economy. Not only does it remove one channel for company funding and higher investment returns, but healthier Chinese companies, including BOC and CCB, continue to head for Hong Kong or overseas exchanges where their shares are snatched up by foreign investors. The lack of investment options also drives overdevelopment, particularly in the real estate sector, as individuals have no choice other than near-zero returns at the banks.

For these reasons, China is likely to kick off its qualified domestic institutional investor (QDII) program in 2005, allowing capital to flow out to foreign (and foreign-listed Chinese) assets. This should both definitively increase returns to Chinese investors and help relieve China's capital account surplus during a time of intense speculation on the RMB. Analysts also expect China to invite more foreign institutional investors as a way of establishing discipline in markets. China has already, as part of its WTO commitments, passed regulations to welcome greater foreign participation in fund management and stock underwriting. (Despite these developments, private equity will still probably be the hot topic for 2005.)

Insurance—Promising for foreign firms

Growth of insurance revenues slowed in 2004 to 11 percent, about half the pace of growth in 2003. Analysts attributed the slowdown to interest rate increases and readjustment in the life insurance sector.

The real success story, however, is foreign insurers in China. Revenues gathered by foreign insurers increased at four times the rate of domestic growth, and according to statistics released by China's insurance regulator, foreign insurers control 15.3 percent of the insurance market in Shanghai and 8.2 percent in Guangzhou. China fulfilled its WTO market-opening commitments in December, allowing foreign insurers to provide health, group, and pension fund insurance, lifting all geographical restrictions on foreign insurers, and allowing foreign firms to hold majority shares in joint ventures. Doors are open to insurance brokers and agents as well: Beijing in January halved the capital requirement for establishing brokerages and clarified branching requirements for brokerages and agencies. Unfortunately, the high capital requirements for foreign insurance issuers—$24 million for the initial office—remains unchanged, and branching applications must be approved one at a time.

Last year also saw the introduction of foreign-provided agricultural insurance in western China. Groupama SA opened a branch in Chengdu, Sichuan, to provide a much-needed way to stabilize farm incomes. Beijing and other insurers will be paying close attention in 2005 to Groupama's progress to gauge the difficulty of introducing new insurance services. Analysts also expect more laws to reduce risk in the insurance sector; Beijing recently clarified how nonlife insurers must manage reserves and set up a nationwide, insurer-funded insurance reserve to cover policyholders in case of bankruptcies. A final point to watch in 2005 is the release of domestic insurance funds to outside investments. In January, PRC foreign exchange authorities granted China Ping An Insurance Co., China's second-largest life insurer, the first quota of $1.75 billion to invest in foreign equities. The move should help increase returns, and thus raise competitiveness, of domestic firms.

Rural issues

Rural China finally had a relatively good year in 2004. High food prices boosted rural incomes by 6.8 percent, the highest growth rate since 1997. (Urban incomes grew 7.7 percent.) Agricultural output jumped 7 percent, largely in response to higher prices. Inflation was also higher in rural areas than in the cities. The central government eliminated rural taxes in some areas and plans to eliminate agricultural taxes in more areas in 2005. But conditions are still far from rosy in the countryside, and abuses by local officials are still the focus of most farmers' complaints. Moreover, China reported that in 2003 poverty rose for the first time since 1978—one in 11 rural residents lives below the official Chinese poverty line, which itself is significantly below the internationally accepted level of $1 per day at 1985 prices. And one good year will do little to narrow the income gap between rural and urban areas—income distribution in China is now more unequal than two-thirds of all countries and on a par with the United States, Brazil, and South Africa. Rural issues will top the government agenda for years to come.

Unemployment

Official urban unemployment is estimated at 4.2 percent, or 14 million, below the target of 4.7 percent for 2004. This number, however, excludes workers furloughed from state-owned enterprises, rural migrant laborers looking for work in the cities, and the millions of surplus laborers in rural areas, so the real number of unemployed could be twice as high. Press reports quote Minister of Labor and Social Security Zheng Silin saying that China must find work for 5 million laid-off workers and 9 million new entrants to the workforce in 2005. As a result, unemployment remains near the top of the list of government worries.

Some of the unemployed are not waiting for government assistance; the number of self-employed people in China is now around 100 million, or about 40 percent of the urban employed, according to the Ministry of Labor and Social Security. This number includes professionals (lawyers, writers, freelancers, and interpreters) as well as housekeepers, wage workers, and some migrant workers.

A curious anomaly last year was the shortage of workers in some of the manufacturing centers along the southeastern coast. Certain factories, particularly those with poor working conditions and low pay, were suddenly short thousands of workers. These conditions and higher rural incomes this year made many young potential migrants decide they were better off on the farm.

What to Watch in 2005

Continued reform

China will soldier on with legal, banking, securities, corporate governance, and transparency reforms this year. The Bank of China and China Construction Bank will likely be listed, creating NPL disposal opportunities for investors.

Energy

Nearly every province in China suffered blackouts during peak load periods last year. Though new power plants are scheduled to come online in 2006 and 2007, structural weaknesses will still plague China's power sector (for more on power in China, see www.uschina.org/members/china/chops/powersector.html). Power shortages are expected again this year, and Jiangsu, Shanxi, and Zhejiang will likely be hardest hit.

In 2005, demand for coal is expected to remain high, and transportation bottlenecks, particularly in rail, will hinder prompt delivery. According to the China Daily, power generation, fertilizer production, steel production, individual consumers, and exports will have priority in receiving coal. As coal is the main energy source for power plants in China, the government reportedly plans to link power prices to coal prices within the next year.

China has also become a major consumer of oil in the last few years and is setting up a strategic petroleum reserve to ensure a steady supply of oil in times of emergency. Crude oil imports rose 35 percent last year (in part because many companies used diesel generators to keep producing during power cuts), but are expected to slow this year as the economy cools.

Water

Water prices will likely rise as a result of widespread shortages.

Interest rates

With the threat of high inflation receding, sharp rate increases look unlikely. Most analysts expect rate hikes of less than 1 percent this year.

What kind of landing?

Most analysts expect investment growth to fall to less than 20 percent in 2005, which will further ease demand for raw materials and bring prices down. Falling world oil prices would also help. As long as inflation stays in the 3 to 5 percent range, there will be little incentive to raise interest rates. The trick will be to make sure that lending and investment goes to companies and projects that will use it wisely—which depends, in turn, on continuing financial sector reform, specifically, getting loans to SMEs. Strong investment is still needed in many sectors, particularly infrastructure and SMEs, to support rapid urbanization, improve rural access to markets, and create jobs (according to CLSA, SMEs account for 75 percent of new jobs in China while the private sector accounts for 60 percent of GDP). While China's economic numbers always require some skepticism, most analysts seem to agree that China is successfully engineering a soft landing as the year opens.

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Last Updated: 14-Mar-05