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China's Economy

• Economic Performance in 2004 and Early 2005
• Finance Sector: Changes in 2004
• What to Watch in 2005
• Tables

Economic Performance in 2004 and Early 2005

GDP

At 9.5 percent China's economy grew robustly last year, boosted by strong fixed-asset investment and exports (see China's Trade Performance). Unexpectedly strong numbers in the first quarter of 2005, particularly for fixed-asset investment, output, and exports, are leading some analysts to question whether the economy is really slowing down. The National Bureau of Statistics on April 20 announced GDP growth of 9.5 percent in the first quarter of 2005, reaching RMB 3.1 billion ($378.68 billion).

Growth in investment, production, and the money supply had all eased in the last few months of 2004, suggesting that China's economy was slowing, though admittedly not by much. Most analysts believe China is in the midst of a soft landing (a gradual slowdown of about 2 to 3 percent in GDP growth), though some believe that China's current growth is sustainable. 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. 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.

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 last fall when the 2004 harvest proved to be a good one, but rising energy and real estate prices may offset lower food prices in 2005.

The consumer price index (CPI) was 3.9 percent for 2004 and fell to 2.8 for the first quarter of 2005. China aims to keep inflation below 4 percent for 2005 as a whole. (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. First-quarter retail sales grew 13.7 percent to RMB 1.5 trillion ($182.5 billion). 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, 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 output of industrial enterprises with sales of more than RMB 5 million rose 16.7 percent in 2004. Monthly figures show that growth eased slightly over the course of the year, however, from nearly 18 percent in the first half. 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). In the first quarter of 2005, value-added output rose 16.2 percent.

Fixed-asset investment grew 25.8 percent in 2004, to RMB 7,007.3 billion ($847.7 billion), down slightly from the previous year. 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. Fixed-asset investment continues to grow faster than GDP, however, indicating that the economy may not be slowing much. Though at 22.8 percent, fixed-asset investment was surprisingly high in the first quarter, UBS argues that this is not necessarily cause for concern, because investment is falling in some of the overheated sectors and rising in sectors where it is sorely needed, such as electricity, coal, and agriculture.

In 2004, 58 percent of investment was in the state-owned and state-controlled sector; 89 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 60 percent, respectively. Housing accounted for nearly 20 percent of all investment (see "Property Bubble--or Not?").

Geographically, the eastern region took in just over half of all investment in 2004, with the remainder divided evenly between the central and western regions. The biggest jumps in investment, however, were in Inner Mongolia (up 56 percent), Liaoning (up 46 percent), and Henan (up 45 percent) compared to 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 April, PBOC announced that it had kept M2 growth to a modest 14 percent in the first quarter.

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 this year.

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. In the first quarter of 2005, lending slowed by RMB 97.6 billion ($11.8 billion) to RMB 737.5 billion ($89.1 billion) over the same period last year.

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. They leapt again in the first quarter of 2005, rising $49.2 billion to $659.1 billion, up 49.9 percent over the same period of 2004. 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. 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.

In March, Premier Wen Jiabao said China is working on a plan for a more flexible RMB, but that any measures taken to make the RMB more flexible will likely come as a surprise. Wen's comments have fueled speculation that China will adjust the exchange rate between the RMB and the US dollar this year.

Government finances 2004: The year of tax reform

China collected a record amount of revenue last year, up 21.4 percent, and government spending grew more modestly at 15.1 percent. Total central budget revenue rose 16 percent, while central spending rose 13.3 percent. The central government ended the year with a slightly lower-than-expected budget deficit of RMB 319.29 billion ($38.62 billion). In the first quarter of 2005, the tax revenue jumped 20.4 percent to RMB 756 billion ($91.3 billion) over the same period of 2004. This higher revenue may allow the government leeway to expand social spending and change 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 $120 million for grain subsidies and will award $480 million in other agricultural subsidies 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, which will be eliminated entirely in 2006.

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 NPC meeting, will has been 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. (This amount is nearly RMB 20 billion [$2.42 billion] less than in 2004.) China's budget deficit, 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 [$38.7 billion] deficit for 2004). Though social expenditures will rise slightly, the government plans to issue RMB 80 billion ($9.68 billion) in long-term Treasury bonds, down from RMB 30 billion ($3.63 billion) 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 in 2006 under China's WTO commitments, China's domestic banks are faced with the need to increase their competitiveness. Domestic banks, particularly Bank of China (BOC) and China Construction Bank (CCB), which the government is preparing for listing, are reportedly improving management. 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. Recent corruption investigations and other scandals may slow listing preparations, however. 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. In March, PBOC issued draft rules for the personal credit information system and indicated that it should be up and running nationwide by the end of the year. 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. In late January, China's moribund markets were at five-year lows.

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. Press reports indicate that a pilot program could start as early as May.

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.

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.

Last year the shortage of workers in some of the manufacturing centers along the southeastern coast caught many observers (and factory owners) by surprise. Certain factories, particularly those with poor working conditions and low pay, were suddenly short thousands of workers. These conditions and higher rural incomes last year made many young potential migrants decide they were better off on the farm. The fact that Guangdong lifted restrictions on incoming migrants in the weeks after Chinese New Year and yet experienced no wave of new arrivals could presage more shortages this year.

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 could be listed, creating NPL disposal opportunities for investors.

At the press conference following the conclusion of the NPC this March, Premier Wen said that five tasks top the government's reform agenda in 2005:

• Restructure government bodies and change government functions;
• Promote state-owned enterprise reform, focusing on corporate governance and joint-stock reform;
• Push forward financial reform;
• Push forward rural reform focusing on tax and fee administration;
• Advance social security reform.

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, though Xinhua News Agency reported in early January that investment in rail is to double in 2005. According to the China Daily, power generation, fertilizer production, steel production, individual consumers, and exports will have priority in receiving coal. In March, China released new regulations for electricity pricing, which, among other things, link power prices to coal prices. The two main grid companies have also announced plans for major upgrades of transmission equipment, which will help ease shortages over the next few years.

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 could slow this year if the economy cools.

Water

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

Interest rates

With inflation seemingly under control, 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. 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). Most analysts expect gradual and slight deceleration of China's economy over the rest of the year.

Table 1: China's Economic Indicators, 2000-04
	2000	2001	2002	2003	2004
GDP (RMB billion)	8,946.8	9,731.5	10,479.1	11,669.4	13,651.5
Real GDP growth (%)	8.0	7.5	8.0	9.1	9.5
Fixed-asset investment	10.3	13.0	16.9	27.7	25.8
Value-added industrial output*	17.8	11.6	16.5	27.3	16.7
Retail sales	9.7	10.1	11.8	9.1	13.3
Consumer price index (%)	0.4	0.7	-0.8	1.2	3.9
Urban disposable per capita income (RMB)	6,280	6,860	7,703	8,500	9,422
Rural net per capita income (RMB)	2,253	2,366	2,476	2,622	2,936
Urban unemployment rate (%)*	3.1	3.6	4.0	4.4	4.3
Source: PRC National Bureau of Statistics (NBS, www.stats.gov.cn) China Statistical Yearbook, 2003 Notes: *Of enterprises with sales of more than RMB 5 million; *According to official NBS figures, which do not include under-employment or the migrant population

Table 2: GDP: 2005 Forecasts
Organization	2005
Credit Suisse First Boston	8.6
Deutsche Bank AG	8.7
Goldman Sachs Group, Inc.	8.8
JP Morgan Chase & Co.	8.5
PRC Center for National Accounting and Economic Growth	8-9
PRC Government target	~8.0
UBS AG	9.6
Sources: Bloomberg; Deutsche Bank AG; JP Morgan Chase & Co.; PRC Government Work Report; UBS AG; Xinhua News Agency

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Table 3: China's Financial Indicators, 2000-04
Sources: Asian Wall Street Journal; NBS China Statistical Yearbook, 2003; People's Bank of China; Reuters Note: NA=not available
(All figures are in billions of RMB or percent unless otherwise indicated)
	2000	2001	2002	2004	2005
M0 supply	1,465.3	1,568.9	1,727.8	1,974.6	2,146.8
% growth	8.9	7.1	10.1	14.3	8.7
M1 supply	5,314.7	5,987.2	7,088.2	8,411.9	9,597.1
% growth	16.0	12.7	16.8	18.7	14.1
M2 supply	13,461.0	15,830.2	18,500.7	21,922.6	25,508.0
% growth	12.3	17.6	16.8	19.6	14.4
Exchange rate (RMB/$)	8.3	8.3	8.3	8.3	8.3
Forex reserves ($ billion)	165.6	212.2	286.4	403.3	609.9
Government revenue (total)	1,339.5	1,638.6	1,890.4	2,171.5	2,635.6
Tax revenue	1,258.2	1,530.1	1,763.6	2,001.7	2,572.0
Domestic debt	415.4	448.4	566.0	602.9	NA
Foreign debt ($ billion)	145.7	170.1	171.4	193.6	NA
Government deficit	249.1	251.7	315.0	293.5	319.3

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