China Quarterly Update, November 2005

34460 World Bank Office, Beijing Quarterly Update November 2005 The World Bank quarterly update provides an update on recent economic and social developments and policies in China, and present findings from ongoing World Bank work on China. The update is produced by a team from the Beijing Office with support from the China country team and the Development Economics Department. Questions and feedback can be addressed to Li Li (lli2@worldbank.org)  China Quarterly Update--November 2005 2 OVERVIEW Economic growth has been higher than expected, in part due to more rapid domestic demand growth. Reversing the pattern of the first half of 2005, domestic demand appears to have rebounded in the third quarter--reflecting both stronger investment and stronger consumption--while the contribution of net external trade declined. As a result, GDP growth slowed only slightly to 9.4 percent (yoy), after 9.5 percent in the first half of the year. Recent developments point to a very slight moderation of growth in the coming year. Against a background of a favorable macro economic and financial setting, we project GDP growth of 9.3 percent in 2005 and 8.7 percent in 2006, low inflation, and-- with domestic demand driving growth again--a decline in the current account surplus in 2006, after a projected record surplus of over 6 percent of GDP in 2005. However, a two- way risk is formed by considerable uncertainty about enterprises' investment behavior. Under current circumstances, more rapid growth in credit and investment would be unwelcome. Stronger domestic demand from either consumption or investment would reduce the current account surplus that is complicating monetary policy and trade relations. However, investment is already considered too high--concerns about overinvestment had triggered the tightening measures in 2004. Recent indicators suggest that the renewed pick up in domestic demand is at least in part due to stronger investment, including in industries with downward price pressures due to over supply. Indeed, investment is likely to continue to grow faster than consumption into 2006, and policy measures may be required to dampen investment. Capital inflows appear to have eased in the wake of the change in the exchange rate regime in July, due in part to a PBC policy of allowing foreign surpluses to partly spill over in bank liquidity in order to drive down market interest rates. So far, the increased bank liquidity has not led to increased credit growth. But there is a risk that the additional liquidity could lead to another investment upturn. Changing the pattern of growth is high on the agenda. The 5th plenary session of the 16th Central Committee of the CPC held in October discussed changing China's pattern of growth, moving to growth that is less resource-intensive, more "knowledge-driven" (that is, through higher efficiency), and more equally-shared. The pattern of growth can be transformed in this direction by rebalancing growth to sectors that require less capital, energy, and resources but generate more urban employment, while improving the efficiency of capital. This will require among others further financial sector reform, better corporate governance, a dividend policy for state enterprises, a larger role for private sector firms, and liberalizing restrictions hindering the development of the services industry and labor movements. These measures need to be flanked by public finance measures that strengthen the role of the government in education, health, and the social safety net--both to further a "harmonious society" and to boost household consumption--and use the tax system to adjust energy and resources use in line with scarcities and social preferences. With health sector reform key, this Quarterly Update has a Special Focus section on Reforming China's Health System.  China Quarterly Update--November 2005 3 RECENT ECONOMIC DEVELOPMENTS: DOMESTIC RESURGENCE? High growth is holding up, supported by rebounding domestic demand. A recovery of domestic demand in the third quarter seems to reflect both stronger investment and stronger consumption. The resurgence in investment in part reflects a fading out of the impact of the slowdown triggered by the policy tightening since May 2004. The contribution of external trade to growth, while still substantial in the third quarter of 2005, dropped from the very high level in the first half of the year. The overall result was a milder-than-expected slowdown in GDP growth to 9.4 percent (yoy), after 9.5 percent in the first half. Domestic demand accounted for some 75 percent of growth in the third quarter, compared to 40 percent in the first half of the year (Figure 1).1 Fixed asset investment (FAI) has unexpectedly rebounded. Nominal FAI growth picked up to 28.5 percent (yoy) in the third quarter, from 26.4 percent in the first half (Figure 2), despite moderate credit growth and profit growth that is considerably below that of last year (Figure 3).2 The rebound was led by investment in manufacturing, especially the consumer goods, natural resource processing, and export-oriented industries. Several indicators suggest that the construction sector picked up steam again since June, including floor space under construction and buildings completed and sold, as well as households' non-consumption expenditures. However, FAI in the real estate sector continued to slow through August. Industrial production has remained strong, growing 16.2 percent (yoy) in the third quarter, slightly less than in the second quarter. Consumer spending became stronger, although not yet enough to take over growth momentum from investment. Nominal retail sales have been growing steadily at 12.5- 14 percent (yoy) since May 2004, with declining consumer price inflation allowing for the pick up in real retail sales growth (Figure 4). Household survey data on "living expenditure" may be a better proxy for private consumption (see Box 2). Urban households' per capita "living expenditure", which had been affected by the policy tightening measures, recovered early this year and has been growing at around 10-11 percent (yoy) in recent months, slightly slower than per capita urban income (Figure 4). Large increases in rural household incomes boosted overall household incomes and consumption: nation-wide household incomes grew almost 16 percent (yoy), in nominal terms, in the first 9 months of 2005. Consistent with these developments, and some recovery in bank lending to households, car sales--which were also hit by the 2004 tightening measures--have rebounded sharply since early summer. Recent trade patterns are in line with buoyant domestic activity. Export growth averaged over 30 percent in the first 8 months (yoy), in US$, but dropped to 26 percent in September, whereas import growth is on the rise (Figure 5). During the second half of 1 A note of caution is that analysis of the direction of the economy is clouded by the caveats with China's macroeconomic data. A key issue is that the monthly indicators on domestic demand--retail sales and FAI--are not always consistent with trends derived from combining the GDP data with the trade data. 2 As illustrated in Box 1 of the August 2005 Quarterly Update, while FAI data is indicative of investment trends, the internationally-comparable national account-based investment growth has in recent years been significantly lower than FAI growth. FAI deflators are published only semi-annually.  China Quarterly Update--November 2005 4 2004 and the first half of 2005, weakness in domestic demand triggered by the policy tightening had significantly affected imports, in particular steel, chemicals, and machinery and equipment. Recently, import growth recovered from 14 percent (yoy) in the first half to 24 percent in August-September. Steel imports--traditionally a good indicator for construction activity--also rebounded in September. These trade developments could mean that the surge in the trade surplus since 2004 has in part been cyclical (Box 1), but given the large gap between exports and imports it will take a sustained period of faster import growth relative to export growth to make a dent in the external surplus. Consumer price inflation has slowed to 0.9 percent (yoy) in September, largely due to lower food prices. Core consumer price inflation remains low. PPI inflation has declined to 4.5 percent (yoy) in September, led by declining raw material price rises (Figure 6). Box 1. The surge in the trade balance: exchange-rate based, structural, or cyclical? There are three factors behind the increase in China's trade balance in recent years. First, the depreciation of the real effective exchange rate since 2001, due largely to a weaker US$, to which the RMB was pegged (Figure 1). Second, a structural element: China's WTO entry has made the country more attractive to FDI, and at the same time, its more developed economy may be capable of sourcing a higher share of exports domestically. In addition, structural factors in China's economy may discourage consumption. To the extent that the surge is structural, it will continue and continue to complicate external relations and monetary policy. Third, a cyclical element. The decline in domestic demand that followed the tightening measures of 2004 decreased imports and stimulated companies to export goods for which domestic demand had fallen. Economists who emphasize the cyclical factor point to a precedent in 1997-98 when China's large current account surpluses coincided with very low growth of domestic demand after the previous boom (Figure 2).1/ This view is supported by the observed rapid reduction in the contribution of (net) external trade to GDP growth in the third quarter of 2005 (see main text). Figure 1. Exchange rate and current Figure 2. The domestic cycle account 14 14 105 14 GDP (percent 12 12 change) Domestic demand 100 12 10 10 (percent change) 10 8 95 Real effective exchange rate (CPI-based) (LHS) 8 8 6 90 Current account 6 4 6 85 (percent of GDP) (RHS) Output gap */ 2 4 4 (percent of 0 80 ) 2 2 -2 75 0 0 -4 1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004 Sources: NBS, IMF IFS, and staff estimates Sources: NBS, and staff estimates. */ Estimated using expenditure 1/ The dip in domestic demand in 2000, apparently caused by an inventories correction, may have been too short to drive a large external trade response.  China Quarterly Update--November 2005 5 Figure 1. Domestic demand drives growth again Figure. 2. Fixed asset investment rebounding 60 Contribution to GDP fromdomestic Growth growth (percent of total) demand (percent FAI, fromnet external trade yoy, monthly 100 3mma) (nominal) 40 80 60 20 40 20 0 0 2004 2005H1 2005Q3 2005Q4 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 (projected) Sources: NBS, and staff estimates. Source: NBS, staff calculation. Figure 3. Investment funding eased to robust pace Figure 4. Consumption still trails investment 40 Growth Industrial Profits (3mma) (LHS) 180 (percent 35 Urban per capita living (Growth yoy) Credit (RHS) expenditure, 3mma 140 30 20 (percent Real retail sales, 3mma 1/ yoy) 25 100 15 20 60 15 10 10 20 5 5 -20 0 0 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 2000 2001 2002 2003 2004 2005 Source: Customs, staff calculation. Source: Customs, staff calculation. Figure 5. Net trade's contribution is coming down Figure 6. Inflation pressures have declined 90 15 (Growth Growth (percent y-o-y) 80 (percent Imports PPI 70 yoy) 10 Price raw materials Exports 60 CPI 5 50 40 0 30 20 -5 10 -10 0 Mar-99 Mar-01 Mar-03 Mar-05 -102003 2004 2005 Source:NBS, CEIC. Source: NBS, CEIC, and staff estimates.  China Quarterly Update--November 2005 6 Box 2. The Household Survey: a better measure of consumption trends? Retail sales are widely used as the key recent indicator for household consumption trends but they are not a very good proxy for household consumption (see August Quarterly, Box 1). The surveys on household living expenditure may provide a better one. The NBS publishes household survey data on household income and expenditure. The 36 cities urban household survey data are published monthly, and the rural household survey data are published quarterly. The national urban household survey data are published only yearly. World Bank estimates suggest that in 2004 total national living expenditure was only 6 percent below household consumption expenditure in the national accounts, compared to an 8.6 percent gap for retail sales.1/ More importantly, growth of total living expenditure has been a better proxy for household consumption growth (Figure 1). In principle, the usefulness of the household survey data is constrained by the fact the rural survey data is only available on a quarterly basis. However, in practice, the consumption measures from the three household expenditure survey series have grown at remarkably similar rates in recent years (Figure 2), which strengthens the case for using the monthly 35 cities survey for monitoring consumption. Figure 1. Growth rate of household consumption Figure 2. Growth Rate of living expenditure per capita 40 % national urban average retail sales of consumer goods 70% 35 cities average 35 living expenditure consumption 60 rural average 30 50 25 40 20 30 15 20 10 10 5 - 0 1992 1995 1998 2001 2004 1992 1995 1998 2001 2004 (10) Data source: CEIC and staff estimation Data source: CEIC The treatment of housing services is the one key difference in data definition between the different surveys (Table). In national accounts it includes both the paid-in rent and the imputed rent of owner-occupied housing, but excludes housing purchases (which are treated as financial transactions). In the urban household survey it only includes the actually-paid rent, with the purchase of a house included in the non-living expenditure and no "imputed" (market) rent. In the rural household survey it includes paid-in rent and purchase of residence, but excludes imputed rent. Table. Treatment of housing service Household consumption Living expenditure: Living expenditure: expenditure: National Urban household Rural household accounts survey survey Paid rent Yes Yes Yes Imputed rent Yes No No Purchase of house No No Yes 1/ Estimated combining the per capita data with population data.  China Quarterly Update--November 2005 7 THE ECONOMIC OUTLOOK REMAINS GOOD The macroeconomic outlook remains favorable, with some export-led slowdown, and limited price pressures. We project GDP growth of 9.3 percent in 2005 and 8.7 percent in 2006, continued low inflation, and a decline in the current account surplus in 2006, after a projected record surplus of over 6 percent of GDP in 2005 (Table 1). The international outlook is favorable, despite the oil price increases. Available indicators (of industrial production) suggest that the global slowdown is bottoming out, and consensus forecasts imply a moderate acceleration of global activity in the latter part of 2005 reaching trend growth of about 3 percent by mid-2006 in real terms. Nonetheless, China's exports should decelerate due to domestic supply-side effects including a leveling off of FDI, some exchange rate appreciation, tax measures taken to discourage energy-intensive exports, as well as a domestic demand recovery. The steep rise in key international commodity prices is projected to come to a halt (Figure 7). On this basis, we project lower increases in China's raw materials purchasing price index, from 8.3 percent (yoy) in the third quarter to less than 5 percent by mid-2006 (Figure 8). Favorable commodity prices could provide a boost to China's resource-intensive economy, reversing the pressure on profit growth from the combination of rapidly rising commodity prices and very low "downstream" price increases.3 Figure 7. Commodity prices expected to Figure 8. China's raw material prices should have peaked (indices, 2000=100) decelerate (yoy growth, in percent) 220 Forecast 16 14 200 Purchasing Price 12 Index: RawMaterials 180 Energy 10 Forecast 160 8 Industrial commodities 6 140 4 120 2 100 Foodand 0 Beverages -2 80 -4 60 -6 Q1-00 Q1-01 Q1-02 Q1-03 Q1-04 Q1-05 Q1-06 Q1-02 Q1-03 Q1-04 Q1-05 Q1-06 Sources: World Bank. Sources: NBS and World Bank estimates. Note: Indices of primary commodities and iron and steel. Calculated using Chinese import weights for 2000. Domestically, key indicators suggest more moderate but still robust investment growth into 2006, with consumption likely to continue to lag investment. Overall credit growth--the key monetary variable for the real economy--has remained 3 Historically, the negative correlation between "upstream" prices (or the gap between upsteam and downsteam prices) and profits/profitability developments is weaker than often assumed, perhaps because both prices and profits are endogenous variables that increase in an upturn.  China Quarterly Update--November 2005 8 Table 1.China: Main Economic Indicators 2002 2003 2004 2005 1/ 2006 1/ The international setting (change in percent) World GDP growth 2.5 3.8 3.1 3.1 Export market growth (high income countries) 4.4 10.4 5.9 7.1 The real economy (change in percent) 2/ Real GDP (production side) 8.3 9.5 9.5 9.3 8.7 Consumption 7.4 6.1 6.4 7.0 7.3 Gross capital formation 13.2 19.1 14.3 13.6 15.5 Fixed capital formation 14.1 19.9 16.8 14.8 13.0 Exports (goods and services) 3/ 29.4 26.8 26.7 23.6 15.5 Imports (goods and services) 3/ 27.5 24.8 25.2 15.5 19.9 Consumer prices (period average) -0.8 1.2 3.9 2.0 2.0 Fiscal accounts (percent of GDP) 4/ Fiscal balance -3.4 -2.8 -1.7 -1.5 -1.0 Total revenue 18.2 18.7 20.5 20.0 20.9 Total expenditure 21.6 21.5 22.0 21.5 21.9 External account (US$ billions) Current account balance 35 46 69 123 105 Capital account balance 32 71 138 72 77 (including errors & ommissions) of which: FDI (net) 47 47 53 50 50 Change in reserves (increase =+) 76 117 206 195 182 Foreign exchange reserves 286 403 610 810 992 Other Broad money growth (M2), e-o-p, in percent 16.8 19.6 14.6 17.9 15.0 Sources: NBS, PBC, Ministry of Finance, and staff estimates. 1/ Projection. 2/ The growth rates of the expenditure components of GDP are estimates and need not match to overall GDP growth rates, due to statistical discrepancies between the data from the expenditure and production sides. 3/ Estimates based on trade deflators published by the Custom Administration. 4/ GFS basis; central and local governments, including all official external borrowing. The data includes repayment of arrears on VAT rebates. In 2004 these were RMB 127.5 bln (0.9 percent of GDP). Treating this as a "below the line" transaction would reduce the deficit--in 2004 by 0.9 percent of GDP. unchanged at 13-14 percent (yoy) since end-2004, and credit to the corporate sector--key for investment--increased at a broadly similar pace, even though M2 growth has picked up (see below).4 Industrial profit growth has come down from 38 percent in 2004, but has been stable at a respectable 20 percent (yoy) since June. Together, these developments suggest an easing of investment over time to a more sustainable but robust pace. 4 Corporate financing via the short-term bonds market that opened in May has--on an annualized basis-- been roughly equivalent to 1 percentage point additional credit growth. Corporate deposits continued to grow broadly in line with credit through September, suggesting that deposits drawdown has not been a financing channel.  China Quarterly Update--November 2005 9 Household consumption will be supported by recent high income growth. In addition, several tax initiatives (see below) should support household after-tax incomes in 2006. However, although rural peoples' non-farm income can continue growing rapidly, it may be difficult to sustain the recent speed of rural income growth because of the one-off nature of the impact of removing agricultural taxes and rural fees and increases in agricultural prices. Private consumption will probably not yet outpace GDP, whereas government consumption will almost certainly not. Policy measures to strengthen social safety nets, pension reform and health insurance could boost consumption, but implementing them will take time. International risks are largely on the downside while domestic risks are upwards, on balance. Key international risks are potential weakness in US activity; impact on global activity from sustained high oil prices; and unexpectedly higher commodity prices, in part because of the impact of a stronger Chinese economy than currently expected on the international markets. Domestic risks are largely centered on corporate behavior. The risk that a profit squeeze would trigger a pronounced slowdown in investment and a wider economic slowdown seems small, given the stable macroeconomic environment, underlying growth potential, and favorable financial conditions. A perhaps larger risk is that investment would not be reigned in sufficiently in industries facing potential excess supply. A build-up of liquidity in the banking system amplifies this risk (see below). With enterprises sometimes more market share-oriented than profit-oriented, there is a risk of further pressure on prices, corporate sector balance sheet problems, and a new round of non-performing loans. A welcome upside risk is stronger-than-expected household consumption, while avian influenza represents a downward risk. ECONOMIC POLICIES The 5th plenary session of the 16th Central Committee of the CPC held in October confirmed that the communist party continues to be of the view that "economic development is the top priority", but wants development to be "comprehensive, harmonious, and sustainable".5 This implies "stable and relatively fast economic growth", and the need to "step up the transformation of the economic growth pattern" towards growth that is less energy, resource and capital intensive, more knowledge and innovation-driven, and more equally shared among the population.6 What does this mean for macroeconomic and structural policies? MACROECONOMIC POLICIES: HOW TO KEEP GROWTH RAPID AND STABLE? Domestic demand and its composition are at the core of several policy debates. The recent rise in the external surplus--the balance between saving and investment--that is complicating international relations and monetary policy is due to high national saving, 5Communiqu