China quarterly update, February 2006

37737 World Bank Office, Beijing Quarterly Update February 2006 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--February 2006 2 OVERVIEW China's GDP growth hardly slowed in 2005, with domestic demand firmly taking the lead over net trade in the second half. GDP Growth was 9.9 percent in 2005, 0.2 percentage point lower than in 2004. Investment was supported by still-robust profit developments and a relaxed monetary policy. Consumption, although still lagging GDP growth, was supported by strong income growth, especially in urban areas, and increasing consumer credit. While China's trade surplus of over $100 billion for the year grabbed the headlines, the contribution of net trade to growth had already turned negative by the end of last year. Although the build-up of foreign reserves was billion very large in 2005, lower non-FDI capital inflows in the second half of the year suggest that the new exchange rate regime should over time add to domestic stability. The outlook for China's economy remains benign. China will benefit from solid export demand, while profit and credit developments suggest that investment remains robust. Consumption may not accelerate much in 2006, though, held back by subdued rural income prospects. Price pressures should remain limited with more moderate commodity price developments and strong increases in potential GDP. Internationally, risks include a disorderly adjustment in global imbalances and trade tensions, even though China's trade surpluses are likely to come down. The main domestic risk is that abundant liquidity will re-fuel credit and investment. For macroeconomic policy, this implies that the "prudent" stance announced last year is appropriate for this year as well. Monetary policy could in the short run focus on absorbing some of the excess liquidity to reduce the risk of excessive credit growth. This task may be complicated somewhat by active financial innovation, whose impact should be closely watched. The overall fiscal stance needs little change for now, but a shift towards social spending is needed to redress China's macroeconomic and structural imbalances. Over time, with a rebalanced economy that relies more on services and consumption, tax revenues may come under pressure. That should be countered by reforms in the tax structure and administration, and medium-term expenditure restraint. The GDP revisions moderate, but do not substantially change, the perspective on China's main structural challenges. China still shows a heavy reliance on industry and investment and a lower than normal share of services in GDP. Interestingly, 2/3rd of the GDP revision came from higher price increases, which implies that China's real exchange rate has appreciated by 10 percent more than previously thought. The Party's guidance for the 11th Five Year Plan signals a change to more balanced growth, with more attention to the environment and income distribution. While local leaders' announcements fall in line with these national goals, local growth targets remain high. To achieve these high growth rates, local spending is likely to continue to be directed at investment rather than at the social services needed for a harmonious society and a more balanced economy. The targeted reduction in energy intensity of the economy by 20 percent over the next five years is very ambitious, and the announced industrial policy, instead of pricing policies, to realize the target raises some concerns.  China Quarterly Update--February 2006 3 RECENT ECONOMIC DEVELOPMENTS Growth held up well in 2005, supported by rebounding domestic demand in the second half. As the effects of policy tightening measures of 2004 and early 2005 faded, investment and consumption increased pace just as export growth started to ease. Although China's 2005 trade surplus grabbed the headlines, the contribution of external trade to GDP growth declined throughout 2005, to about zero in December. On the basis of newly revised GDP data, GDP grew 9.9 percent in the last quarter of 2005 and for the year as a whole, compared to 10.1 percent in 2004. According to the old data, GDP rose an estimated 9.4 percent in 2005 (Figure 1). Investment has remained strong. Reflecting the fading impact of the tightening measures and still favorable financing conditions, nominal fixed asset investment (FAI) growth edged up throughout 2005, despite a slowdown in FAI in real estate (Figures 2 and 3). As a result, year-average nominal FAI growth was at 25.7 percent not much lower than in 2004.1 Within industry, FAI was strong in all sectors except communication, computers and other electronics, where it may have been weaker because foreign direct investment leveled off in 2005. Investment in inventories appears to have recovered through 2005, after the apparent draw down of inventories in response to the policy tightening. The continued strength of investment has raised concern among policymakers, notably because of the potential for future over-capacity in some sectors, and the consequences this may have for prices and profits. While it is true that prices in some consumer goods sectors are under pressure, reported excess capacity may not always be cause for concern. For instance, average capacity utilization in US industry typically varies between 74 and 85 percent over the economic cycle. Consumer spending has grown solidly but continues to lag investment. Household consumption is buoyed by solid income growth and consumer credit. Nominal retail sales have been growing steadily at 13-14 percent (yoy) since May 2004, with declining inflation allowing real retail sales growth to rise from 10.2 percent in 2004 to 12 percent in 2005 (Figure 4). Growth in real per capita living expenditure of urban households rose through 2005 and averaged over 8 percent in January-November 2005, compared to about 7 percent in 2004. Households added 11.8 percent of GDP to their savings deposits in 2005, more than in 2004, although less than in 2003. Lower household residential investment explains at least as much of the higher addition in 2005 as higher household saving does.2 External trade developments confirm that domestic demand is taking over growth momentum from exports. Exports seem on track to a more moderate pace, after a 3 year bout of over 30 percent growth (in US$). Merchandise exports growth slowed to 25 1 The internationally-comparable national accounts-based investment growth has in recent years been significantly lower than FAI growth. In contrast to the annual FAI data, the monthly FAI data (used in Figure 2) include only urban investment above a certain scale (RMB 50,000 for real estate and private FAI, RMB 500,000 for other FAI). 2 According to the 36 cities urban household survey, household expenditure not spent on "living expenditure", which should largely be residential investment, did not increase (yoy) in January-November 2005, despite robust income growth.  China Quarterly Update--February 2006 4 percent in the fourth quarter of 2005 (in US$) from 35 percent in the first quarter (Figure 5). At the same time, reflecting stronger domestic demand, merchandise import growth rose from 12 percent in the first quarter (yoy) to 22 percent in the fourth. With imports outpacing exports in December, the contribution of net trade to (yoy) growth became negative in that month (in nominal terms) just as the international headlines reported a record trade surplus of US$102 billion in 2005. Foreign reserves surged in 2005, although capital flows moderated. Despite a 2.6 percent exchange rate strengthening in 2005 to 8.07 yuan/dollar, and strong competition from other Asian countries, inward FDI was US$ 60 billion in 2005, only slightly lower than in 2004. Outward FDI--largely through acquisition of foreign enterprises, especially in natural resource industries--increased in 2005 to US$6 billion, bringing the stock of outward FDI to over US$50 billion, almost 10 percent of the stock of inward FDI. Although inward non-FDI flows eased considerably in 2005, the large trade surplus and steady FDI inflows made China's foreign reserves increase US$209 billion in 2005 to US$819 billion. Despite abundant liquidity, consumer price inflation remained low. Swelled by the foreign reserves purchases, which were only partly sterilized, M2 grew by 17.8 percent (yoy) by end-2005, 3 percentage points more than targeted at the start of the year. However, credit growth has been less fast (see the November 2005 Quarterly Update), and consumer price inflation has been falling through 2005 to 1.6 percent (yoy) in December because of falling food prices and decelerating raw material prices (Figure 6). Measured by the broader measure of the GDP deflator, inflation was 3.8 percent in 2005. So far there is little to suggest that the higher growth in liquidity will spill over in substantial inflation, although it may unduly fuel investment. The National Bureau of Statistics (NBS) released revised national accounts data in January. The special focus section (at the back of this Update) discusses the GDP revision and its implications. The section finds that, compared with the old data, the new data provide better information on the economy, show several changes in the structure, and indicate significantly faster price increases during 1993-2004. Nonetheless, the section also finds that the new data do not fundamentally alter the picture of China's economy, its growth pattern, and issues of concern for policy makers. ECONOMIC PROSPECTS AND POLICIES The Proposal for the 11th Five Year Plan (2006-2010) states policymakers' key objectives. It stresses that "economic development is the top priority", but development should be "comprehensive, harmonious, and sustainable". 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.3 3Communiqu