ASEM trust fund country strategy notes 2002

34087 ASEM Trust Fund Review Meeting Washington D.C., April 19, 2002 Country Strategy Notes China: ASEM Country Strategy Note April 2002 1. To date China has benefited from $ 8.3 million in ASEM Trust Fund (TF) resources for 12 country-focused technical assistance projects. It has also been included in several multi-country studies. These activities are helping China deal with some of its most pressing challenges, which, if not adequately addressed, have the potential to cause a far more severe crisis than that experienced in East Asia some years ago. ASEM TF grant resources have funded international experts in areas of vital concern to China, which is now restructuring bankrupt state-owned enterprises (SOEs), establishing a legal, policy and institutional environment conducive to private sector development, reforming what has been a technically bankrupt financial sector, developing a national social security system to facilitate labor mobility and allow SOEs to shed burdensome social responsibilities, and protecting the poor and vulnerable from the effects of economic restructuring. China's size and the scale of these problems means that no one donor is able to respond adequately to its needs. The country's development partners are therefore collaborating on key issues, as dictated by their comparative advantages. The partnership of ASEM is a fine example of how the such collaboration can work, and work successfully. Recent Developments Relating to ASEM TF 2. Growth in 2001. China's economic performance in 2001 remained strong, with growth officially estimated at 7.3 percent. This reflects the fact that domestic demand rather than the international economy--which fell into recession during the year--is the main driver of the country's aggregate economic performance. The Government's ongoing fiscal stimulus program aided domestic consumption and investment growth, although the effects of foreign capital flows on investment were also significant. Indeed, foreign direct investment in China reached $45 billion last year, making China the largest recipient of FDI inflows in East Asia.  3. Progress but an unfinished agenda on banking and corporate sector reform. A slowdown in China's economy towards the end of the year brought into sharp relief a number of structural and policy issues. Investment demand in the latter part of 2001 was slowed by a credit crunch, as banking system reforms resulted in bank efforts to strengthen their portfolios and make higher provisions for losses. This is desirable in a transition economy, and significant strides are being made in banking reform. The main targets of reforms are strengthening supervisory and regulatory functions of the People's Bank of China's (PBOC, the Central Bank), commercializing the four major state banks, and bringing the banks' management, credit and accounting systems closer to international standards. Action taken by the PBOC have included establishing a special asset management company within each state bank to handle non-performing loans; merging their provincial branches and provincial capital city branches; and division of the financial businesses provided by banks, insurance, brokerage, and credit cooperatives. Many state-owned banks are preparing to list on local and overseas stock exchanges. However, China must still take many steps to prepare its financial intermediaries to operate in the more competitive environment created by China's recent accession to WTO on December 11, 2001. 4. Although great effort is being put into reshaping the industrial sector, its losses expanded during the year. While all industrial enterprises reported a growth of 8.1 percent in profit for the 2001, this was lower than in 2000. Key state enterprises have been particularly affected, and in the first two months of 2002 their profits fell by over 37 percent (y/y). In addition to changes in accounting methodology, the decline in oil prices and a fall in output account for the shrinking SOE profits. The government is therefore showing greater support for private sector development, and in March 2002 the State Development Planning Commission issued a document entitled, "Some Opinions on Promoting and Guiding Private Investment." This spelled out policies encouraging private investment in all areas open to foreign investors, ending discrimination by state banks against private investors, and allowing some tax holidays for private firms in their start-up stage. Since the private sector is the fastest growing part of the economy but has been constrained by limited access to financing and an unsupportive business environment, this policy paper is considered important for private sector growth. 5. Increasing income inequality and social instability. China's rapid economic growth has not prevented rural-urban inequalities and inter-provincial income gaps as the coastal provinces grow at a much faster rate than inland areas, especially the west. Between 1998 and 1999, the growth rate (3.8%) of rural per capita net income in all regions was barely a third of that between 1995 and 1996 (13.2%). And some of the poorest provinces had little rural income growth or even declining incomes. Poverty reduction during that period slowed and inter-provincial income gaps widened. Recent data suggest that rural poverty may have fallen over the past two years, and especially in 2001, as improvements in the rural terms of trade and higher rural incomes were accompanied by stronger growth in rural consumption. Nevertheless, this does not mean an end to rural distress, which is widespread, nor does it mean that rural-urban inequality is narrowing. If anything, the gap has widened, as urban income growth has outstripped that of the rural areas and, with the exception of last year, urban consumption growth has 2  also been more rapid. Thus, more than 200 million rural people in China still live on less than $1 per day. Urban areas, though generally much better off, are nevertheless seeing a rise in poverty due to slowing economic growth and economic restructuring. The Government, with support from its development partners, is identifying ways of accelerating pro-poor growth and human capital development in the lagging western region, where most of the poorest Chinese live. 6. The increased unemployment that has accompanied enterprise restructuring and provoked social tension has spurred government efforts to develop a financially sustainable national social protection system to provide services formerly delivered by enterprises. July 2001 saw the launch of the Liaoning Social Security Pilot Program, which is testing an approach for transferring management responsibility for social insurance from enterprises to municipalities and provinces. After a pilot period, the approach developed will be expanded to other provinces. Impacts of and Lessons from ASEM TF I 7. The ASEM Trust Fund for China is assisting the country to deal with the vulnerabilities described above. The six TA grants made available under ASEM TFI for market-oriented corporate and financial sector reform totaled US$5.1 million and focused on bad debt resolution for banks (US$1.4 million), development of deposit insurance for banks (US$0.4 million), strengthening smaller banks (US$1.5 million), debt restructuring and loan workouts of state enterprises (US$0.6 million), building government capacity in debt management (US$0.7 million), and addressing critical social aspects of corporate restructuring (US$0.5 million). These activities brought in external expertise and technical support to assist policy makers in some of the key issues facing them. 8. During implementation of these grant-funded activities, several lessons were learned which has benefited the design of subsequent projects.