China Quarterly Update, February 2005

34457 World Bank Office, Beijing China Quarterly Update February 2005 The World Bank quarterly update intends to provide an update on recent economic and social developments in China, and present findings from ongoing World Bank work on China. The update is produced by a team from the Beijing Office. Questions and feedback can be addressed to Li Li (lli2@worldbank.org) 1  China Quarterly Update--February 2005 Overview: macro risks easing, more emphasis on reforms Despite the unexpectedly high growth in the last quarter of 2004, the risk of China's economy overheating has declined, as domestic demand growth and consumer price inflation have come down in the wake of measures taken to cool the economy. However, the domestic slowdown was more than compensated by buoyant export growth and moderating import growth. As a result of the strong trade balance, the buildup of international reserves accelerated through 2004, even as capital inflows eased in the second half of the year. Public finances benefited from the strong growth of activity and imports, and government used the higher than budgeted revenues to repay arrears on VAT refunds and beef up the social security fund. Many local governments forged ahead with further support for farmers by abolishing the agricultural tax. The macroeconomic outlook for 2005 remains favorable, with a supportive external environment, prospects of robust domestic demand growth, and waning underlying inflation pressures. In these circumstances, policymakers are rightly putting emphasis on institutional and structural reforms. The December Central Economic Work Conference formulated directions on macroeconomic management, public finances, and institutional and structural reforms. The announced switch from a "proactive" to a "prudent" monetary policy stance likely reflects the authorities'willingness to increase interest rates if warranted. Announced further interest rate reforms could improve rural finance and resource allocation. The fiscal deficit target for 2005 remains largely unchanged from last year's outcome, whereas the announced increase in government spending on public goods and services, especially in poor rural regions, could improve equity and increase consumption. Several worthy tax reforms are under consideration, including unification of enterprise income tax regimes and a fuel tax. To reduce the tendency of over- investment and improve the use of land, urban finance, the intergovernmental fiscal system, and the performance monitoring system for local governments are in need of reform. Recent Economic Developments-- domestic demand easing China's economy finished the year 2004 on a strong note, with a gain of Figure 1: Growth in domestic demand easing 9.5 percent in GDP against 9.3 10 percent in 2003. This unexpectedly 9.5 high outturn was driven by strong 9 export performance in the second 8.5 half of the year, whereas domestic 8 7.5 demand has been easing in 2004, led 7 by a slowdown in investment. 6.5 Growth in domestic demand declined 6 from almost 11 percent in the first 5.5 half of the year to a more sustainable 5 2001 2002 2003 2004H1 2004H2 8.5 percent in the second half (Figure Source: NBS, Staff Estimates 1). Investment growth has 2  A Snapshot of China's Economy Figure 2. Investment growth is moderating. Figure 3. Retail sales growth has picked up. % y-o-y, 20 50 Real Fixed Asset Investment Retail sales, real deflated by PPI 40 15 Personal disposable income, real 1/ 30 10 y-y) 20 (%, 5 10 12m 0 ma 0 3mm 2002 2003 2004 1999 2000 2001 2002 2003 2004 -5 -10 Source: NBS, and staff estimates Source: NBS & staff 1/ Deflated by CPI. calculation Figure 4. Money growth has subsided. Figure 5. Trade has continued expanding rapidly, % y-o-y imports have slowed down. 24 Monetary Grow th 3MMA, Y-o-Y 60% 22 20 50% 18 40% 16 30% 14 20% 12 10% 10 Export Import 2001 2002 2003 2004 0% Money & Quasi-Money (M2) 2001 2002 2003 2004 Money(M1) Source: PBC Source: Customs & staff calculation Figure 6. Goods price inflation has trended down. Figure 7. Real estate prices have risen sharply. 10% y-o-y % y-o-y 14 12 8 PPI 10 6 8 6 4 4 CPI 2 2 RPI 0 0 Non-food -21999 2000 2001 2002 2003 2004 CPI 2003-1 2003-7 2004-1 2004-7 -4 -2 -6 house house rent land rent Source: NBS & staff estimate Source: NBS 3  come down from a breakneck pace of over 40 percent year-on-year (yoy) in real terms in the first quarter of 2004 to an estimated 13 percent in the fourth quarter (Figure 2). Thus, overall it seems that the authorities'monetary policy and administrative measures to slow the economy taken over the course of last year are starting to show results. A pick up in growth of private consumption, buoyed by solid household income growth, has partly offset the investment slowdown (Figure 3). Rural household incomes have risen particularly robustly, supported by higher agricultural output, a hefty grain price increase, and a reduction in net agricultural taxes. Real retail sales grew 10.2 percent in 2004, compared to 9.4 percent in 2003.1 Inflation as measured by the CPI has come down in the second half of 2004. After peaking at 5.3 percent in July, consumer price inflation declined gradually to 2.4 percent by December (Figure 6), largely due to a decline in food price increases. Since September, "upstream"prices like the PPI and prices of raw materials and imports have also decelerated. A note of caution is that not all demand and price pressures show up in CPI inflation. High real estate price increases (Figure 7) are not fully reflected in the CPI index, as the share of residential services in the CPI basket is likely to be too low. In addition, prices of several goods and services administered by the government including public transport, rents, utilities, electricity and coal have lagged cost increases. Other indicators are consistent with slowing domestic demand growth. M2 growth (yoy) has declined in 2004, to end the year at 14.6 percent, compared to 19.6 percent in 2003 (Figure 4), with bank loan growth following a similar trend decline. Real industrial value added growth (yoy), which peaked at 19.4 percent in March 2004, has since declined to 14.4 percent by the end of the year, whereas energy consumption growth also eased throughout 2004. Reflecting the slowdown in domestic demand, the growth of imports measured in dollars also declined through 2004 from 42.4 percent in the first quarter to 30.3 in the fourth (yoy). Exports have outpaced imports. Continued export strength2 reflects more production capacity coming on stream, robust external demand, and China's rising price competitiveness due to the depreciating US$ (Figure 5). But higher exports in the second half of 2004 also reflect the slowdown in domestic demand, especially investment: exports of steel and cement were particularly strong-- products less in demand at home because of slowing investment. The trade surplus totaled US$32 billion for 2004 as a whole, after showing a deficit in the first four months of the year. The contribution of trade to GDP growth will likely turn out to be even higher than the nominal numbers suggest, as import prices rose a hefty 10 percent in 2004, compared to only 5 percent for exports. Economic growth has become more balanced over 2004. In the recent decade or so, growth had relied heavily on a rapid expansion of industry (which, in 2003, contributed about 73 percent to GDP growth) and, on the demand side, on investment (which reached 1Retail sales are only a rough indicator for total consumption, which further includes consumption on services, goods in kind, and imputed consumption on durables and housing. 2The surge in China's exports is confirmed by import data released by destination countries. 4  42 percent of GDP in 2003).3 While beneficial in many respects, this pattern of growth has been intensive in capital, and has been associated with limited urban employment growth, a limited role for private consumption, and high resource and energy intensity in the economy. While a significant rebalancing of the pattern of growth and the associated policies is still "in the works", during 2004 the contribution of agriculture and services to overall growth increased-- value added in these sectors rose 6.3 percent (against 2.5 percent in 2003) and 8.3 percent (7.3 percent) respectively. Industrial growth slipped by 1.6 percentage point to 11.1 percent. This pattern of growth seems to be better for employment: 9.8 million urban jobs were created in 2004, taking down registered unemployment 0.1 percentage points to 4.1 percent, the first decline since 1995. The balance of payment surplus and concomitant reserve buildup accelerated through 2004, even as capital inflows diminished. Net capital inflows (including "errors and omissions") reached US$60 bn., or 8.4 percent of GDP, in the first half of 2004. These flows consisted of US$ 30 bn. in FDI, US$ 19 bn. in borrowing, US$5.6 bn. in banks' reallocation of foreign exchange assets, and US$ 5.5 bn. from overseas IPOs. Figure 8. Capital flow volatility has increased Foreign exchange reserve reached 12 Asian crisis US$610 billion by end-2004, having increased by a full US$95 billion in the 10 fourth quarter, apparently driven by the 8 rising trade surplus rather than capital overheating flows. Capital inflows, while they 6 remained strong in 2004, are estimated 4 to have declined through the year, from US$49 billion in the first quarter of 2004 2 to 26 billion in the fourth.4 At the same time, the volatility of the flows has been - increasing in 2004 (Figure8), which 1982 1985 1988 1991 1994 1997 2000 2003 complicates the authorities' efforts to sterilize the reserve built-up-- even Source: staff estimate. Note: The volatility index shown is a volatility-weighted though the overall volume of average of all capital flows. This index is calculated as sterilization remains manageable for VIt=? (