China - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 16321-CiA MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE PEOPLE'S REPUBLIC OF CHINA February 25, 1997 Country Operations Division China and Mongolia Department East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  DATE OF LAST CAS (March 5, 1996 - CAS Progress Report) CURRENCY EQUIVALENTS (as of November 1996) Currency = Renminbi Currency Unit = Yuan (Y) $1L00 Y 8.3 Y 1.00 $0.120 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADP - Agricultural Development Project CAS - Country Assistance Strategy CPPR - Country Portfolio Performance Reviews EDI - Economic Development Institute FDI - Foreign Direct Investment FIAS - Foreign Investment Advisory Service GDP - Gross Domestic Product NFYP - Ninth Five-Year Plan OECF - Overseas Economic Cooperation Fund (Japan) PBC - People's Bank of China SOE - State-Owned Enterprises TA - Technical Assistance TVE - Township and Village Enterprises WTO - World Trade Organization FISCAL YEAR January 1 - December 31 Vice President : Jean-Michel Severino, EAP Director : Nicholas C Hope, EA2 Division Chief Klaus Rohland, EA2CO Staff Member Tom C. Tsui, EA2CO  FOR OFFICIAL USE ONLY China Country Assistance Strategy Table of Contents Introduction ....................................................... 1 1. The Economy ... 2. Key Challenges and the Government's Strategy . . . 6 3. The Bank Group's Objectives and Strategy. . . 9 4. The Bank Group and China . . .16 A. IBRD and IDA's Proposed Lending and Nonlending Services .16 B. Effective Partnership: The China Portfolio .19 C. Creditworthiness .19 D. Evaluation of Risks .20 E. Exposure Management ............ .......................... 23 F. IFC and MIGA . ............................................ 23 5. Cooperation with Other Institutions .................................. 24 6. Issues for Board Consideration .......... ............................ 25 Attachment 1. China Country Assistance Strategy: Diagnostic Matrix China Country Assistance Strategy: Country Program Matrix Annexes 1. Selected Indicators of Bank Portfolio Performance and Management Bank Group Fact Sheet (FY1994-2000) IBRD/IDA Lending Program (FY1994-2000) 2. IFC and MIGA Programs (FY94-97) 3. Strategic Objectives and Lending Program Policy Objectives and Nonlending Services Program 4. Poverty and Social Development Indicators 5. Key Economic Indicators 6. Key Exposure Indicators 7. Status of Bank Group Operations in China This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. l   MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY FOR THE PEOPLE'S REPUBLIC OF CHINA Introduction 1. China has sustained an impressive growth performance since 1978. However, its economic transformation is still on-going as China continues to "cross the river by feeling the stones." The Government needs to maintain the momentum of structural reforms to attain its objective of sustained rapid growth with stability. The recently approved Ninth Five Year Plan and Fifteen Year Perspective Plan call for actions in five key areas. First, reforms in banking, state enterprises, and public finance will be necessary to improve the efficiency of resource allocation and enhance macroeconomic stability. Second, infrastructural investments, especially in the interior regions will support more balanced development and improve the quality of life. Third, programs to alleviate poverty and improve access to education, to expand the coverage of affordable health insurance, and to build a sustainable social security system will keep risks and uncertainties in employment and in incomes on a manageable level. Fourth, sustained and stable growth in agriculture will raise rural incomes, reduce poverty, and ensure food security. And fifth, measures will need to balance rapid economic growth, natural resource use, urbanization, and industrialization with a safe and healthy environment for present and future generations. 2. The Bank Group's strategy supports these objectives and proposes interventions in a wide range of sectors and provinces to foster economic and social development through approximately 15 projects with a volume of about US$2.5 - $3.0 billion annually and an extensive program of nonlending services. The IFC plans to build on last fiscal year's record gross investment approvals in China, albeit at a somewhat slower pace, and seek opportunities through all the regions- especially the interior. Subject to a speeding up of the procedure for obtaining host government approvals from the Chinese authorities, MIGA expects some further increase in issuing new contracts over FY96. 1. THE ECONOMY A. Recent Economic Developments 3. Government policies in 1995 and 1996 lowered inflation and edged GDP growth down to a more sustainable level. The key measures included administrative restrictions on investment, careful management of central bank credit, increases in administered interest rates, and price controls and subsidies for some essential commodities. Excellent harvests relieved upward pressure on food prices and bolstered growth of output and incomes in rural areas.' 1. The Chinese Economy: Fighting Inflation, Deepening Reforms, World Bank Report No. 1 5299-CHA, May 1996.  - 2 - 4. Economic indicators for 1996 support the conclusion that the government has cooled the economy without damaging the momentum of growth. However, almost three years of comparatively tight monetary, fiscal and investment policies have further unmasked the structural problems facing the Chinese economy. Problems of state-owned enterprises (SOEs) and the banking sector loom large, and open urban unemployment is unprecedented. 5. Decelerating Growth And Inflation. From its peak of 25.2 percent in October 1994, inflation (retail price index) has come down steadily to five percent in September 1996. The economy cooled without sacrificing growth, a unique accomplishment since the start of reforms. In the first three quarters of 1996, GDP grew at an annual rate of 9.6 percent, down from 10.5 percent in 1995.2 This slowdown reflects continued reduction in investment growth (from 15 percent in 1995 to about 12 percent in the first three quarters of 1996), buoyant consumption and a negative contribution of net external demand, despite the rebound in exports from the second quarter of 1996. GDP growth edged lower in 1996 as ... while retail sales remained strong. and exports rebounded. real investment continued to decline... ReWl QM of GDP nd Fbed -h~ I(% Nimy PA s t-W Wh OA (bI bi990 yI-. -soJy * -1 d US &Jls) 236 50 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~64 - T~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 24,k 1' le11991 1 99 1993 , 994 , 903 1909 7*s*44 i2 - 6. There are some signs that aggregate domestic demand may be slowing further. The deceleration in the growth of industrial output and retail sales in the third quarter suggests that the government is on track in its objective of reducing inflation to below 10 percent and maintaining growth at around 8 to 9 percent. Inflation continued to fall ... ... despite growing foreign exchange ... reflecting tight Central Bank reserves ... credit. Influi-, Juu - ~ 71991ptber 19it [ w^sln*de;^oll>~~~~~~~~~~~~~~~~~~~~~~N 1S> |0,2 i - o1,- 1-1-J.; I--- 2. The newly-published China Statistical Yearbook includes revised estimates of GDP growth for the past two years. Earlier estimates placed GDP growth at 10.2 percent in 1995.  - 3 - 7. Mounting SOE Problems. The performance of state enterprises deteriorated further in 1996. The recent slowdown in demand and policies of the past three years-in particular, lower fiscal subsidies and relatively tight credit reflecting both PBC's policy stance and the banking system's increasingly commercial focus-contributed to the difficulties of the state sector. Above all, the poor performance of industrial SOEs stems from structural deficiencies. Industrial SOEs are increasingly unable to face growing domestic and foreign competition, resulting in reduced overall profits. 8. Industrial SOEs, as a whole, remained profitable in 1996, but their profits at end-September were only one-fourth of their level a year ago, with the ratio of net profits to sales plunging to a historical low of less than I percent.3 Almost one-half of industrial SOEs are now making losses, amounting to Y 65 billion (or 1.3 percent of GDP) in the first nine months of 1996, up 20 percent from the year before. Inter-enterprise arrears and wage and tax arrears also continued to accumulate. Slower growth and restructuring efforts by firms have generated increasing numbers of workers, who are either laid-off or receive partial pay, leading to higher levels of open unemployment in China's cities than ever before. Official unemployment figures remain low, at 2.9 percent for all of urban China, but there is widespread recognition that these figures fail to capture fully the actual unemployment levels in the major urban areas. 9. Emerging Trade Surplus, Record Reserves. Following exceptionally fast export growth in 1995 (above 20 percent in nominal US dollars), exports in the first nine months of 1996 were actually lower than their corresponding level a year ago (by three percent). Exports have started to rebound, however, and growth in the third quarter of 1996 was 7.8 percent over the same period last year. Imports grew at 6 percent (in nominal US dollars) during the first nine months, substantially below growth rates registered in the last two years, reflecting the slower pace of economic growth. The result was a turnaround in the trade balance from a deficit of $1.2 billion at end-March to a surplus of $8 billion by September 1996. 10. Trends in external trade have been influenced by changes in the trade regime. The lower value added tax (VAT) rebate rate for exports, applied since the beginning of 1996 probably slowed export growth. Large Treasury arrears or, VAT rebates appear to have created liquidity problems for some export enterprises. The government's efforts to accelerate the payment of overdue VAT rebates and the processing of rebate requests are likely, therefore, to have contributed to the pick up in exports. 11. Exemptions on tariffs levied on investment goods imported by foreign-invested companies were eliminated on April 1, 1996. This led to the spike in imports early in the year, as firms stepped up their imports before the regime change came into effect. Other tariff reforms, introduced on April 1, reduced the average (unweighted) tariff rate from 35 to 23 percent. Tariffs on 4,900 different commodities and items were cut, covering 75 percent of the products on which China currently levies duties. 12. Institutional bottlenecks in trade are also being eased. In September 1996, the government began to allow foreign firms to become minority shareholders in foreign trade joint ventures established with Chinese partners. Negotiations concerning China's application for WTO membership have acquired 3. Data refer to industrial SOEs with independent accounting systems..  - 4 - renewed momentum; while substantive issues remain, willingness to step up the pace of work on the accession protocol is apparent. Another milestone in China's integration into the world economy was achieved on December 1, with China's acceptance of its obligations of current account convertibility set forth by the IMF's Article VIII. 13. The outlook for China's export performance remains favorable. First, high levels of export- oriented foreign direct investment continue to flow into the country. Second, the steady appreciation of the real effective exchange rate since July 1993 has started to level off this year, reflecting China's reduced inflation rates. Third, prospects for continued productivity gains in the export sector are good. 14. Foreign direct investment (FDI) inflows continued unabated in 1996, as they reached $20.2 billion in the first six months of the year, compared to $16 billion the year before. For the first time, China recorded large factor payments ($10 billion) in 1995, representing proper accounting of the repatriation of profits by foreign-invested companies.4 The FDI inflows contributed to the rapid build-up in foreign exchange reserves, which stood at $95 billion in September, equivalent to nine months of imports. 15. Central Bank credit remains tight. The Central Bank maintained a tight policy stance Components of Money Growth (%) through 1995 and the first half of 1996. Reserve 1993 1994 1995 1996 money growth was kept to 20-23 percent in this 6 mth period, despite rapidly increasing foreign exchange Change in Reserve Money' 35.2 31.1 20.6 23.4 reserves. In June 1996, PBC's domestic assets were Contribution of: net domestic assets 89.6 29.0 37.3 23.7 only 8 percent higher than a year ago, reflecting net foreig assets 10.4 71.0 62.7 76.3 PBC's attempts at partial sterilization of foreign netforeign assets a 31.2 34 .5 29.9 29.7 exchange inflows; between December 1995 and Contribution of: June 1996, PBC's net foreign assets increased by net domestic assets 98.4 70.5 90.3 80.3 Y 174 billion while its net domestic assets decreased net foreign assets 1.6 29.4 9.8 19.8 by Y124 billion. Broad money growth has decelerated somewhat since June 1995, but remains la Change in end-period stock over 12 months high at 30 percent. Domestic credit still accounts for the bulk of the increase in broad money, but the contribution of net foreign assets increased substantially in 1996. 16. Despite relatively sustained, rapid increases in broad money, inflation has been declining steadily in the past eighteen months. The trend decline in the velocity of broad money, observed since the start of reforms, continued through 1996. While this cannot continue forever, it is difficult to predict at what point financial deepening will level off, and lead to fast money growth feeding into higher prices. The Government eased monetary policy slightly in mid-1996, signaling heightened concern over the deteriorating financial performance of SOEs and state banks. Domestic credit expanded in the second quarter of 1996, as loans to enterprises and individuals increased by 26.4 percent in the second quarter compared to 22.8 percent in the first. 17. The Central Bank continued to loosen administrative controls and started to use indirect means of monetary management more actively in 1996. Open market operations were initiated in April; the 4. This also introduced a sizable wedge between the growth of GDP (10.5%) and GNP (9%).  - 5 - coverage of the credit plan was further reduced; short-term money market rates were freed; and administered interest rates were cut (and the margin between deposit and loan rates increased), first in May and then again in August, to yield lending rates that are now positive and deposit rates that are close to zero in real terms. 18. The short-term outlook for the Chinese economy is predicated on the policy stance of the monetary authorities. The Central Bank's policies have reflected the strong political consensus on the need to fight inflation. Despite some indications of a softening in aggregate demand, however, resurgence of inflation remains a risk. The Central Bank's policies are under considerable pressure from mounting international reserves, and lower interest rates are encouraging a shift in the composition of household assets towards securities but also more liquid forms of money. 19. Fiscal Decline Arrested? The past year has seen the end of the steady decline in government revenues (as a percentage of GDP); improvements in tax administration and streamlining of tax exemptions are starting to yield dividends. Total revenues in the first ten months of 1996 grew slightly faster than nominal GDP, despite declines in SOE income tax proceeds and accumulation of substantial arrears on indirect taxes (Y 31 billion at end-June), while budgetary expenditures increased more slowly.5 Therefore, the 1996 budget deficit is likely to fall below its 1995 level of 1.7 percent of GDP.6 Particularly noteworthy are the substantial increases in indirect taxes and customs duties, the latter reflecting the elimination of tariff exemptions. B. Medium-Term Prospects 20. Efficiency gains from economic reforms boosted China's impressive growth performance since 1978. Harvesting these gains will be as important in the future. The projections underpinning the medium-term outlook over the next ten years for the Chinese economy assume that the government will continue to deepen reforms in two strategic areas. The first would further increase exposure of state enterprises and the financial sector to competitive market forces. As enterprises and banks become more responsive to market signals, indirect macroeconomic management will become more effective. This, in turn, will ease the phase-out of administrative controls, further enhancing productivity growth. The second would restore the health of government finances by raising government revenue as a share of GDP and shift expenditure towards health and education, poverty reduction, infrastructure and environmental protection. 21. In the medium term, GDP growth is expected to decelerate to a more sustainable rate of 8.5 percent with inflation maintained in the single digits (see Annex 5). Consumption is projected to increase more rapidly than GDP, reflecting expectations that savings rates will start to decline in the medium term. With growth in imports outpacing export increases, the resource surplus will dwindle by 2005. The anticipated increase in repatriation of profits will in tum generate a current account deficit, projected to reach 1.6 percent of GDP by 2005. This deficit can be financed largely through steady increases in autonomous capital inflows. Following Hong Kong's reintegration in 1997, the level of 5. This is based on the Chinese definition of revenues and expenditures. Presentation based on the IMF GFS (Government Financial Statistics) expenditure definition requires adding interest payments and subsidies; the latter are treated as negative taxes in the Chinese definition. 6. The budget deficit is on a cash basis. Inclusion of the large VAT rebate arrears would increase the deficit, on an accrual basis, by I percent of GDP.  - 6 - reserves is expected to decline and stabilize at around the equivalent of seven months of imports of goods and services. The budget projections assume a gradual elimination of the deficit by the year 2000, through sharp increases in revenues, in line with the government's policy pronouncements. Revenues may reach 20 percent of GDP by 2005, reflecting reforms in tax administration, expansion in the tax base largely through elimination of exemptions, and the integration of extrabudgetary funds into the budget. The projected revenue increases are large enough to accommodate higher expenditures in priority areas. 2. KEY CHALLENGES AND THE GOVERNMENT'S STRATEGY 22. The forces behind continued high growth in China are many: its high savings rate, the relative stability of the economy, the administrative strength of the government, the country's high literacy rate, the industriousness of its labor force, the support of a wealthy Chinese diaspora, and the "advantages" of backwardness (as some areas will gain significantly from the first stages of reform). But the possibility of a virtuous circle of rapid growth, high savings, and relative stability confronts an array of challenges that could slow China's progress. These challenges, and a strategy to meet them, are articulated in the Ninth Five Year Plan and the Fifteen Year Perspective Plan that were approved last year by the National People's Congress. These plans differ from previous ones in that they focus on policies and programs, and place less emphasis on quantifiable targets. The intensive, not extensive, dimension of growth has become more important. The five key areas of concern are: - Ensuring macroeconomic stability and maintaining the momentum of structural reforms. China is in the midst of its transition from a centrally-planned to a market economy. Benefits from the next stages of reform for state-owned enterprises (SOEs), the financial sector, and public finance will be significant. Completion of reforms in these areas will facilitate macroeconomic management, provide efficiency gains and more rapid growth, and encourage the proper allocation of resources and discourage corruption. The Government intends to reform state enterprises gradually, with initial emphasis on strengthening corporate governance in 1,000 large state enterprises and transforming them into modern corporate entities. Local governments will be encouraged to reform enterprises under their control, with small enterprises being sold, merged, leased, or restructured. In the financial sector, the Government will focus on transforming the state banks into genuine commercial banks, intensifying the supervision of financial institutions, establishing a modern payments system, strengthening the regulatory framework for capital markets, establishing a unified and transparent money market, reforming the reserve deposit system, and expanding open market operations. In fiscal policy, the Government's priority will be to broaden the tax base, eliminate tax exemptions, strengthen tax administration, and rationalize extrabudgetary revenues and expenditures. To ensure macroeconomic stability while these reforms are being implemented, the Government intends to keep a tight rein on monetary and fiscal policy and close control of state investments. With regard to trade policy, the Government has stated clearly its intention to continue to open further to the outside world.  - 7 - * Reducing infrastructure bottlenecks. Infrastructure shortages in China have constrained growth and affected the quality of life. Inadequate infrastructure has limited access to the interior provinces, and added to urban congestion and air pollution. The health of the urban population is threatened by unsatisfactory water, sanitation, drainage, and solid waste removal services. The Government will reduce infrastructure bottlenecks by adjusting the investment pattern in favor of water management, energy, transportation, and telecommunications. While power system expansion and reform remain as high priority, the Government also seeks to adjust the balance between energy development and conservation, and to develop alternative energy sources. In transport, the objective is to develop railway transport capacity and an integrated trarnsport system. Infrastructure development is rapidly becoming more complex as the Government endeavors to attract private finance to the sector. * Enhancing human development. China succeeded in reducing the incidence of poverty by some 170 million in 1978-85; but progress since then has been more difficult to achieve. Today, the number of Chinese absolute poor with a per capita income below the national poverty line is estimated to be around 65 million according to official Chinese statistics.7 Maternal health in China is good by developing country standards, but women in poor areas face problems in access to affordable, quality health care. In addition, girls' enrollment rates in basic education in poor and minority areas still lag far behind national norms, and dropout rates of girls in lower secondary levels are too high. Recently, rural-urban migration has increased dramatically due to surplus labor in agriculture and higher growth rates in the coastal areas. Labor markets in urban areas remain rigid because urban employment continues to be dominated by state enterprises. The poor financial performance of state enterprises has contributed to rising unemployment and placed the urban social security system in jeopardy. Steady gains in poverty reduction.... but many poor remain (poverty incidence in percent) (Population living below US$1 per day*) Incidence (%) 60 Dollar per day 50 T poverty line China 30 A . Other East 20 | National As-a 10 poverty line * South Asia 96 mn I _ 515 mn \\ 78 84 8 90 'the Caribbean 78 80 82 84 86 88 90 92 94 110 mn Other Developing 25 mn * Based on the income (expenditure) necessary to buy a * In constant 1985 dollars, using purchasing power minimum standard of nutrition and other basic necessities parity (PPP) exchange rates The Chinese Government's "8-7 National Poverty Reduction Program" is designed to eliminate poverty by 2000. It has been operating since 1993. but it remains underfunded 7. The number of Chinese absolute poor depends on the poverty line used. Using the national definition of poverty results in a range between 65 to 100 million poor, whereas the number jumps to 350 million if international norms of minimum acceptable living standards are used. See Poverty in China: What do the Numbers Say? World Bank background note (June 1996).  - 8 - Box 1: Government Strategy for Promoting Education of Girls In the "Law of the People's Republic of China on the Protection of Rights and Interests of Women," which became effective on April 3, 1992, the Government recognizes the education of girls as a societal responsibility. The Law states that: (a) "schools and departments concerned shall, by implementing the relevant regulations of the state, guarantee that women enjoy equal rights with men in such aspects as starting school, entering a higher school, job assignment upon graduation, conferment of academic degrees and dispatch for study abroad "(Article 15)"; and (b) "the governments, society and schools shall, in the light of the actual difficulties of female school-age children or adolescents in schooling, take effective measures to ensure that female school-age children or adolescents receive compulsory education for the number of years locally prescribed" (Article 17). Several other measures have been taken to create a supportive environment for the promotion of girls' education. Legal protection for the rights and interests of women and girls is enshrined in the Compulsory Education Law and The Law Regarding the Health Care of Mother and Infants. The State Council issued the "Outline for Women's Development in China" before the UN Fourth Conference on Women in Beijing, and further highlighted the importance of girls' education to women's development and social status. Publicity drives have been initiated and the Chinese Government has expressed its determnination to keep girls' dropout rate and lack of attendance to under two percent. Teacher training is being bolstered, especially for female teachers and principals. Social action in the form of financial assistance through the "Hope Project" and the "Spring Bud Plan" illustrate national efforts to help retain girls in school by lowering direct costs of schooling to parents. despite determined government efforts to double expenditures on poverty reduction each year. There will be greater emphasis on coordinated regional development, with increased investment in interior provinces. To achieve the targeted urban unemployment rate of 4 percent, the government intends to create job opportunities for 40 million people in urban areas. Compulsory education will be extended to nine years and greater attention will be focused on vocational and technical skills, as well as on-the-job training. To improve rural health, authorities will give high priority to improving the quality of drinking water, controlling contagious diseases, and preventing occupational diseases. Increasing the overall efficiency of the health care system will be a priority. * Sustaining stable growth in agriculture and ensuring food security. Agriculture and the rural economy have lagged behind other sectors in recent years, and rural incomes have grown much more slowly than urban incomes. China is constrained by its limited cultivable land area8 and insufficient water in the north. Expanded and improved irrigation systems, flood control, and efficient water management will improve crop production significantly. China has progressed in liberalizing its agriculture policy and pricing, but further steps are needed. Institutional reform must also proceed, and allow the non-state sector to play a greater role in marketing and distribution of cotton and grain. In particular, improved cooperation and joint ventures among farmers, breeders, processors, and distributors could improve productivity, quality, and efficiency. The Ninth Five Year Plan places sustained and stable growth in agriculture and the rural economy at the top of its agenda. This is one of its most difficult challenges over the next 15 years. The Plan states four goals: to achieve greater self-sufficiency in grain (with production rising to 490- 500 million tons by the year 2000); to raise farmers' standard of living; to make better use of technology and speed up the development of nearby industries that use agricultural products; and to 8. China accounts for seven percent of the world's arable land, yet feeds 22 percent of the world's population.  - 9 - eliminate poverty. To achieve these objectives, the Government intends to protect agricultural land, upgrade marginal lands, invest in water transfer, storage, and irrigation, further reform land tenure systems, as well as invest in agricultural research and technology, revitalize the fertilizer industry, expedite the commercialization of agriculture, and improve grain distribution. To absorb surplus labor in agriculture, the Government will devote greater budgetary and financial resources to rural and agricultural investments and develop township and village enterprises. * Protecting the environment. Rapid economic growth, urbanization, and industrialization have been bought at the cost of a sharp increase in air and water pollution. Levels of total suspended particulates remain well above those considered safe by the World Health Organization; sulfur dioxide concentrations exceed the lowest acceptable Chinese air quality standard. Few urban rivers meet the national water quality standard; groundwater quality continues to deteriorate at an alarming rate, and petroleum discharges to surface waters are once again increasing. The Ninth Five Year Plan will increase the use of economic incentives and environmental taxes within a clear regulatory framework to pursue environmental objectives. In rural areas, the Government proposes to protect land resources and improve management of soil, water, and forestry resources. All new construction projects will need to abide by environmental protection plans, and environmental education will be expanded to encourage the involvement of the general population in environmental protection. Urban planning and the development of small towns will take environmental concems into account, wastewater treatment will be improved, and noise pollution will be reduced. Industrial pollution is to be controlled throughout the production process. 3. THE BANK GROUP'S OBJECTIVES AND STRATEGY9 23. This Country Assistance Strategy (CAS) has been built on agreement of priorities with the Chinese Government. The Bank Group's strategy and objectives remain essentially unchanged from the 1995 CAS. They have been grouped around the same five major themes (see para. 22) that concern the Government: (a) macroeconomic growth and stability; (b) infrastructure; (c) human development, comprising poverty alleviation, health, education and social protection; (d) agriculture and rural development; and (e) environmental protection. 9. Attachment I sets out the diagnostic matrix and the country program support matrix.  - 10 - Box 2: Progress since the last CAS Since the last CAS was reviewed about twenty-one months ago, the Government has adopted several new reforms: 1. Macroeconomic and Structural Reforms. The fiscal and monetary framework improved, with 1996 growth at 9.7 percent and inflation down to 6.1 percent. Tariff reforms in April 1996 lowered the average rate from 35 to 23 percent. The RMB convertibility on current account was achieved in December 1996. State-owned enterprise reform is proceeding gradually. Increased competition in a context of tightened budget constraints is forcing restructuring; more flexible labor policies have resulted in over one million SOE employees laid off during the first half of 1996; and the government recently adopted a strategy to retain one thousand large SOEs, mostly industrial, to form the "core" of China's modern enterprise system and let the rest go. Emphasis is on mergers and acquisitions for loss- making SOEs; some will be sold or merged with non-state enterprises. China has undertaken several reforms in the financial sector, including: integrating the inter-bank market, freeing interest rates in the money market, and commencing open market operations; re-classifying the four specialized banks as commercial banks, increasing their autonomy in lending decisions, and allowing them to start writing off their bad loans; and separating ownership links between banks and non-banks, increasing competition through entry of new banks, and diversifying ownership of nationwide banks. In reforming public finance, the State Council issued a new policy in July 1996 on extrabudgetary funds, which integrates government funds into the budget; began auctioning government bonds in early 1996, and may have arrested the past declining trend in government revenues (as a percentage of GDP). 2. Infrastructure. The Electricity Law has come into effect. China has displayed new willingness to experiment with innovative financing mechanisms for infrastructure (such as BOT schemes), but needs to assure investors that China is serious, flexible and willing to share risks. Despite record domestic savings rates, few non-state resources go to infrastructure financing. The Chinese authorities' support of the orderly expansion of the domestic capital market will provide important financing possibilities for the future. 3. Human Development. Although domestic resources to fight poverty are still insufficient, the government has decided to spend 40 percent more each year than it now spends-bringing the total to about Yuan 100 billion (or about $12 billion) by 2000. Targeting of the core poor in projects has improved. In education, China has improved access by the poor-including women and minorities. Some rural counties have begun to increase accountability and transparency of fund uses. In health, the government is making better use of the limited resource envelope by helping the poorest, focusing on prevention, and prioritizing services. 4. Agriculture and Rural Economy. China has liberalized its agriculture policy and price structure, particularly for livestock products and fruits and vegetables. Rules governing the township and village enterprises (TVEs) have been relaxed to encourage competition and open rural employment opportunities. The Government has introduced new environmental guidelines that will restrict the TVEs' pollution practices. In the past year, China established a model river basin corporation and self-financing irrigation and drainage districts, and pricing increases of bulk water throughout China. Also, substantial increases in administered prices for grain and cotton-in line with world price trends-have improved rural incomes measurably. 5. Environmental Protection. In July 1996, Premier Li Peng affirmed key aspects of China's environmental priorities. He emphasized the importance of stricter environmental management as instructed by the State Council, the need for rigorous environmental impact statements for all new construction and renovation projects, and raised the awareness of the environmental effect of urban congestion and increased car ownership. A sizable number of small paper and pulp mills operated by TVEs have already been shut down as a consequence. User charges for environmental services have also improved.  - I1 - Macroeconomic Stability with Growth 24. Macroeconomic and structural reforms continue to be central to the Bank's assistance strategy in China. Development of the non-state sector is key to ensuring stability and growth, and is a primary focus of IFC and MIGA programs in China. The Chinese authorities and the Bank agree on the overall content of the reform program, and the likelihood that completion of such reforms will necessarily span more than a decade.' The Bank Group's program has been designed to support the timely implementation of key elements of structural reforms of banking, SOEs, and in public finances. Progress in each of these areas has been uneven. 25. Financial Sector Reforms: The Bank Group's strategy rests on three pillars: (a) assist the Government in establishing a modern market-oriented framework through technical assistance and advice, (b) help existing banks to adapt to commercial banking practices, and (c) promote new entry of non-state banks and financial institutions. These pillars clearly support each other; the Bank Group's contribution in each of the areas depends on continued involvement in comprehensive sectoral reform. 26. We will continue to assess financial reform policy through analytical work and disseminate the findings in workshops and seminars. An example of this approach was the March 1996 annual consultation on the financial sector. We will assist in establishing the sectoral infrastructure (legal, prudential, accounting, and payments system), under the ongoing Financial Sector Technical Assistance Project (FY93), to be followed by a proposed second technical assistance operation that could help to set up a national payments systern. The objective of the proposed Construction Bank Transformation Project (FY97) is to help its management create a more efficient, market-oriented commercial bank. The EDI is developing a multiyear training program for Chinese bankers, that should contribute positively in developing a market-oriented banking sector. 27. The Bank, under IDF grants, is helping the institutional development of the new Minsheng Bank, China's first non-state owned bank, and the China Securities Industry Institute. The IFC is providing advice and TA to develop programs for the new city banks, and exploring the possibility of taking a minority share in the Shanghai City United Bank as well as in other commercial banks. IFC is also considering lending to private non-bank financial institutions, such as the Orient Finance Company. 28. SOE Reform: China will need to deal with more problem SOEs that will emerge as banks become more commercial and policies shift away from subsidizing credit. Delinking provision of social benefits from SOEs' productive operations is essential to open the way to further reforms. Stronger, market-based incentives focused on internal governance mechanisms and accounting/auditing controls, as well as external disciplining forces, such as inter-firm competition and a market for managers, are badly needed. 29. The Bank's strategy is to assist the Government to: (i) confer autonomous management rights to the enterprises associated with improved internal governance, a modern and transparent accounting system, diversified ownership, and reduced budgetary and financial subsidies; (ii) reduce 10. For a recent analysis of structural reform issues, see *-The Chinese Economy: Fighting Inflation, Deepening Reforms," World Bank Report No. 1 5299-CHA, May 1996.  - 12 - enterprise responsibility for housing, pensions, health, and education; and (iii) promote competition to foster greater efficiency. 30. We will assist China's SOE reform at two levels. First, building on earlier works (including China: Reform of State-Owned Enterprises - FY96), we will extend the analysis of SOE reform in studies of State Asset Management Reform (FY97), Municipal Finance (FY98), and Housing Reform (FY99). To follow up on the recently published study on Pension System Reform, EDI is planning to sponsor a conference on "Pension Reform: International Experience and Chinese Options" during FY97. Technical assistance to prepare for future lending operations will be considered at a later stage. Second, the Bank Group will finance projects that demonstrate how reform measures can be implemented. The Hubei Enterprise Reform Project under preparation (FY98) aims at reforming the manufacturing and services sectors in the municipalities of Wuhan and Huangshi. The project would help the government divest small SOEs and formulate measures to delink gradually social benefits from enterprises. The operation is designed as an integrated Bank Group project with IFC and IBRD closely collaborating. In agriculture, we plan two projects-State Farm Commercialization (FY97) and Heilongjiang Agriculture Development Project (FY97). The former will attempt to accelerate enterprise reform throughout the state farm systems in about 15 provinces, and the latter has already inspired ownership diversification in agribusiness in one of China's most commercially underdeveloped provinces. In infrastructure, the Tuoketuo Thermal Energy Project (FY97) aims to commercialize state power companies and will quantify the specific costs of their social responsibilities and the impact on profitability. As there are indications that labor shedding in SOEs has affected women workers disproportionately, future Bank projects in SOE reform will address this issue. 31. Public Finance Reform: The Bank is assisting China by: (a) the Fiscal Technical Assistance Project (FY95) that help develop the new National Tax Administration, a central-provincial grants scheme, budget management systems and, China's capacity to analyze tax policy; (b) a Public Expenditure Study (FY97/98) to advise on how to improve China's public investment process; and (c) a Municipal Finance Study (FY98), that will help the local governments to improve their financial management. The Bank supports legal aspects of macroeconomic reform, and legal and regulatory reforms in infrastructure, principally through the Economic Law Reform Project (FY95). Infrastructure Development 32. In FY97-99, half of the Bank's new lending will be for infrastructure. This translates into 13 operations, comprising six power projects, five for highways, one for railways, and one for waterways. Each project aims to improve the quality of services by maintaining and upgrading existing assets, raising operating efficiency, meeting the needs of the users, and reducing environmental impact. 33. In power, generation capacity of some 17 to 20 gigawatts annually and rapid development of the transmission system will be needed at capital costs between $15-20 billion each year. The two power projects that will be presented to the Board in FY97 (Tuoketuo and Waigaoqiao), will support institutional and pricing reforms and mitigate the environmental consequences of coal use. 34. In transport, during the NFYP, overall investment requirements are estimated at about $45 billion for railways, $100 billion for highways, and an additional $15 billion to improve ports,  - 13 - Box 3: Evolving Framework for Private Highway Finance in China The transport centerpiece of China's NFYP is a national trunk highway system, which calls for construction of 35,000 km of expressways in 12 corridors over the next 15 years. This $150 billion capital program will far exceed any national highway system in the world. The Govemment estimates that it can fund roughly 20% of the country's future highway requirements, while the balance will be handled by the various provinces through both domestic and foreign loans. The Bank Group has an active program for highway development in China, with 10-12 major projects underway at any given time. However, the Bank's resources can only fund 30% of individual project requirements-far less than the foreign capital amount needed. China operates some 4,000 km of toll expressways, but few have been constructed with private funds, and those mainly in Guangdong and Sichuan Provinces. Aside from Hopewell's GSZ Superhighway, projects are sponsored by a few Hong Kong developers using their own equity capital. Commercial debt financing is generally unavailable without sovereign guarantees. The process and framework for mobilizing substantial capital from international firms and foreign sources is not yet well defined, so policy on tariff adjustments, foreign exchange risk, and convertibility will be based on trial and error in individual projects. Until a 'critical mass' of experience is achieved, overseas commercial lenders will be reluctant to assume any project risks with private toll expressways. Therefore China must soon develop a legal and regulatory framework attractive to private investors and commercial lenders. Several project and policy initiatives of the Bank Group can assist the Chinese authorities through: * Model procurement documents for BOT projects: The Bank Group is advising the State Planning Commission and the Ministry of Finance on draft procurement documents and standard project agreements for toll highways associated with the proposed Wuhan Junshan Yangtze Bridge BOT project which the Bank has been asked to support. * Asset-based financing techniques: Through the innovative use of Bank-financed toll road projects in Guangdong Province, a successful B-share financing on the Shenzhen Stock Exchange was completed. Similar types of financing are expected to follow in China. * BOT pilot proiect financing: A component of the proposed Third National Highway project (FY98) in Hubei mentioned earlier is expected to include the development of a bridge over the Yangtze River on a BOT basis with the private sector. airports and inland waterways. The Bank's projects will promote sectoral reforms that will allow competitive service providers. In railways, an important first step will be to separate ownership and management and reorganize the railway into lines of business operations. In highways, FY97 will be a year to assess how future projects can improve road safety, road maintenance, subsector finance, and road system management. 35. To promote private financing of infrastructure, China needs to: * develop transparent and competitive contracting; enforceable legal, regulatory, and tariff structures; and clear identification and assignment of risks; * design an administrative framework to balance state and non-state interests in infrastructure provision and streamline approval and regulatory processes; and * strengthen the domestic capital market, particularly the bond market, to establish another stable source of domestic finance.  - 14 - 36. Currently, China is sponsoring a series of pilot projects to establish a more rational framework. One of these is the Yangtze bridge component included in the proposed Third National Highways Project (FY98). The MIGA is interested in providing support, and recently guaranteed a privately financed power project on Hainan Island. The Bank is actively seeking opportunities to use its partial guarantees to mobilize additional private financing for infrastructure. The Government is reluctant to extend sovereign counterguarantees for private projects. The IFC encourages greater private participation in infrastructure by financing demonstration projects, which can serve as catalysts for improved legal and regulatory frameworks. It has approved investments in ports in Xiamen and Nanjing, and is actively pursuing opportunities in the water and power sectors. But concession frameworks require improvement, and adequate Government support mechanisms need to be put in place to attract larger private financial flows. Human Development 37. Human Development projects in China encompass a broad range of activities in education, health, poverty alleviation and social protection, and are designed and implemented with particular concern for the welfare of women and children. Health projects have concentrated on improving maternal and child health and basic health services in poor areas, and girls' education is the focus of a series of education projects in the poorer provinces. 38. Gender issues are also part of the Bank's social protection agenda.. For example, preliminary findings show that labor market reforms in China appear to be having adverse effects on women's employment prospects and work conditions. A proposed labor market study (FY98) will study this issue in detail. The results of this study will inform the design of future projects. 39. Poverty Reduction. The Bank will assist China in further specifying the implementation needs of the "8-7 Poverty Reduction Program" (para. 22). We will address the underfunding issue by complementing Governmrent resources targeted at poverty reduction with well-focused Bank Group financing, using innovative and workable strategies that can be replicated. During the IDA- 11 period, we will devote over half of available IDA funds to direct poverty alleviation with the remainder for human resource development in poor areas, rural water supply, and a limited amount for technical assistance. 40. Education. The Bank Group's strategy is to improve the access and equity of China's basic education system, with emphasis on the poor, ethnic minorities, and girls. Our lending program incorporates basic education projects for the rural poor; the fourth project in the series (Basic Education IV - FY97) will fund girls' and minorities' education. Other on-going and planned operations will upgrade education inputs, decentralize financing and administration of the higher education system, and tailor the education system to the changing labor market. A proposed higher education project (FY99 - mainly for universities in poor, inland provinces) will develop curricula and a much-needed student loan scheme.  - 15 - Box 4: Developing New Approaches to Poverty Reduction in China . China's success in lifting 170 million out of the poverty trap between 1978 - 1985 was achieved largely through broad participation in rapid rural economic growth. In an effort to consolidate initiatives undertaken by some 27 separate ministries and agencies with their own poor area projects, the Government established in 1986 a Leading Group to expedite economic development in poor areas. . The Bank Group's poverty report (China: Strategies for Reducing Povertv in the 1990s), which was released at the "International Conference on Poverty Issues in China" (held in Beijing in October 1992), proposed new approaches for poverty reduction. Although the "8-7 Poverty Reduction Program" initiated in 1993 is very much China's own, the Bank Group's input is evident in the design of parts of the program and its areas of focus. The special approach includes investments to: augment upland agricultural productivity, rural enterprise development, labor mobility, basic rural infrastructure (including roads, drinking water, small scale irrigation, etc.), access to basic education and health services, off-farm employment, and poverty monitoring and project implementation. The main objective was to propose some possible new models for China. * The report's recommendations are being implemented through Bank-assisted projects located in some of the remote, upland areas highlighted in the report. The Southwest Poverty Reduction Project (FY95) was developed to reduce absolute poverty in the worst affected upland areas in three resource-poor provinces (Guangxi, Guizhou, and Yunnan) in southwestern China. In keeping with the agreement at the Beijing Conference, the project was developed with strong community participation during preparation and implementation. The proposed Qinba Mountains Poverty Reduction Project (FY97) extends the approach into three additional provinces in China's near northwest (Ningxia, Shaanxi. and Sichuan). It will promote "market friendly" increases in rural labor mobility from the poor areas to better-off rural and urban areas, upgrade China's ability to track the level of poverty at the national and local levels, and provide low income women with access to working capital (microfinance) and a secure place to deposit their savings. 41. Health. The Bank's lending and nonlending services for health sector have assisted the government in improving the quality of public and basic health services, especially in maternal and child health (MCH) programs and in the control of infectious and endemic diseases, such as tuberculosis and schistosomiasis. Recently, we have helped to establish programs in newer areas, including the prevention and control of chronic diseases and HIV/AIDS. The Basic Health Services Project (FY98), will integrate improved planning and management, service quality, as well as measures to enhance access in poor counties. Noncommunicable and chronic diseases are an increasing burden in China, and we plan to develop further IBRD/IDA blend and IBRD projects with interested provinces and municipalities. Reforming the health finance system is a top priority, and recent sector work is addressing health-care cost, coverage, and management. Agriculture and the Rural Economy 42. The Bank Group's assistance strategy is to accelerate commercialization of the agriculture sector; assist local governments to develop new income-generation programs (including TVEs) in lagging provinces; develop new approaches to food security; promote better utilization of marginal agricultural land through sustainable techniques; incorporate major water schemes into future projects, that include institutional reform and user participation as integral components; and encourage investment by the non-state sector in agribusiness and agroprocessing. 43. The Bank plans to lend for an average of two operations each year (FY97-99) in the sector. To the extent that resources permit, work will commence on three or four additional projects to ensure a dependable pipeline. They would address large-scale water shortages in the north; inadequate  - 16- entrepreneurial development and public investment in the rural interior provinces; lack of logistical and integrated marketing systems for agricultural commodities required to link to urban and overseas markets; reforestation of denuded uplands; and inadequate feed processing capacity and technology for higher-valued animal products. In complementary interventions, IFC will assist agribusiness, including TVEs, by increasing access to domestic and overseas finance, upgrading technology, and enhancing management. The IFC will encourage local and foreign private investment to meet domestic demand, as well as export opportunities, with special focus on poor provinces. Environmental Protection 44. Environmental Protection. We will assist China to strengthen institutions and tools for improved environmental management, and to finance related investments that will produce improvements quickly. Although environmental pressures from rapid industrial growth, urbanization, and agriculture have intensified, work at the policy and institutional level has begun to bear fruit. A linchpin in this work has been the Environment TA project (FY93), which helps the National Environment Protection Agency (NEPA) to develop and implement national environmental policy. This is complemented by economic and sector work on industrial pollution control and energy and water resource pricing. 45. The major issues on the Chinese environmental agenda and our work program are: to provide safe drinking water; to manage hazardous and toxic wastes; to reduce waste output by increasing industrial efficiency in energy use; to protect marginal agricultural lands by promoting sustainable practices; to introduce coastal zone management techniques; and to preserve forest reserves and biodiversity. A study (FY97) on the dynamics of economic growth and environment, will highlight issues for China's sustainable development in the twenty-first century. In addition, we will study environmental management of river basins to improve the quality of water for the entire basin (FY98). Other reports will include Municipal Finance (FY98), Industrial Pollution Control (FY98), and an update of the Environmental Strategy (FY99). Our GEF and Montreal Protocol projects will take an increasingly sectoral approach. 4. THE BANK GROUP AND CHINA A. IBRD and IDA's Proposed Lending and Nonlending Services (FY97 - 99) Lending Program 46. The indicative lending program of $2.5-$3.0 billion a year for FY97-99 (Annex 2 and 3) will enable the Chinese authorities and the Bank Group to pursue the strategy set out in this CAS. IDA-I I resources will be directed toward poverty reduction (54 percent), the social sectors (30 percent), agriculture and environment (13 percent), and technical assistance (3 percent). It should be noted that resource constraints over the past few years have led to a depletion of the project pipeline and, unlike the past, we will not be able to substitute standby projects for delayed projects. We are increasing our efforts to re-build the project pipeline within the budgetary envelope. 47. Size and Coverage of Lending. A substantial Bank lending program in the range of $2.5-3.0 billion a year for approximately 15 projects in a broad range of sectors underpins the assistance strategy  - 17 - for China. For equity reasons, broad regional coverage is important to the Chinese authorities. To offset emerging regional disparities in China, the Bank will lend progressively more in the interior. This is important given the underdeveloped domestic mechanisms to transfer resources to the interior, and the difficulty in attracting foreign investment away from the coast. Lending to richer provinces will be used to pilot innovative projects that, once proven, may be taken up by interior provinces. The regional distribution of recent IDA lending shows its success in moving steadily away from the richer, coastal provinces and into the poorer, interior areas. A less marked trend exists for IBRD lending. IDA Lending to China by Regional Share IDA-9 (FY91-93) IDA-lO (FY94-96) Planned IDA- I (FY97-99) ($3 billion) ($2 billion) ($0.9 billion) Coast Coast Coast 47% 19%1 Interior Interior 53% ~~~~~~~~~~~~~99% Interior 48. To ensure sufficient presence to advise on policy reforms and to promote regional diversity in our annual lending program, we plan for two or three operations on average in each of the five thematic areas of our country assistance strategy (para. 22). This brings the average loan size to between $200 million to $300 million, but we will also be supporting some smaller projects with more modest loan requirements if they are particularly valuable as pilot or "best practice" examples. 49. Potential Constraints to Bank Lending. Continued lending for poverty and the social sectors is at the heart of the Bank's assistance to China. Limited IDA availability" is a constraint in this regard as the Ministry of Finance and the State Planning Commission require that all loans be repaid by the beneficiary, not from central government revenues. As a result, IBRD lending in the social sectors is effectively restricted to projects with satisfactory repayment capacity or to cases where the provincial entity can repay. 50. To introduce more IBRD lending in the social sectors over the next few years, the Bank will pilot projects to demonstrate the benefits of IBRD lending. Indeed, the Bank is already financing a few blend projects and developing several others that use IBRD funds for project components that generate revenue. We are considering IBRD-loans for human development in provinces with sufficient capacity to repay. The goal would be eventually to extend the pilots to poorer areas for activities and projects with less capacity to repay and encourage the Government to establish resource transfer mechanisms as other countries in the region have already done. 11. IDA lending to China is programmed to cease from FY2000, with the end of IDA-I .  - 18 - Nonlending Services Program 51. The objectives of NLS are threefold-providing advice, undertaking analysis to prepare for our own operations, and assisting in capacity building. These objectives in turn reinforce each other, and deepen the Bank Group's knowledge of the Chinese economy. The Bank and the Chinese authorities have developed jointly a three-year work program in the five pillar areas of the CAS (Annex 3). Complementary to the Bank's own ESW work program, EDI and FIAS will deliver additional nonlending services to China. 52. We provide advice to Chinese officials and agencies through our Resident Mission on short notice. Short policy notes also address China's questions ranging from FDI issues to problems of funding social insurance programs. The annual CEM and our analytical economic and sector Box 5: The Case for Lending China is still a low income developing country with an estimated GNP per capita of US$620'2 in 1995, well below the operational guideline for IDA eligibility of US$905. Income varies between the different provinces and municipalities but even the richest municipality, Shanghai, records a per capita income of only US$1,832. China has more poor people than sub-Saharan Africa"3. The country also has a strong and proven record of adopting and carrying out effective policies; China has high savings rates and low indebtedness and relies mainly on its own resources to fund development. But the Chinese Government has stated repeatedly that it values continuing World Bank assistance both through lending and advice. The proposed level of Bank lending of approximately US$2.5 - $3.0 billion a year, while high in absolute terms, represents the lowest lending on a per capita basis in the region. Bank funds can do much to ensure that domestic resources are used well. Bank projects pilot innovative approaches to areas of need, catalyze repeater projects that demonstrate sound policy principles, and help to build institutions necessary to complete structural reforms. Vital sectors and important regions have yet to attract private capital, and budgetary resources are inadequate to fund them. Foreign direct investment (FDI) inflows reached $38 billion in 1995, and rose to $40 billion in 1996. These inflows do not meet the need for public investment in essential sectors. To date, the predominant share of FDI has gone to the real estate and manufacturing sectors in coastal provinces, exacerbating regional disparities. Accordingly, the Bank Group is helping China to set up the framework for private flows. The other priorities of the Bank's program-poverty alleviation, health, education, natural resource management, the environment, and urban development-have low, current potential for attracting FDI. reports are intended to inform China's policy-makers on options for reforms. A recent example is the pension system reform report (FY96) that analyzes the principal benefits of a reformed pension system more suited to a market economy. Capacity building is undertaken in various ways. For instance, EDI is playing an increasingly prominent role by means of its training programs in health, public finance, and banking. Bank economists and Chinese counterparts work on joint analytical products. A successful example was the collaboration between the Bank and the State Planning 12. By the Atlas method. 13. If the dollar a day standard is applied.  - 19 - Commission (SPC) in developing the strategic issues of the draft Ninth Five-Year Plan. Some of our technical assistance also supports capacity building. B. Effective Partnership: The China Portfolio 53. The China portfolio continues to be of very high quality, despite the nature of the projects, which are usually complex and often geographically dispersed. The OED has rated all but two of 60 evaluated China projects as satisfactory, and the Quality Assurance Group (QAG) has identified China's as one of ten outstanding portfolios. The quality of the China portfolio rests on strong borrower commitment and local administrative capability, frequent supervision by Bank headquarters staff, monitoring and reporting from the Resident Mission, and systematic Country Portfolio Performance Reviews (CPPRs) with our Chinese counterparts. The most recent CPPR held in China in April 1996 discussed speeding up project processing, availability of counterpart funding, reducing procurement delays, making greater use of our field office capability, and more systematic performance monitoring of future projects, and agreed on a Joint Action Plan. The CPPR meeting also agreed that better use of technical assistance and foreign consultants would further enhance portfolio quality. 54. Of the 102 active Bank Group-assisted operations, only seven are encountering significant problems. These problems are due, in part, to counterpart fund shortages, particularly in the rural and social development sectors where revenues are more difficult to generate. During recent discussions with the Bank, the Government recognized the significance of this problem and agreed to take necessary measures. We are dealing with other problems by agreeing with the borrowing entities on measures to enhance implementation or, in exceptional cases, by restructuring. All projects are expected to return to satisfactory status within twelve months. The need to improve the effectiveness of technical assistance operations, and reservations in China about the cost-effectiveness of foreign consulting expertise included in many TA operations, are current subjects of the ongoing discussions on portfolio improvement. Efforts in the near term will also focus on quality at entry as we continue to improve the economic and social analysis of China projects. C. Creditworthiness 55. China's total debt increased to $118.1 billion in 1995 from $100.5 billion in 1994. This resulted in a reduction of the debt to GDP ratio from 18.6 percent in 1994 to 16.9 percent in 1995. IDA and IBRD debt outstanding was $14.3 billion at end-1995. The ratio of IBRD debt-service to total exports was 0.5 percent, and the ratio of IBRD debt service to the debt service ratio of public external debt was 5.9 percent. Around one-half of China's total external debt is owed to private creditors and commercial banks. Short-term debt amounted to $22.3 billion at end- 1995, accounting for 18.9 percent of the total, up from 17.4 percent in 1994. The share of external debt at variable rates has declined steadily from 36 percent in 1990 to 32 percent in 1995, thus lowering China's vulnerability to interest rate fluctuations in international financial markets. 56. China's creditworthiness is reflected in the continued favorable treatment sovereign Chinese debt enjoys in international capital markets. The debt to GDP ratio is projected to decline to 13 percent by 2005. The ratio of debt service to exports is about 10 percent (1995) and is expected to increase slightly to 11.6 percent over the medium term. But, servicing of all external obligations (including FDI) claims a much larger share of exports than debt service alone. This ratio (factor service payments plus amortization as a share of exports) stood at 22 percent in 1995 and is expected to increase in the  - 20 - medium term (25.5 percent in 2005), as foreign investment projects continue to mature and generate rising profits. D. Evaluation of Risks 57. China's rapid growth in the past two decades, the Government's track record of gradual, incremental reforms, and the country's credentials in international financial markets make China a very creditworthy borrower. At the same time, the sheer size of the Bank's proposed lending program warrants a constant and careful assessment of the risks confronting the economy, close monitoring of policy and economic performance, and a continuous review of the Bank's program in light of changing circumstances. Persuasive as the past record of China's economic successes may be, we cannot overlook the vortices and cross-currents generated by the forces of transition and the difficulties of managing fundamental change in a fast growing economy the size and complexity of China's. 58. Continued growth in China could be jeopardized in several ways, many of them unforeseeable. Here, we review two possible scenarios that could unfold in the next two to three years-one where the origins of the slowdown are triggered by the forces of transition themselves, and the other where trade frictions could hurt China's integration with the world economy. We also briefly examine longer term risks to sustainable, rapid growth in China-risks that could exert themselves forcefully, but only after the next decade or two. 59. Consider the first scenario. In the past year, the majority of state enterprises in China have come under severe financial strain. They have been subjected to competitive pressures from non-state firms (including joint ventures) and imports, and the government's paramount concern with stability and low inflation has meant steadily lower subsidies to state enterprises through the budget and the financial sector. In the first nine months of 1996, the Government estimates that about half of all industrial state enterprises incurred net losses equivalent to 1.3 percent of GDP (para. 8). Unable to meet their wage bills, several have accumulated wage arrears, many have laid off workers, and some have even gone bankrupt. 60. Although these results may herald increasing efficiency in the use and allocation of resources, they have also heightened concerns in government circles about rising unemployment in urban areas. Much of this unemployment is in cities of interior provinces, where there are high concentrations of uncompetitive state enterprises, relatively few non-state firms, and low levels of foreign investment. So far, the Government has been able to advance state enterprise reforms gradually while keeping unemployment within politically acceptable limits. But the specter of unrest in urban areas serves as a reminder of the delicate balance that needs to be maintained between the pace of reforms and their social consequences. 61. Urban unemployment could rise to levels considered intolerable by policymakers which, in turn, could lead to a more conservative view on the pace of state enterprise reforms. In either event, the Government could relax its current stance on reforms and stability, slow the pace of (or even stop) enterprise reforms, and support financially ailing firms with fresh credits from the banking system and subsidies from the budget.  - 21 - 62. Continued for some time, these policies would slow growth in two ways. First, the pattern of investment would tilt further toward inefficient state enterprises with slower productivity growth.'4 And second, loan portfolios of banks would deteriorate rapidly 15, eventually making banks insolvent,'6 thus forcing their recapitalization and restructuring. 63. The Government possesses the fiscal headroom to absorb significant recapitalization costs of banks without resorting to inflationary finance.'7 So the immediate growth effects of this scenario need not be severe. Over the longer term, however, the Government's fiscal situation would be strained. Without significant increases in tax revenues, higher interest payments on government debt would siphon resources away from high priority areas such as education, health, infrastructure, and the environment, with implications for the sustainability of rapid growth. 64. More importantly, such a scenario portrays a sequence of actions that would be quite uncharacteristic for China's policymakers. Their practice since 1978 has been one of occasionally halting, but generally unremitting, forward movement on economic reforms. On rare occasions in the past, the Government did slow reforms to a virtual halt in one or two areas. But it did so for short periods, and resumed the process once conditions were more appropriate. This may yet happen in the state enterprise sector. But recent statements of senior officials suggest strongly that the Government is determined that state enterprise reforms should proceed the transition to a market-based system. 65. The Bank, nevertheless, needs to be prepared for the eventuality of a slowdown in reforms in state enterprises and the financial sector. We propose that our response be two-pronged. First, we would redouble our efforts to engage the Government in a policy dialogue on how best to resume these reforms. And second, we would discontinue loans that require the involvement of state industrial enterprises or financial institutions. We would, however, continue lending for poverty alleviation, especially as slower growth is likely to have a disproportional effect on the poor. And we will also continue lending in areas that will have an important bearing on long term growth prospects, namely environmental protection, infrastructure development (especially in interior provinces), health, and education. 66. China faces a second set of risks, but these arise in its relations with the world economy. Recent trade frictions with its trading partners have been resolved without punitive actions on either side, but tensions could escalate and disagreements become more frequent if China's accession to the WTO is denied or postponed indefinitely. 67. China has the capacity to absorb isolated protectionist or retaliatory actions by individual countries. Well diversified exports and imports, by product category as well as by country of 14. Studies have shown that the total factor productivity growth of state industrial firms is a third to half of non-state firms. 15. Government officials have indicated on several occasions that the bad debts of the banking system are about 20 percent of the outstanding loan portfolio. Foreign observers have speculated it could be higher. 16. Given their relatively small capital base, the net worth of the large state commercial banks is already probably negative. 17. The ratio of government debt to GDP is very low by international standards. Even if Government were to recapitalize the banks by swapping bad debts for bonds equivalent to 40 percent of GDP (on the extreme assumption that 40 percent of banks loans are nonperforming and unprovisioned), the Government's debt-GDP ratio would be significantly below the average for all developing countries and close to that of the United States. Moreover, under reasonable assumptions, this debt-GDP ratio could be expected to fall over time.  - 22 - destination (or origin), provide a natural shield against a variety of external shocks. Moreover, foreign funded enterprises account for a large portion of its trade,'8 creating a potential lobby for open markets in trading partner countries. 68. Nevertheless, China remains vulnerable to concerted efforts by major industrial countries to curtail access to their markets. While the probability of this is low, China could make it lower still by strengthening its case for entering the WTO, observing international rules of competition, ensuring an open and transparent trade policy with appropriate dispute resolution mechanisms, and setting a firm timetable for reducing trade restrictions to acceptable international levels. Such a course of action would have intrinsic benefits of its own, apart from those of more intensive engagement in world trade and increased access to world markets. The Bank will work with the Chinese authorities in providing technical assistance and identifying a feasible path for a comprehensive approach to trade liberalization that takes into account Chinese concerns on unemployment, adjustment, and support for sunset industries. 69. China is also vulnerable to a sudden downturn in inflows of foreign direct investment. This could occur for a number of reasons. For example, the bulk of these flows come from neighboring countries with a large Chinese population. They could turn off the spigot were bilateral relations to sour. Alternatively (but less likely), a sudden deterioration in China's external payments position, perhaps as a result of protectionist action by trading partners, could raise questions about retaliatory restrictions by the Government on profit remittances of foreign investors in China. This might damage China's credibility in the eyes of the foreign investor community. 70. A downturn in inflows of foreign investment is unlikely to slow growth substantially in the short run. Even though China attracts a significant level of FDI flows to developing countries, FDI accounted for only 13 percent of aggregate investment in China in 1995. On the other hand, sluggish FDI flows over a long period would deny the Chinese an important avenue for transferring new technology, learning new management styles, and absorbing the latest marketing techniques. If other avenues for information flows, such as trade, are kept open, however, the consequences for growth in the long run could be minimized. 71. Finally, even if China were to navigate successfully the potential pitfalls of transition, it still faces huge development challenges that, if improperly managed, could jeopardize the sustainability of rapid growth. These challenges include a deteriorating natural environment, rapid urbanization, shortages of water in the parched North, inadequate infrastructure, adjustments to huge structural change in output and employment, and rising inequalities between urban and rural areas and between the coast and the interior. Long-term factors arrayed in China's favor are high savings, a literate labor force, relative stability, administrative strength, and a supportive Chinese diaspora. These strengths have driven China's rapid growth over the past two decades. They will be equally necessary to overcome the challenges facing the economy in the next two. 72. The Bank Group's strategy refrains from linking variations in the country program size to specific triggers. This is because the likelihood of across-the-board slippages in the reform program discussed above is low. The Government is committed to gradual market-oriented reforms, has 18. One third of exports and one-half of imports.  - 23 - demonstrated good judgment in pursuing a sound macroeconomic framework, and is determined to pursue structural reforms. The record of the Government over the past sixteen years and broad consensus at the highest political levels on the direction and pace of reforms puts the Bank's program on a secure footing. Nevertheless, we will keep an especially keen eye on key economic indicators and follow the progress of structural reforms closely with our Resident Mission in Beijing. To monitor the state enterprises will be difficult, given the paucity of good data. But we will watch trends in state enterprise profits and losses, the rate of urban unemployment (especially in high risk provinces), and revenues (and arrears) from state enterprise income taxes. To follow the macroeconomic policy of Government, we will watch the ratio of government revenues to GDP, the issuance of treasury bonds, and the growth of key monetary variables such as Central Bank reserve money, domestic credit,19 and broad money. To keep abreast of developments in the external accounts, we will look for trends in exports and imports as well as flows of FDI and the stock of international reserves. E. Exposure Management 73. We have explored the implications of the CAS lending program for the Bank's exposure to China20 in light of the new approach to portfolio concentration management. Projected disbursements from the existing pipeline and the proposed lending program of $7.1 billion (IBRD- only) over FY97-99, results in China's exposure increasing from $8 billion in FY96 to $10.4 billion by end-FY99. This is less than IBRD's current exposure to Indonesia and Mexico and would not require any addition to IBRD's capital and reserves. However, there are implications in outer years. For example, disbursement of the end-FY99 pipeline, without any further lending, would result in China's exposure peaking at about $15 billion in FY03. requiring a modest increase in capital and reserves. The path of IBRD's exposure to China depends on a number of factors, including lending levels after FY99, actual disbursements, and how the Chinese pursue other options, such as the prepayment of their existing higher interest debt. We will continue to monitor our lending level closely in subsequent CAS's to ensure that it accords with the IBRD's capacity to build the required level of capital and reserves. F. IFC and MIGA 74. The Bank Group's affiliates are all present in China. Cooperation has been good, and increasingly an integrated approach is being followed; the anticipated collaboration between IBRD and IFC in the Hubei enterprise reform project is a prominent example in this regard. The EDI supports the activities of both IBRD/IDA and IFC through training that has been developed jointly. IFC 75. Since 1993, IFC's operations in China have begun to take off. Through FY96, the Corporation has approved 24 projects in China, with gross IFC investment totaling $776 million. In FY96, IFC's 19. Including "other items (net)" in the monetary survey. 20. See R96-263, " A New Approach to Portfolio Concentration Management" approved by the Board on January 28, 1997. The IBRD exposure to the large borrowers, within the CAS planning horizon, will be constrained by the lower of the two limits: i) an equitable access limit of 10% of the Statutory Lending Limit, and ii) a portfolio concentration risk limit. The former is about $20 billion and the latter, which will be determined in conjunction with reserves and other decisions on net income at the time of the Net Income Paper in July 1997, was about $13.3 billion as of end FY96.  - 24 - gross investment approvals for China's operations totaled $490 million, ranking China sixth among IFC's client countries. With the rapid expansion of IFC's operations in China, relations with Government agencies have also improved markedly which, in turn, reinforced IFC's ability to engage in policy dialogue and to provide feedback from private investors to Chinese authorities. 76. The IFC's mandate is to boost China's growth by helping the non-state sector contribute more to China's economic development through: (a) financing privately-led joint venture projects; (b) assisting SOE restructuring and corporatization; (c) supporting private participation in infrastructure projects; (d) helping TVEs and indigenous private entrepreneurs; and (e) promoting capital market development. The Corporation plans to increase its help to China's infrastructure sector, capital markets, and agribusiness sector. In infrastructure, IFC (with the Bank and FIAS) has been helping China to establish a more private sector-oriented framework. In capital markets, IFC has already provided extensive advice and TA to the Shanghai City United Bank, which was set up to fund non- state enterprises in Shanghai. More TA for Beijing City United Bank, Minsheng Bank, Orient Finance Company, and others is being introduced. In the agribusiness sector, growing IFC assistance to joint ventures is aimed at meeting both increasing domestic, as well as overseas, demand. The IFC has already devoted considerable resources in the difficult area of SOE reform, and is working on a joint venture project with Scana Industries (Norway) and Leshan Metallurgical Machinery and Roll Works, a Chinese SOE, to revitalize Leshan Works. The Corporation is also working on a possible restructuring of the Zhongyuan Pharmaceutical Plant. 77. The IFC is entering a new, but strategically important area in the non-state sector of China by working with indigenous private entrepreneurs and enhancing their ability to access credit. This makes work on capital market investment activities important. In FY97, IFC is preparing two projects- Orient Finance Company and China Sci-Tech (CSI)-by offering credit lines that would be onlent to nonstate-sector firms. While IFC's initial efforts to invest directly in TVEs have been less than fully successful, several new possibilities (including an agroprocesssing TVE) are promising. MIGA 78. The MIGA's operations in China also expanded rapidly beginning in 1993. From an aggregate liability of less than half a million dollars in FY93, MIGA's aggregate (outstanding) liability in China grew to $12 million in FY94, $80 million in FY95, and exceeded $112 million in FY96. The China portfolio comprises 24 contracts. Annex 7 (page 5) sets out the activities supported by MIGA in China. Issues surrounding adequate MIGA headroom for more China guarantees and obtaining host government approvals from the Chinese authorities may constrain future activity levels. 5. COOPERATION WITH OTHER INSTITUTIONS 79. China has not drawn on any IMF resources in the recent past. The Bank and the Fund maintain close coordination on macroeconomic developments, and cooperate in the staffing of important missions. The IMF is also involved in the preparation and implementation of the Bank- supported Fiscal and Financial Technical Assistance Projects. Over the past year, Bank staff have continued to increase the frequency of their consultations in Manila with the ADB. In addition, the Bank and the ADB undertook a more explicit effort to divide areas of greater or lesser emphasis. As an  - 25 - example, ADB will continue its assistance to the telecommunications sector, while the Bank has withdrawn from it. The Bank and ADB are also cooperating on a possible interbank payment systems project. The ADB extended $1.1 billion to China in 1996, principally to finance infrastructure (75 percent) and urban environmental improvement (13 percent). Japan continues to be the largest bilateral donor to China. We consult regularly with key Japanese agencies, particularly OECF and Japan EXIMBank. The OECF has traditionally stressed infrastructure financing in China, but has increased interest in environment and social sectors in which the Bank has extensive involvement. We are cooperating and discussing possibilities of coordinating project financing with OECF. The OECF provided nearly $1.4 billion to China in 1995; slightly over 90 percent went to infrastructure financing. In Technical Assistance, the Bank is coordinating with the UNDP, whose Country Cooperation Framework (1996-2000) shares similar emphases. We have worked together with the UNDP, WHO, and UNICEF to develop the Iodine Deficiency Disease Control Project. We are increasing our interaction with the NGO sector in China with a view to eventually participating more actively in each other's work. 6. ISSUES FOR BOARD CONSIDERATION 80. We have emphasized the structural reforms in the SOE, financial, and fiscal areas that are needed to complement China's development of direct and indirect economic tools to manage its vast economy. Such reforms address areas of great complexity, and the process of change will necessarily be undertaken over the medium- to long-term. The Chinese authorities would like the Bank Group to be involved in most sectors, supported by lending between $2.5 to $3.0 billion each year, comprising some 15 operations annually. This would be accompanied by extensive non-lending services involving EDI and Bank affiliates including the IFC, MIGA, and FIAS. 81. With IDA resources declining, the Bank Group intends to promote the increased use of IBRD- IDA blend resources and IBRD-only loans for poverty and social sectors. To offset emerging regional disparities, the Bank Group plans to lend progressively more to the interior provinces. On cofinancing, China has yet to encourage it on a large scale. The Bank would welcome more cofinancing with both bilateral and export credit agencies. 82. The Executive Directors may wish to discuss the risks China could potentially encounter in the implementation of its economic reforms, especially with regard to state-owned enterprises and the financial sector. At issue is whether the size of the proposed lending program is appropriate, both in terms of China's developmental challenges and the portfolio concentration policy approved by the Board on January 28, 1997. The Board may also wish to express its views on the sectoral composition of Bank Group lending and the suitability of the strategies proposed. The issue of IBRD lending for poverty and social sector projects in China is still unresolved and merits the Board's attention, as well as the proposed regional shift of the Bank's lending to the interior. James D. Wolfensohn President by: Gautam S. Kaji   China Country Assistance Strategy: Diagnostic Matrix KEY ISSUES IN DEVELOPMENT PERFORMANCE DIAGNOSIS 1. Growth with Macroeconomic stability The challenge is to keep inflation low, while making Inadequate reform of the financial sector, state-owned enterprises and public finances prevent growth more efficient and equitable. development of strong macroeconomic management tools and serve to dampen economic growth. Despite recent success, improved macroeconomic Financial sector: management is imperative. In the medium-term, continued progress in financial sector, enterprise and * Banks still required to support loss--making state-owned enterprises at administered interest public finance reforms is critical. For stability, more rates. intensive and more equitable growth is needed. Steps are * Central Bank has few indirect policy instruments and inadequate regulatory and supervisory needed to open the economy further, implement more capacity. Administrative measures still used to restrain inflation. thoroughly the evolving legal framework, and develop the non-state sector. State-owned enterprises: * Absorb a disproportionate share of resources and dampen growth and employment creation. * Still insufficiently subject to market discipline. Have inadequate systems of governance. * Responsibility for workers' pension, health and education obligations complicate reform. Public Finances: * Steady decline in budgetary revenues as percent of GDP over past decade; unequal regional distribution. * Government budget inadequate to cover costs of market reforms, including funds to reform social insurance system. Critical social and physical infrastructure underfunded. To meet required additional expenditures requires raising Government revenue from present 11.3 percent of GDP to over 18 percent. * A broader tax base and improved compliance through better tax administration will bring a solution. * Extra-budgetary funds amount to an increasingly larger share of revenues. Efforts to improve their management, and incorporate them in the budget have just begun (State Council Circular 7/96). Legal Framework: * Nascent market-oriented legal system still has gaps in rules governing such areas as property, bankruptcy, contract, mortgage and securities. rCD * Deepening implementation of laws will depend on training and re-training of lawyers, judges, o t law teachers and government officials in the new legal framework.  China Country Assistance Strategy: Diagnostic Matrix e KEY ISSUES IN DEVELOPMENT PERFORMANCE DIAGNOSIS 2. Infrastructure Bottlenecks * Years of inadequate investment in infrastructure have caused severe bottlenecks. Heavy investments required now and in future. o infrastructure constraints - specifically in energy and transportation - will reduce growth.. * Power generation capacity of 17-20 gigawatts annually and aggressive development of the transmission system needed to improve reliability and quality of supply and maintain current growth levels. Requires investing $15-20 billion per year, compared to $12-14 billion invested in 1993-94. * Transportation systems unable to accommodate rapid growth since 1980 in passenger and cargo traffic. Investment requirements: $45 billion for railways, and $100 billion for highways over the Ninth Five-Year Plan period (1996-2000). * Domestic resources and foreign direct investment can meet most long-term needs. But appropriate instruments and incentives not yet established for channeling domestic savings. Lack of a transparent framework for private participation constrains FDI . * Stronger municipal finances required to alleviate bottlenecks plaguing cities throughout China. 3. Human Development * The number of poor fell sharply in the early half of the 1 980s. Gains then were relatively easy: Poverty and Income Distribution rural reforms and agricultural advances brought quick benefits to poor farmers on flat lands. Despite years of record growth, poverty persists. The * Poverty alleviation is now a much bigger challenge, requiring targeted, multisectoral absolute poor number around 65 million, most in remote, interventions, including access to off-farm employment. resource poor rural areas. Urban poverty an emerging * Low government spending on poverty alleviation makes the task more difficult. problem. Income disparities widening, but still modest by * Coastal / interior and rural /urban income gaps increasing, exacerbated by urban and coastal international compaxisons. bias in govenmment policy. * Human Resources Development Long term sustainability of growth requires improvements * Education and health both severely underfimded. in health and education services. The issue is particularly * The poor lack adequate access to education, especially in rural areas. Minorities and girls serious for the poor, but also affects non-poor areas and suffer from unequal access. populations. * Richer areas also face problefns in equitable access to education. * The centralized education system is inefficient. To meet the needs of a reforming economy and labor market, curriculum and other inputs need upgrading. * In higher education, very thin tertiary cohort with unknown implications for future growth.  China Country Assistance Strategy: Diagnostic Matrix KEY ISSUES IN DEVELOPMENT PERFORMANCE DIAGNOSIS * Lack of affordable health care and health insurance, especially in poor and rural areas. * Basic health status indicators have deteriorated, especially in poor areas. * Non-poor areas also face problems. Low priority and funding for public health means difficulty in combating communicable and non-communicable diseases. * Severe inequality in public health expenditures with state employees (GIS, LIS) capturing the bulk. Rise in chronic diseases poses new challenges. * Health financing system reforms are essential for efficient delivery and affordability of health services. 4. Agricultural Development and the Rural Economy After spectacular advances during the first part of the * There is little uncropped agricultural land remaining and it is costly to develop. reform period, productivity gains have slowed and rural incomes have stagnated. Agricultural development is a * Investments in water transfer, irrigation, and storage will help improve productivity at the prime concern of the government. Govermment focus on margin, as will a more efficient grain distribution and handling system. Agricultural research food security heavily influences agricultural policy and the is underfunded. Development and dissemination of new techniques has lagged. rural economy. * Stagnating rural incomes contribute to rising regional disparities and large migratory flows, and have the potential to threaten social stability. * The Chinese government's perceived need to provide low cost and adequate domestic grain supplies to urban consumers have meant food security issues have a major impact on agriculture policy. The result has been substantial government interventions creating distortions in grain pricing and marketing. * The food security mode selected will have enormous consequences for natural resource use, long-term environmentally sustainable growth, income equity and rural employment. 5. Environmental Degradation Rapid growth and industrialization have led to severe * Industrial wastewater contributes three quarters of the total water pollution around major cities. problems of water pollution and atmospheric Air pollution in many major cities exceeds Chinese and WHO standards by large margins. To contamination. Careful management of China's natural contain losses requires substantially improved management and investments to sustain or resources is a precondition for sustained growth in China. restore resources. * Carbon dioxide emissions are second largest in the world. Substantial investment in point source and municipal effluence control and treatment needed to avoid rapidly increasing environmental damage. Investment must be coupled with effective environmental regulation. w 0- * Uneven distribution of water causes severe water shortages and major floods . Soil erosion,o deforestation, desertification, and wetlands and grasslands damage result in a severe deterioration in national ecosystems and pose threat to future agricultural sustainability.  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Government Progress Benchmarks Bank Group Strategy Instruments o Obiectives Strategy/Actions (Fiscal Years 97-99) IBRD/IDA NLS IFCIAIGA _ 1. Promote Growth * Strengthen indirect * Elimination of the Credit * Technical assistance operations Financial Sector CEM 97 TA to with instruments to manage Plan for commercial banks (ongoing and planned ) to further Shanghai City macroeconomic aggregate demand. by 1999. strengthen financial system Construction Bank CEM 98 United Bank stability infrastructure and the regulatory Trans. (FY98) * Continue structural * Expanded use of open system. CEM 99 Orient Finance reforms of financial market operations, starting Fin. Sect. TA 11 Co ($30 system. 1997. . Lending operations to assist in the (FY99) (blend) Financial million LOC) transformation of specialized Sector Review * More frequent adjustment banks to commercial banks. ABC (FY 99) of administered rates. Commercialization * NLS to complete GOC/Bank (FY98) * Increased tax deductibility understanding of this sector and of loan-loss provisioning, provide policy advice on sequencing. . Continue structural * Progress in phasing out * Provide advice on SOE reform SOE Reform State Asset Join Bank's reforms of the SOE sector. commercially unviable through TA and NLS. Management Municipal SOEs. Poverty Reduction in (FY 97) SOE Reform * Finance pilot projects to Western Region (FY98) * Increase corporatization of demonstrate key strategies. (FY98) Municipal industrial SOEs. Finance Municipal SOE (FY98) Reform I (FY99) Public Expenditure Review (FY97) * Continue structural * Stabilize govermment * NLS to advise on public reforms of the public revenues as a ratio of GDP expenditure, revenue mobilization Revenue fmiance system. by end FY 97. Increase and municipal finance. Mobilization revenue to GDP ratio by (FY 98) end 2000 * Ongoing Fiscal Technical Assistance Project (FY95) is Provincial implementing the national tax Expenditure administration, helping develop a Review FY99 central-provincial grants scheme and improving China's public Civil Services. investment process. Reform FY99  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Government Progress Benchmarks Bank Group Strategy Instruments Objectives Strategy/Actions T (Fisc l Years 97-99) IBRD/tDA NLS IFC/MIGA Lower tariffs and non- * Improve management of * Provide advice through NLS. Industrial and tariff barriers . extra-budgetary funds in Trade Policy line with State Council Review FY98 circular of July 1996. * More equitable intergovernmental fiscal arrangements put in place. * Improve the legal * Progress in key economic * Assistance with implementation framework and strengthen legislation, including of the Economic Law Reform implementation.. securities law, bankruptcy Project (FY95). law, implementation of company law, banking law and central banking law. IL Alleviate * Development of improved * Establishment of detailed * IFC to attract more private Transport Inland Water- Meizhouwan Infrastructure legal and regulatory legal and regulatory participation in infrastructure Hunan Guangdong ways (FY 97) Power Constraints frameworks appropriate framework based on the through demonstration projects. Hwy (FY97) for a socialist market new Electricity Law. Municipal With Bank economy. Xinjiang Highway 11 Finance Study Group, (FY97) (FY 98) technical assistance on. * Increase supply of * Restructuring plan of the * Ensure that expansion of Nat'l Hwy Im Elubei Conference on legal and infrastructure within an power industry submitted infrastructure capacity proceeds (FY98) Promoting the regulatory enviromnentally to the NPC for approval. on an environmentally Use of framework for sustainable context: * National roads system to be sustainable basis (especially Railways Vm (FY98) Domestic BOT projects. * Power - add generation expanded by 130,000 km telecoms, gas & electricity). Capital capacity of 17-20 giga- by 1999 (total 1.25 million * Support thirteen infrastructure National Hwy IV Markets for watts per year, requires kim). operations to include six power (FY99) Infrastructure investment of about S 15- projects, one railway, five Financing 20 billion per year. highways, and one waterway. Inland Waterways 11 (FY97) (FY99) * Roads - develop national * Revising Railways Law to * Support new infrastructure Tn-Provinces Hwy hIfrastructure highways system. allow separation of state financing mechanisms (through (FY99) Management oA * Railways Improve and enterprise functions BOT schemes, partial guarantees, and Financing e capacity of railways and and permit restructuring of cofmancing and syndication) to Energy (FY98) _ inland waterways system. railway enterprise. facilitate increased private sector Shanghai Waig I______________ _ _investment. Thermal (FY97)  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Government Progress Benchmarks Bank Group Strategy Instruments Objectives Strat eActions (Fisca l Years 97-99) o .________ _ _ IBRD/IDA NLS IFC/MIGA _ * Water SuMply - Improve Tuoketuo Power domestic water supply (FY97) and sanitation systems Energy Conservation (FY98) * Mobilize investment * Average power tariffs funds by enacting price approach LRMC country- Hunan Power Dev. reforms and user fees to wide but especially in the (FY98) increase retained earnings coastal provinces. of infrastructure * Adjust railway tariff to Jiangsu Power (FY98) companies. approach cost recovery Thermal (FY99) * Development of a * Implementation of SPC's * Pilot of BOT component in a framework for private pilot BOT projects. Bank-supported infrastructure Other participation in * Issuance of BOT decrees. project. Container Trade infrastructure. * IFC to promote demonstration Project (FY 99) projects. * Diversify internal sources * Elimination of the Credit * Disseminate Bank Group of financing using Plan by 1999. analysis and findings on ways to domestic capital markets. * Promote the use of support domestic capital markets domestic capital markets and financial sector development. for infrastructure financing especially the bond market. IIL Promote * The 8-7 national plan to * Increase poverty spending * Target the absolute poor through a IDA: Qinba Inequality and Human eliminate poverty by the to 15 bn RNIM in 9th Five series of investment projects. Mountains Poverty Income Development Year 2000 by raising per Year Plan period. Poverty projects implemented in (FY97) Distribution capita income in poor tandem with health and education (FY97) A. Alleviate Poverty counties through a targeted * Higher rate of completion projects. Nat'l Rural Water intervention program. of 6 years education for * Ongoing and future Poverty Supply 11 (FY97) rural poor. projects include labor mobility Inequality 11 components targeting the absolute Poverty l (FY99) (FY99) _ _ _ _ _ _ ___ poor. * Fund the development of applied agricultural technologies in upland areas. * Increase resettlement rate of the absolute poor in urban and peri-urban areas.  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Government Progress Benchmarks Bank Group Strategy Instruments Objectives Strategy/Actions (Fisc, Years 97-99) IBRD/IDA NLS IFC/MIGA B. Education. * Improve access to | Progress towards meeting * Ongoing and planned Bank IDA: Basic Education education in poor and | government goal for operations to target girls and IV (FY97) minority areas. education spending (4% of minority enrollment. GDP by the year 2000). * Achieve universal basic IDA: Basic Education education (grades 1- 9) by IV (FY97) the Year 2000. * Ensure that access to * Develop special programs * Support sustainable student- IDA: Basic Education education is equitable. to increase enrollment of assistance program in poor V (FY99) girls and minorities. counties. * Operational scholarship * Support for scholarship fund system that includes target targeting poor students included funds for poor and rural in planned higher education students. project. * Raise the quality of * National curriculum educational inputs revised. * Measurable rise in pupil learning achievement. * Decentralize the financing * Establishment of a and administration of the provincial education education system. financing formula. * Make the educational * Increased placement % of * Implementation of vocational IDA: Voc. Education II system more responsive to graduates in appropriate education project. (FY97) a changing labor market. positions. C. Health * Meet the basic health * Continued emphasis on * Main focus of Bank operations in IDA: Basic Health Child Health needs of the rural poor. special programs for the IDA-1 I period continues to be Services Vm (FY98) and poor. targeted interventions in poor Development areas with priority on maternal Mat. Health and Child (FY98) CD and child health and other disease Development (MCH - prevention activities. 11) (FY99)  China Country Assistance Strategy: Country Program Matrix (FY 97-99) ..00 Development Government Progress Benchmarks Bank Group Strategy Instruments o Objectives Strategy/Actions (Fisca l Years 97-99) IBRD/IDA NLS IFCIMIGA _ * Regain momentum in the * Increase resource allocation * Design and implement disease fight against for disease prevention. prevention projects, including: (a) communicable diseases. prevention and control of * Prevent the spread of non- * Introduce new health communicable diseases in poor communicable and chronic promotion strategy and areas; and (b) adoption of multi- diseases. programs. sectoral approaches to prevent and control non-communicable diseases and sexually-transmitted diseases and Human Immune- deficiency Virus (HIV) in high- risk areas. * Reform the health finance * Institute co-payment * Disseminate health finance study. IDA: Basic Health system. scheme in pilot areas. Pilot interventions to Services (Health VIll) operationalize the study. (FY98) D. Strengthen the * Reforms in social * Assistance with implementation Housing social safety net. insurance (pension, of the enterprise housing and Reforms unemployment,) and in social security project. (FY99) housing. * NLS to provide advice. Dissemination of findings of Pension Reform study. IV. Promote * Protect agricultural land * Increase in the number of * Projects which promote continued Sustainable Coastal Grain Ningbo Taihan Apricultural and upgrade marginal land provinces instituting coastal development of sustainable Dev. (FY98) Marketing Mushroom Development and water resources. zone management. Increase techniques to upgrade marginal (FY97) Farm (Pipeline and the Rural in % of forest cover. land. IDA: Poverty Project Economy Reduction in W. Symposium on Region (FY98) Food Security Huaxin Turtle (FY 98) Breeding and IDA: Tarim Basin 11 Processing Co. * Invest in water transfer, * Reduced water and * Incorporate major water storage, (FY98) (blend) . (Pipeline storage and irigation fertilizer use per hectare in transfer, irrigation, drainage and Fruit & Project) grain production in northern flood control schemes into future Wanjiazhai Water Vegetable China. projects. Transfer (FY97) Mktg (FY98) * Improve efficiency of grain * Reduced marketing margin. * Assist in implementation of Grain distribution. Distribution Project (FY93). , Heilongjiang ADP Food Security * Increased proportion of * Use NLS to advise the gov't on (FY97) (FY 97) grain sales at "market" establishing a food security policy prices. that balances food security Tarim Basin ll (blend) concerns & efficient agricultural (FY98) resource use.  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Government Progress Benchmarks Bank Group Strategy Instruments Objectives Strategy/Actions (Fisca Years 97-99) IBRD/IDA NLS IFC/MIGA * Reduced fiscal subsidies for Xiaolangdi 11 (FY98) Northeast grain. Domestic grain price Water close to international price Animal Husbandry Resources (FY99) (FY99) Tarim Basin 11 (FY98) Agriculture Policy Review State Farms (FY 99) Commercialization .__________________ (F Y 97) ._________FY 97 V. Safeguard the * Prevention and control of . Reduced deterioration rate * Bank strategy focused on urban Guangzhou City Environment Environment industrial pollution is in water and air pollution environment problems. River Center Transport in the 21st focus of environmental basin pollution control is a new (FY98) / Century protection efforts. focus area. (FY97) Shandong Environment (FY97) * Intensify building of . Work with municipal and Guangxi Urban. Dev. Industrial China's environmental provincial authorities to develop and Environment Pollution legal system. more effective enforcement of blend) (FY98) Control environmental regulation (FY98) * Inprove use of economic . Increase excise tax on * Advice through NlS and TA on Huai Ile River Energy and the incentives (effluent fees major pollutants. Increased pollution control Pollution Control I Environment and fines) and collection rate for pollution (FY98) (FY 98) environmental taxes. levy fees. Beijing Environment Environmental 11 (FY98) Strategy Update (FY99) * Completion of national * Inprove level and structure Forestry Industries vehicle pollution control of user charges for (FY99) action plan. environmental services in > non-Bank projects . 0-C  China Country Assistance Strategy: Country Program Matrix (FY 97-99) Development Goveent nt Progress Benchmarks Bank Group Strategy Instruments Objectives Strategy/Actions . (Fisc I Years 97-99) i _ IBRDIIDA NLS IFCIMIGA o _ * Increasingly use tariffs to Sichuan Urbanr finance public waste Environment control and treatment. (FY 99) * In rural areas, government * Bank operations to support Liaoning Urban interventions (both policy sustainable development and Transport (FY99) based and through management of forest resources. physical investments) in Improve land use on degraded and Huai He River soil, water, forestry and marginal soils. Development of Pollution 11 (FY99) the expansion of protected new watershed protection areas. methods. Hebei Water Supply and Envir.(FY99) * Efforts to involve the public in the enforcement Urban Development I of environmental (FY99) ________________ regulations.  ANNEX 1 Page 1 of 1 China - Selected Indicators of Bank Portfolio Performance and Management Indicator FY94 FY95 FY96 FY97* Portfolio Performance Number of projects under implementation 103 107 109 102 Average implementation period (years)a 3.8 3.8 3.7 4.3 Percent of problem projects rated U or HUb (for past years, rated 3 or 4) Development objectivesc 1.9 1.9 1.8 2.0 Implementation progress (or overall 9.7 3.7 3.7 3.0 status for past years)d CanceledduringFYinUS$m 13.0 159.5 43.6 7.8 Disbursement ratio (%)e 24.8 24.7 22.4 23 Disbursement lag (%)' 11.7 10.5 11.0 15.3 Memorandum item: % completed projects 3.7 2.3 3.9 3.9 rated unsatisfactory by OED' Portfolio Management Supervision resources (total US$ thousands) 4583 5002 6144 6380 Average supervision (US$ thousands/project) 44 47 56 55 Supervision resources by location (in %) Percent headquarters 53 70 66. 59 Percent resident mission 47 30 34 41 Supervision resources by rating category (US$ thousands/project) Projects rated HS or S 37 44 52 54 Projects rated U or HU 112 105 161 74 h Memorandum item: date of last/next CPPR Feb-96 a. Average age of projects in the Bank's country portfolio. b. Rating scale: "HS" denotes "Highly Satisfactory", "S" denotes "Satisfactory", "U" denotes "Unsatisfactorv", and "HU" denotes "Highly Unsatisfactory". c. Extent to which the project will meet its development objectives. d. Assessment of overall performance of the project based on the ratings given to individual aspects of project implementation (e.g., management, availability of funds, compliance with legal covenants) and to development objectives. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: investment projects only. f For all projects comprising the Bank's country portfolio, the percentage difference between actual cumulative disbursements and the cumulative disbursement estimates as given in the "Original SAR/PR Forecast" or, if the loan amounts have been modified, in the "Revised Forecast." The country portfolio disbursement lag is effectively the weighted average of disbursement lags for projects comprising the Bank's country portfolio, where the weights used are the respective project shares in the total cumulative disbursement estimates. g. OED data, available in the statistical appendix to the most recent ARPP reports. h. Average planned supervision budgets for problem projects appear lower than in previous years. In the last two years, supervision inputs for one very complex, multiprovincial project drove up the per project average. Difficulties with that project are now close to resolution. * Planned for FY97, otherwise, actual as of 11/25/96.  ANNEX 2 Page 1 of 2 China - Bank Group Fact Sheet FY 1994-2000 IBRDAIDA Lending Program, FY 1994-2000 Past Current Planneda Category FY94 FY95 FY96 FY97 FY98 FY99 FY00 Commitments (US$m) 3070.0 2999.5 2970.0 2920.0 2865.0 2600.0 2700.0 Sector (%)b Macroeconomic & Structural Reform of which: Financial Sector 0.0 12.5 0.( 0.0 20.2 0.8 10.1 SOE Reform 0.0 2.0 0.0 (.0 7.0 1.9 5.0 Infrastructure of which: Transport 16.9 25.3 22.9 24.0 19.2 28.1 15.1 Energy 19.7 22.3 28.3 27.4 18.0 11.5 23.1 Other 8.1 0.( 0.0 0.() 0.0 3.9 7.6 Human Development of which: Poverty (.0 (0.0 0. 8.6 7.0 7.7 0.0 Education 0.0 3.3 4.4 3.8 (.0 3.9 2.5 Health 3.6 3.9 3.4 0.0 2.4 1.9 2.5 Agriculture Dev.& Rural Economy 41.5 15,3 16.8 32.4 8.7 3.8 15.1 Environment & Urban Develop. Environment Protection 5.2 3.7 15.8 3.8 7.0 21.1 10.1 Urban Development 4.9 11.7 8.4 0.0 10.5 15.4 8.8 TOTAL 100.0 100.0 1)0.0 100.0 100.0 100.0 100.0 Lending instrument (%) Adjustment loansc Specific investment loans and others 100.0 100.0 100.( 100.( 100.0 100.0 100.0 TOTAL 100.0 100.0 10(.( 100.0 100.0 100.0 100.0 Disbursements (US$m) Adjustment loansc 0.0 0.