China - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 25141 MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE PEOPLE'S REPUBLIC OF CHINA January 22, 2003 China Country Management Unit 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.  CURRENCY EQUIVALENTS (as of October 31, 2002) Currency = Renminbi Currency Unit = Yuan (Y) US$ I 00 Y 8 277 Y I 00 US$ 0 1208 FISCAL YEAR July I - June 30 ABBREVIATIONS AND ACRONYMS AAA - Analytical and Advisory Activities IMF - International Monetary Fund ADB - Asian Development Bank JBIC - Japan Bank for International Cooperation APEC - Asia Pacific Economic Cooperation MIDGs - Millcnnium Development Goals APL - Adaptable Program Loan NMIGA - Multilateral Investment Guarantee Agency AusAID - Australian Agency for International MOF - Ministry of Finance Development MOFTEC - Ministry of Foreign Trade and Economic CAE - Country Assistance Evaluation Cooperation CAS - Country Assistance Strategy NGO - Non-Government Organization CCICED - China Council for International NPL - Non-Performing Loan Cooperation on Environment and ODS - Ozone-Depleting Substances Development OED - Operations Evaluation Dcpartmenit CDF - Comprehensive Development Framework PBC - People's Bank of China CPDF - China Project Development Facility PPP - Purchasing Power Parity DFID - Dcpartment for International QAG - Quality Assurance Group Development (United Kingdom) RAINS - Regional Air Pollution Information and ESW - Economic and Sector Work Simulation EU - European Union SDPC - State Development Planning Commission FDI - Foreign Direct Investment SME - Small and Medium Enterprise FY - Fiscal Year SOE - State-owned Enterprise GDP - Gross Domestic Product SSIF - Sichuan SME Investment Fund GDLN - Global Development Learning Network TA - Technical Assistance GEF - Global Environment Facility TVE - Township and Village Entcrprise IBRD - International Bank for Reconstruction and UNDP - United Nations Development Programme Development ICT - Infonmation and Communication UNEP - United Nations Environment Programmuie Technology IDA - International Development Association WBI - World Bank Institute IFC - Intemational Finance Corporation WTO - World Trade Organization IBRD IFC Vice President: Jemalud-din Kassum, EAP Assaad J. Jabre, CIOVP Country Director: Yukon Huang, EACCF Javed Hamid, CEAHK Task Team Leader: Akihiko Nishio, EACCQ Stoyan Tenev, CEADR  PEOPLE'S REPUBLIC OF CHINA COUNTRY ASSISTANCE STRATEGY Fiscal Years 2003-05 TABLE OF CONTENTS Page No. EXECUTIVE SUMMARY . . 1. COUNTRY CONTEXT .................... . .............. .............................. I A. Overview. I B. Macroeconomic Management .1 C. Structural Reform ............................. ............... 3 D. Poverty and Inequality ............................. . 6 E. Economic Outlook and External Environment. 8 2. THE GOVERNMENT'S PRIORITIES .......10..................... ................. 10 3. PROGRESS DURING THE LAST CAS PERIOD AND LESSONS LEARNED . 14 A. Objectives of the Last CAS ........... . ........................................................ 14 B. Major Developments Since the Last CAS .14 C. QAG and OED Assessment. 19 D. Client Survey and Feedback from Consultations ............ .................... .......... 20 4. THEMATIC FRAMEWORK FOR THE BANK GROUP'S ASSISTANCE PROGRAM ...................................................... ...... 22 A. Developing Themes for a Changing Situation .22 B. Improving the Business Environment and Developing the Market Economy .23 C. Addressing Needs of the Poorer/Disadvantaged People and Lagging Regions .25 D. Facilitating an Environmentally Sustainable Development Process ... ................ 28 5. THE BANK GROUP ASSISTANCE PROGRAM . .30 A. Knowledge Agenda/AAA Program ....................... ........ ........... ........ 30 B. Lending Program: Levels, Focus and Selectivity ....... ................................... 32 C. Exposure .37 D. Portfolio Management ................. ......... 38 E. Safeguard Policies .39 F. Partnerships .40 G. Risks .............................................. ............... ... 42 H. Creditworthiness ............. ............................. 44 I. IFC and MIGA Programs ................................. ................ 45 J. Managing for Development Results .............. ................... ...................... 46  ANNEXES A 1: Key Economic and Program Indicators - Change From Last CAS A2: China at a Glance B 1: Progress Made in Achieving Goals of Previous China Country Assistance Strategy (1997) B2: Selected Indicators of Bank Portfolio Performance and Management B3: FY03-05 Lending Program B4: The Knowledge Agenda, FY03-05 B5: Social Indicators B6: Key Economic Indicators B7: Key Exposure Indicators B8: IBRD Medium-tenr Exposure Projections B9(a): Operations Portfolio (IBRD/IDA and Grants) B9(b): Statement of IFC's Held and Disbursed Portfolio BlO: Country Program Matrix (FY03-05) C: Summary of Consultation Results D: The Bank Group Assistance Program E: Global Goals and Corporate Priorities F: Private Sector Development Strategy G: World Bank Support for Good Developmental Governance H: Sumnmary of China Country Gender Review I. Improving the Quality and Client Responsiveness of Core Project Services: Financial Management and Procurement J: Overview of Ongoing External Assistance to China TEXT TABLES Table 1 1: Macroeconomic Indicators ................... ................................. ...... 2 Table 1.2: Key Economic Performance Indicators .. 9 Table 3.1: Operational Performance Indicators .. 14 Table 3.2: IFC Program in China: Approvals 1997-2002 ..18 Table 5 1: The Bank's Evolving Objectives and Instruments: The Case of Energy .. 35 Table 5.2: Key Debt Indicators, 1997-2001 ...................................... ...... 45 TEXT BOXES Box 1.1: Recent Structural Reforms.. 4 Box 1.2: Summary of China's Progress with Respect to the Millennium Development Goals ...... .......... .................................... 8 Box 2.1: Main Features of the Tenth Five-Year Plan (2001-2005) . .10 Box 2.2: Establishing a Framework for Good Developmental Governance . . 12 Box 3.1: Examples of Recent Bank Group Support for Innovation and Change in Chm a ............................................... ................... 19 Box 4.1: Thematic Framework for the CAS ......... .............. .............................. 23 Box 4.2: World Bank Support for Improving China's Financial System . .25 Box 4.3: Helping China's Rural Poor ..27 Box 5.1: Sub-national Development Issues - An Important Area of Bank Involvement .. . 31  Box 5.2: Examples of Support for Innovation and Change ........... ........................... 36 Box 5.3: Blending of DFID Grant and IBRD Loan: Partnership in Action ....... ............ 41 Box 5.4: China's Development Model and How It Compares with CDF ....... ............ 42 TEXT FIGURES Figure 1.1: Headline Economic Indicators (1996-2001) ........... ............................. 2 Figure 1.2: Number of Poor in Rural Areas, 1987-1999 ............ ............................. 7 Figure 3.1: IBRD and IDA Commitments to China, FY93-02 .. . ............................... 15 Figure 3.2: Portfolio Quality ............... ....... ................................................. 16 Figure 4.1: Environmental Issues and Bank Support ................... ....... .............. 29 Figure 5.1: Geographic Focus of Lending . . ........................... .......... ................ 33 Figure 5.2: Lending - Sectoral Composition ....................... ...... . .................. ... 34 Figure 5.3: Bank Operations by CAS Theme ...................................................... 37  CHINA: COUNTRY ASSISTANCE STRATEGY Executive Summary Background i. This is the first Country Assistance Strategy (CAS) for China smce it ceased borrowing on concessional terms from the International Development Association (IDA). The country context now is very different from that of the previous CAS in 1997 and the Progress Report in 1998. In particular, the new CAS coincides with: a shift in China's reforms, from the liberalization phase to the more difficult structural and institution building phase, dynamic growth of the private sector; and a continuing need but reduced availability of concessional external financmg. The CAS also reflects the changing nature of the China-World Bank Group relationship, in particular: the potential gains to both sides, with China positioned not only to receive Bank assistance, but also to share lessons of its development experiences more broadly and contribute to thmiking on global development issues of common concern; the growing importance of the Bank's advisory services; the more active role that the International Finance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA) will play, and the recognition of benefits that Bank partnerships with other donors, the private sector and civil society can have. Recent Developments ii. Since the last CAS, China has managed macroeconomic conditions well. It has relied on stimulatory macroeconomic policies and a stable exchange rate to sustain domestic demand and activity and support structural reforms. Economic performance during 1997-2001 was among the best in the world, with annual GDP growth averaging 7-8 percent, and a much strengthened external position At the same time, considerable progress has been made against a broad structural refonn agenda and with respect to the Millennium Development Goals (MDGs) This is remarkable given the depth of the East Asian financial crisis, as well as the dislocations caused in the domestic economy as a result of the policy initiatives implemented during this period, most notably in the enterprise and rural sectors. Chma 's accession to the World Trade Organization (WTO), achieved in 2001, is providing major impetus to continued reforms. Developnment Challenges Facing China iii. Despite the impressive growth, sound macroeconomic policies and large cushion of domestic savings and international reserves, China needs to address the challenges of strengthening its medium- term financial position. Government debt increased; contingent liabilities are also large, mainly as a result of non-performing loans in the banking system, under- funded pensions, and enterprise arrears. Equally, there is need to build on recent reforms to strengthen the fiscal position, especially sub-national finance, and reshape institutions and the business environment in order to address key aspects of China's national development agenda. iv. Despite substantial progress on poverty reduction over the last decade, more than 200 million people m China still live on expenditures of less than US$1 a day (34 million in 1999  11 using the official US$0.67 poverty line). They account for about 18 percent of the globalpoor and are found mostly in rural areas of the lagging inland provinces. Trends in inequality and social indicators suggest that disparities have widened in recent years, between urban and rural areas and also between coastal and inland areas. While China is on track to achieve the MDGs, barriers such as unequal access to health and education are still formidable challenges. Government's Priorities v. The Govermnent's development strategy, as crystallized in its Tenth Five-Year Plan (2001-2005) and reaffirmed in the recent 16th National Congress of the Communist Party, identified as a national goal the achievement of a "well-off society." While GDP is expected to quadruple during 2000-2020, the concept of China's development that is embraced goes well beyond increases in income to stress the quality of such growth and the importance of all-round social progress. Environmental sustainability and the application of modern science and technology, especially information and communication technology (ICT) to raise productivity and generate greater benefits are the cornerstones of the strategy. Entrepreneurship, an increased role for private investment, closer integration with the world economy, and an improwed legal system and stronger protection of property rights have been emphasized. The increased flexibility of resource movements, a continued emphasis on human resource development, active measures to narrow social disparities - especially rural-urban and regional gaps, and better management of the rural urban transition are identified in recent policy statements as key areas of concentration. The Govermnent has stressed poverty reduction, sustainable development of its lagging western region, and informatization as strategic priorities, and for each established a "leading group" with coordination responsibilities that cut across the mandates of individual agencies. After downsizmg the central government administrationdrastically in 1998, the Government has been strengthening governance of the public sector. In particular, it has been fighting corruption aggressively and transforming the function of government from direct involvement in commercial activities to strategic guidance and economic regulation, market supervision, social protection and public service. Developments and Lessons Learned Since the Last CAS in 1997 vi. Operationally, lending declined sharply during this period, due largely to concerns about exposure of the International Bank for Reconstruction and Development (IBRD) to China - since the IBRD single-country concentration limit was being approached - the increased financial cost and preparation requirements of IBRD loans, and the availability of domestic low- interest credit that was provided as part of the Government's stimulus package. However, the Bank's portfolio has remained strong and even improved, while demand for the Bank's Analytical and Advisory Activities (AAA) shifted towards more challenging issues - exemplified by deep-rooted structural problems related to globalization, governance, poverty and sustainable development. Greater emphasis has also been given in AAA to "rapid response" policy notes, and less to the more traditional, comprehensive reports. Institutionally, the Bank's decentralization initiative has made it easier to serve its client, but the complexities in dealing with the Bank's matrix structure along with the application of its environmental and social safeguard policies have been recurnng issues.  vii. The Bank's Quality Assurance Group (QAG) and the Operations Evaluation Department (OED) have recently carried out various assessments of Bank-supported activities, including reviews of operations for poverty reduction, forestry, environment, involuntary resettlement related to river basin development, energy development, and transport. These evaluations found strategies to be well directed generally and projects that either in whole or in part set the standard for best practice; they also provided valuable feedback on areas to improve. The OED is now carrying out a Country Assistance Evaluation for China, due to be completed in early FY04 Vill. Since 1997, government officials, project implementing agencies, and representatives of civil society have participated in five formal consultation exercises, and most recently in a broad- based client survey. The private sector has also been extensively consulted by IFC, in particular through a major study of the domestic private sector in China and a Joint Bank/IFC study on enterprise reform and corporate governance. Overall, the views voiced during these consultations have been consistent over time. The Bank's assistance to China has been appreciated, in particular the transferring of knowledge and new ideas through both lending and AAA, while concerns have been raised about the cost of doing business with the Bank and the need to streamline procedures. Thle World Bank Group's Assistanice Progranm ix. Under the overarching theme of supporting China in makmg two historic transitions - from a rural, agricultural society to an urban, industrial society, and from a centrally-planned economy to a more globally integrated market-based economy - the Bank Group's assistance strategy is designed to help China: (a) impr-ove the business environment and help accelerate the transition to a market economy, mostly through an array of knowledge transfer activities; (b) address the needs of the poorer and disadvantagedpeople and lagging regions, through mvestment lending in rural development, infrastructure and social sectors, as well as AAA and training; and (c) facilitate an environmentally sustainable development process, through investment lending in natural resource management, watershed rehabilitation and wastewater treatment, energy, global environment projects supported by the Global Environment Facility and Montreal Protocol, and policy work. x. Given the increasing emphasis on knowledge in the China-Bank Group relationship, a major Knowledge Agenda is planned to facilitate policy discussions and lay the groundwork for future lending. Its key features can be characterized as being: more demand-driven; reliant on a variety of delivery mechanisms including research; and based on the increasing use of local experts and institutions. Under the broad themes identified above, the Knowledge/AAA Agenda is organized to address some specific development concerns identified by the Government. Adjustment to its accession to the World Trade Organization (WTO) is one such area of work, as is sub-national finance. This involves an assessment of domestic as well as regional/international impacts of the wider opening of the Chinese economy, and the need to restructure financial institutions and promote the private sector Equally, issues related to rural- urban migration, labor market flexibility, social protection, and urbanization are being tackled through this program, supported by capacity-building through World Bank Institute (WBI) courses (including distance learning). An important thread that runs through much of this work  iv is the need to address China's still-substantial poverty and growing inequality, exacerbated by enviromnental problems, in all their dimensions. xi. An annual IBRD lending program of about US$1.2-1.3 billion is envisioned, larger than in the last two years but less than the US$3 billion peak reached in the mid- 1990s. This is subject to completion of ongoing discussions of an exposure management arrangement. Selectivity has been enhanced by focusing more on the disadvantaged regions and the importance attached to promoting innovation and change through Bank operations, including in the coastal provinces. In terms of geographical distribution, three-quarters of the proposed projects will support the poorer, inner provinces, compared with 62 percent dunng the last CAS period. In terms of sectoral composition, transport - with a focus on completing key segments of the national and provincial highway system and linking the lagging regions - and urban projects focused on environmental mitigation (water, sanitation and air pollution) remain the two largest sectors, accounting for 34 percent and 24 percent of the FY02-04 lending program, respectively. Lending for social sectors including free-standing techmcal assistance accounts for 14 percent, facilitated by blending arrangements supported by the United Kmgdom's Department for International Development (DFID) and potentially by other external partners. Rural development - supporting both poverty reduction and natural resource management objectives - accounts for about a fifth of expected lending. Energy - focusing on raising efficiency and on renewable energy - accounts for less than 10 percent. xii. Support for innovation and change is a major feature of Bank operations. For mstance, the proposed projects would introduce more programmatic and pilot operations, strengthen links to private sector financing, push urban lending down to secondary and smaller cities under an intra-provincial framework, move further toward an inter- modal approach to transport needs within a province and down to local levels, support non-traditional and smaller-scale energy projects, and deepen the focus on social service needs in poor areas. xiii. Over the past two to three years, the Bank has deepened its collaboration with other partners to share knowledge and enhance results. Most notable is the tripartite partnership with the Government and DFID - its cornerstone is the "blending" of DFID grants with IBRD loans to provide concessionary finding for social sector and poverty reduction projects in the post-IDA period, while tapping different types of expertise to enhance the quality of operations. Other important examples are the first formal Bank-European Union (EU) cofinanced project in Asia for natural forest management and AusAID's support for the Bank's Global Development Learning Network (GDLN) activities in one of the poorest western provinces. The ability to attract more concessional finance for China's development will depend upon stronger upstream cooperation by external partners on a complex development agenda as well as on innovative mechanisms that help surmount local financing difficulties. Collaboration has also been increased with the UN agencies - for poverty- related work and in the health sector especially - and with the International Monetary Fund on fiscal reforms. With the greater field presence of the Asian Development Bank, more efforts have been made to align sectoral approaches and hannonize institutional procedures and policies with those of the client xiv. IFC's strategic priorities during the CAS period include: targeted technical assistance to improve the business environment, particularly for financial markets, private participation in  v infrastructure and small and medium enterprises (SMEs); SME capacity building and development of alternative sources for SME financing; the financial sector development by supporting private banking and non-bank financial institutions; private sector development in China's western and interior provinces; enterprise restructuring; and expanding the presence of private enterprises in infrastructure, social services, and envirom-nental technology sectors. The focus will be on model transactions that set standards in corporate governance, international accounting, environmental technologies and practices, and efficiency of private enterprise operations, with the aim of creating demonstration effects and helping Chinese companies become internationally competitive players. MIGA's activities are intended to generally complement the Bank Group's strengthened emphasis on sub-national capacities in China, while addressing the interest in guarantees and investment marketing ansing out of China's post-WTO opening. Risks xv. While China's current financial situation remains strong, the medium- tenn fiscal position needs strengthening, mostly due to risks from contingent liabilities. However, in assessing the overall macroeconomic/financial risk for China, the following factors should also be considered: (a) the Government's track record in economic management; (b) on the domestic front, China's impressive growth momentum and its predominant reliance on domestic savings for financing; and (c) on the external front, its remarkable trade performance, the restricted convertibility of the currency on capital account, and its strong external reserves position in relation to overall public indebtedness. As for country risks, the main source would be the economic dislocations that are likely to follow closer global integration in the wake of accession to the WTO. To manage these risks, the Government would need to deal proactively in handling post-WTO accession adjustments, especially in the lagging regions, while continuing to address the longer-term problems of poverty, inequality and urban labor displacement.  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR CHINA 1. COUNTRY CONTEXT A. OVERVIEW 1. The progress of China over the past two decades is as remarkable as the complexity of the development challenges it faces. So far, it has managed the transition from a centrally- planned to a market-based economy better than most other transition countries. Officially- reported per capita income has increased at an annual average rate of almost 9 percent over the past two decades, reaching US$890 last year. In 2000, China entered the ranks of lower middle- income developing countnes. During the period since the start of economic liberalization in the late 1970s, over 250 million people have been lifted out of poverty. Clearly, framed against international development experience, both its anti-poverty and growth perfonnance are impressive. In this sense, drawing on its know-how, China has much to offer the developing world. 2. But the size of its population (1.27 billion in 2001) and economy, and its vast geographical area (third-largest in the world), expose China to the entire range of development problems confronting large countries These problems are complicated by inadequate human capital formation, a severely degraded natural resource base, and a still-high incidence of poverty. Further, China's rapid economic development is occurring in the midst of major systemic transformations - from central planning to markets, from an agrarian to a manufacturing/services based economy, and from being relatively closed to fast-paced globalization. A decentralized administrative and economic setting makes the management of this complex economic transition even more difficult. 3. There are no simple answers to China's development challenges, but China's success will bring not just national benefits, it will also generate regional and global payoffs. Understanding and helping to address such challenges constitute the core of the Bank Group's country assistance strategy. B. MACROECONOMIC MANAGEMENT 4. Since the last full CAS in 1997, China has managed macroeconomic conditions well. It has relied on stimulatory macroeconomic policies and a stable exchange rate to sustain domestic demand and support continued structural reforms. Despite the debate on reported statistics in tracking China's economy, it is clear that these policies, combined with foreign investment inflows, have delivered strong economic results Economic perfonnance since 1997 has been among the best in the world, especially considering the structural policy and institutional reform program implemented during this period. Specifically, enterprise reform initiatives, increased import competition, and a policy- induced "soft- landing" after 1995 resulted  - 2 - in major structural adjustments in the Chinese economy. It is estimated that nearly 26 million (or one in five workers) in state-owned enterprises (SOEs) lost their jobs during Figure 1.1: Headline Indicators (1996-2001) 1998 to mid-2002 (in addition to a 12 250 smaller number of non-SOE layoffs) - of 10 200 which some 17 million have since found 8 W employment. The pace of job-creation 6150 outside farming fell well below the 2.4 -w. 4 - percent rate considered necessary to o 2x - 100X absorb the 8-9 million people who seek o 50 new jobs each year. Moreover, the _ persistence of excess production -2 0 capacity and deflationary pressure 1996 1997 1998 1999 2000 2001 throughout this period suggests that the IGDP r 'CPI -FX reserves macroeconomic effects of structural transitions are still to run their course (Figure 1.1). 5. Nevertheless, neither during the Asian crisis (1997-98) nor in the more recent global slowdown (2000-present) has the Chinese economy suffered from as severe a downturn as its neighbors, or other developing countries. Over this period, GDP growth averaged 7-8 percent annually. Despite strong export growth, the contribution of net external demand (exports less irnports) to economic growth turned negative after 1999. However, consumption and investment demand were supported by a combination of fiscal, quasi fiscal, and monetary policy, aided by the domestic spending resulting from foreign direct investment (Table 1.1). While government revenue rose from 12.1 percent of GDP in 1997 to 17.2 percent in 2001, the government budget deficit increased from 1.8 percent of GDP to 4 percent in 1999, before falling slightly to 3.2 percent in 2001. Governnent expenditure, as a share of GDP, increased by 6.5 percentage points over a fbur-year period. Over the same period, government debt rose from 11.4 percent of GDP to 23.8 percent. Table 1.1: Macroeconomic Indicators | 1996 1997 1998 1999 2000 2001 Growth (% per year) ___IT1 __ GDPgrowth 96 88 78 7.1 80 73 Consumer price index 8 3 2 8 -0 8 -1.4 04 0 7 Non-agricultural employment 2 9 1 6 0 6 1 0 1.9 2 2 Shares (% of GDP) I I Domestic savings 42 43 42 41 39 40 Budget balance -I 6 -1 8 -3.0 -4 0 -3 6 -3 2 External current account balance 0 9 4 2 3 4 2 1 1 9 1 5 Total government debt 11 4 17 8 20 9 22 8 23 8 Levels (US$ billion) _ Net FDI inflow 38 1 417 411 37 0 37 5 37 4 Stock of intcrnational reserves 105 140 145 155 166 212 Stock of external debt a/ 129 147 144 152 146 170 Ofwhich Short-term debt 25 31 17 15 13 51 Source World Bank and IMF staff estimates and official data a/ Coverage was cxpanded in 2001 to include categories excluded earlier, especially short-tenm debt, which is now shown on a remaining, rather than onginal, maturity basis  - 3 - 6. Macroeconomic growth has been sustained, but the medium-term financial position needs to be strengthened Not only has recorded govermment debt increased, but contingent liabilities, too, have risen as a result of non-performing loans in the banking system, under- funded pensions, enterprise arrears and other liabilities. Under various assumptions, total public debt could account for a very large proportion of GDP (see Risks: Section 5-G). Despite the rise in govemment debt, China retains a number of cushions to withstand extemnal economic shocks. The external current account surplus has narrowed, reflecting the slower growth of world export markets and a surge in imports as both domestically-owned and foreign- invested finms retooled for the period following accession to the World Trade Organization (WTO), but export potential is good. After rising in 1997-98, external debt - both total and short tenr - had fallen by 2000; by end-2001, it was 14.7 percent of GDP (definitional changes do not penmt a comparison between 2001 and earlier years). The stock of international reserves has doubled from the end- 1996 level, and is 25 percent larger than external debt and more than 9 months of imports. This is an exceptionally high level of reserves for a developing country. There has also been a rapid growth of onshore foreign currency deposits in China's commercial banks which has enlarged the pool of resources available to the economy. China contmues to be the largest developing country destination for direct investment, with annual gross commitment levels of over US$45 billion. The effective exchange rate has been relatively stable. 7. Nevertheless, China's sub-national governments, banks, enterprises and pension funds cannot simply "grow out" of their current problems; sustained structural and institutional reforms are needed. It is likely that their funding gaps are larger today than m 1997 which, even with rising govemment revenues, may reduce the resources available for meeting other development needs and facing economic contingencies. Concerns about these problems existed even before the start of this round of macroeconomic stimulus, but the recent increase in govemment spending has deepened such concerns and stimulated calls for fiscal consolidation and a reappraisal of the efficiency of govermment expenditures. C. STRUCTURAL REFORM 8. The pace of policy and institutional reform accelerated in the mid-1990s, magnifying difficulties while improving longer-term prospects. Following successful liberalization measures in the 1 980s, a second generation of refonns was initiated in the mid- 1 990s to address structural constraints on productivity-based growth that were inherited from the central planning era. Simultaneously, the arduous process began of repositioning the public sector to meet the requirements of an increasingly complex, market-based, and globalizing economy. Central to the refonrn program was the nexus of issues linking govenmment revenue and expenditure, social protection, enterprise performance, and financial stability (Box 1.1).  - 4 - Box 1.1: Recent Structural Reforms Tlhe Challenge - a Gordian Knot. The 1979 reforms eliminated some major economic dis tortions and boosted incentives for production, mainly in rural areas By the mid-1990s it became obvious that at the core of China's development challenge was a rigid production structure sustained by increasing budgetary and banking subsidies, and protected by sub-national governments in ways that fragmented the domestic market. Declining enterprise profitability, decentralization and tax evasion caused budgetary revenue to collapse from 35 percent of GDP in 1978 to below 12 percent This limited the scope for public action, especially in public services provision and social protection Also, weaknesses in macroeconomic control resulted in unsustainably high output growth and inflation, which masked a deterioration in banking and enterprise solvency and liquidity A Difficult Economic Environment Comiplicatinig Enterprise Reforms. The second-generation reforms initiated in the mid -to-late 1990s focused on restructuring enterprises - raising efficiency, making them market- responsive, preparing them for globalization They occurred in the context of a policy-induced "soft-landing" in the economy, leading to capital and labor redundancy and a rapid dismantling of guaranteed employment and "cradle-to-grave" social policies. Moderate pressure was exerted by import competition and statutory tariffs falling from over 45 percent in 1993 to 12 percent today, which exacerbated the incipient deflationary pressures that still persist Further, the decision to maintain a stable Renminbi during the Asian financial crisis protected regional economies and world financial markets, but at some domestic cost All of these measures highlighted China's position that the best response to economic contingencies is to stay the course with deep and difficult, but gradual, structural reforms to increase the flexibility of its domestic economy on which, ultimately, its economic performance rests Moving on Multiple Fronts. Because of complex inter-linkages China's policy agenda needs to move on several fronts, and to accelerate the pace of reform because of visible problems in some areas, global competitive pressures (since the mid- 1 990s), and the expectations of its citizens The sequence and pace of recent enterprise-financial system reforms illustrates the challenge Viable, market-responsive enterprises require modern corporate structures, supporting regulations and business and physical infrastructure, competitive markets, and diversified sources of finance The Government is working in all of these areas (e g , easing pnvate entry, developing capital markets, rewriting laws, restructuring auditing and accounting standards and institutions) But it recognized that such measures would be ineffective if the financial condition of enterprises did not improve, including the excessive burden of social obligations inherited from the pre-reform past Systems for the provision of housing and social insurance - traditionally provided in China by enterprises - needed to change The Government liberalized the housing market, created a mortgage lending instrument, and promoted the real estate market to tap household savings while addressing housing shortages In 2000, it introduced an improved unemployment insurance scheme and pilot reforms in social insurance to implement the modern pension scheme that had been under discussion since the mid- 1990s, with risk and financial pooling at municipal and higher levels Efforts are also underway to establish more equitable and sustainable health financing schemes Confronting Financial Sector Reform. Although reform of the financial system has moved at a slower pace, largely because soft-budget constraints on firms and quasi-fiscal stimulus through the banking system have been needed to support employment growth since 1998, several measures were implemented These include actions to help banks (through partial re-capitalization and the transfer of non-performing loans to asset management companies), establishing supervisory authorities for the capital market and insurance companies, current account convertibility, use of indirect instruments of monetary control, and greater attention to portfolio quality in banks With WTO accession and expected foreign entry into China's financial market, the country will need an overhaul of institutions and market structure Fiscal reforms have been implemented to repair government revenues, improve expenditure planning and implementation, and strengthen government financial management Recovering revenues at the Central Government level were accompanied by a higher level of fiscal stimulus This included transfers to sub-national governments during the recent economic slowdown, thus supporting employment and growth while other structural reforms work their way through the economy  9. An important change since the last CAS is the growing recognition of the important role that the private sector can play in addressing China's reform and development challenges. Over the past decade, China's economy has undergone a fundamental transformation, from complete reliance on state-owned and collective industrial enterprises to a mixed economy where private industrial enterprises also play a strong role The private sector (non-agricultural) has emerged as the most dynamic component of the Chinese economy in the 1990s and today accounts for about a third of China's GDP. In recent years, new employment in the private sector has exceeded the combined total for state, collective, and township and village enterprises. The 1999 constitutional amendment giving formal recognition to the country's emerging private sector, along with the buildup of foreign direct investment and the reform of SOEs, is setting China's economy on a course of major structural change. 10 Chinese private companies are the most dynamic players in the economy, and in recent years government policies have been aimed at promoting their growth. However, they still face tough challenges in the current busmess environment in terms of entry restnctions, uneven playing field, weak capacities to partner and compete globally, and inadequate access to intermediated financing (see Annex F). There are significant regional disparities regarding private sector development in China, with the interior provinces lagging behind coastal areas. The continued growth of the private sector cannot be taken for granted without continued progress in market refonms to improve the business environment. Recently, the Government has intensified its reform efforts in this area by promulgating laws and regulations to promote small and medium enterprises (SMEs), introducing measures to improve private enterprises' access to financing, and gradually relaxing restrictions to private sector entry in a number of sectors (see Box 1.1). 11. The recent round of structural reforms was implemented under difficult circumstances. Externally, the Asian crisis and more recently the global economic slowdown tempered the pace of change in several areas, particularly the imposition of hard budget constraints on SOEs and higher standards of banking sector perfonnance. Domestically, effects of the soft landing and lagging employment creation influenced the pace and sequence of reforms. Further, concerns about disparities in social indicators and incomes, emerging gaps in social protection and public services, and increasing rural discontent since 1997 due to declining fann pnces and reduced off- farm employment have played a decisive role in tax/spending and policy decisions. 12. These issues must continue to be addressed systematically, as the Government launches a third- generation of refonns to build the institutions needed to sustain a modern market-based economy. Since 2000, the Government has moved broadly to define a new role for itself in the economy, de- monopolizing sectors such as energy and telecommunications, while selling hundreds of SOEs (chiefly at the sub-national level). China's WTO agreement represents the most radical set of proposals to open its economy ever proposed by a new member. The Government has announced its intention to adhere to both the letter and spirit of this and other multilateral agreements. It views such international commitments as a powerful instrument to revitalize structural reform and build a strong, modern, internationally-competitive economy. 13. One area of structural reform needing more attention is sub-national finance. Today, nearly 70 percent of public expenditure takes place at the sub-national level (province, prefecture, country and township/village), and more than 55 percent takes place at sub-provincial  - 6 - levels. In fact, it is the sub-national levels of Government that implement to a large extent the national agenda, but their very heavy expenditure responsib ilities are out of line with international practice and are unsustainable given current revenue assignments. Expenditure assignments at local levels need to be tailored to the revenue that is available. Moreover, the current system of inter- governmental transfers needs to be examined together with the revenue and expenditure assignments. This would help support development priorities more effectively while reducmg the need for ad hoc transfers, which have been growing in recent years. 14. Regional disparities in fiscal spending and service provision are very large by international standards, and have grown rapidly. Fiscal reforms have raised the total tax effort since the mid- 1990s, and a large share of the increase in revenues has been allocated to spending by sub-national governments. Recent measures - such as transferring a high proportion of income tax revenues to sub - national governments - are aimed at strengthening sub - national finances. However, the current program of earmarked transfers is not fully effective in achieving policy objectives, and inadvertently, there can be rigidities in existing social spending that sometimes restnct the ability of sub-national governments to address directly the needs of the poor. Local governments are highly dependent on extra-budgetary revenues, which are not always allocated in ways that support national objectives, and the efficiency of many sub- national expenditures needs to be improved. Ultimately, the ability of the Government to engineer rapid, pro-poor growth, especially in lagging regions, will be determined by its continuing efforts to improve the current system of inter-governmental finance. National and sub- national fiscal issues, considered recently in two detailed studies of central and provincial expenditures, will continue to merit the Bank's attention. D. POVERTY AND INEQUALITY 15. Poverty in China has been a predominately rural issue, although urban poverty is a growing concern. In the first stage of economic liberalization during the 1980s and early 1990s, partial freeing of prices and markets, introduction of individual farming (replacing collectives), and opening to trade and foreign investment resulted in high growth. While rural poverty fell substantially due to increased production, high agricultural prices, and expansion of rural non- farm employment in township and village enterpnses, income inequalities widened as a result of more rapid growth in China's coastal areas. Now, there are signs that, smce the mid- 1990s, falling grain prices and the domestic slowdown that followed the Asian financial crisis have contnbuted to slowing the pace of poverty reduction. By some expenditure measures, the number of poor may even have risen in recent years, while income gaps are high and persistent. 16. Defining poverty either with income of less than US$0.67 a day (the Government 's definition) or less than US$1 a day (international practice), the number of rural poor has declined steadily between 1987 and 1999 (Figure 1.2). The former measure shows that the number of poor people had declined to just 34 million by 1999. Although the number of rural poor with incomes below US$1 a day has also declined (from 129 million to 97 million), the number of poor with expenditures below US$1 a day has increased from 214 million to 235 millionduring 1996- 1999. The detailed poverty data for 2000 and 2001 are still being processed by the statistical authorities, but once all the data are analyzed, it is likely that more recently, China's high overall growth rate is not reducing its poverty as fast as m the 1980s and early 1990s. This does not negate China's impressive past success in poverty reduction but suggests that new approaches  - 7 - that are being piloted currently - combining income diversification with improved targeting and safety nets - need to be scaled up rapidly. Figure 1.2: Number of Poor in Rural Areas (1987-1999) 400 -+--officaal estmated number 350 - of rural poor (in million) c with income of less than