China - Weathering the storm and learning the lessons

Z~~~~~~l LI J\ 1-+,'S ;>-41 C' &7 X~ 1> 3 Ll - "T( i:DCCL 19602 July 1999 0 -' i, f K &KAKt'?Ki A L e. slw K-l 1  A WORLD BANK COUNTRY STUDY China Weathering the Storm and Learning the Lessons The World Bank Washington, D.C.  Copyright ( 1999 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing July 1999 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. 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Library of Congress Cataloging-in-Publication Data has been applied for.  Contents Abstract v Acknowledgments vi Executive Summary 1 PART 1 How CHINA IS WEATHERING THE STORM 1 1 Chapter 1 The Storm Clouds Emerge: Macroeconomic Developments and Policy Response 12 Macroeconomic Trends 12 The Authorities Respond: The 1998 Macroeconomic Policy Package 17 The Economy Responds: Macroeconomic Trends in 1998 19 Challenges for the Future 23 Notes 23 Chapter 2 Reforming China's Enterprise and Financial Sectors 25 Weaknesses in the Enterprise and Financial Sectors 26 Performance and Reform of the Enterprise Sector 27 Reform of the Financial Sector 32 Public Investment Program 33 Notes 36 Chapter 3 Challenges of Labor and Social Protection Magnified by Macroeconomic Shocks 38 Labor Markets 38 External Shocks and the Terms of Trade 39 Public Spending and Fiscal Tradeoffs 41 111  Public Investment Program 43 Notes 43 PART 2 BUILDING ON LESSONS LEARNED 45 Chapter 4 Developing a Macroeconomic Policy That Reflects External and Internal Uncertainties 46 Uncertainties Facing China in 1999 and 2000 46 Managing the Macroeconomic Policy Mix 49 Notes 5 1 Chapter 5 Developing a Pro-growth Strategy for the Enterprise and Financial Sectors 53 Transforming the Enterprise Sector 53 Reforming the Financial System 55 Limiting the Strain on Enterprises 58 Note 59 Chapter 6 Tackling the Social Agenda 60 Maintaining Employment 60 Supporting Consumption and Social Protection through Public Spending Choices 65 Monitoring the Evolving Social Impact 67 Annex. Job Growth Projections, 1998-2000 67 Notes 70 PART 3 STATISTICAL ANNEx 71 References 105 CHINA: WEATHERING THE STORM AND LEARNING THE LESSONS iv  Abstract T he difficulty of dealing with a domestic slow- tribution. It examines the policy options for the future down in China has been compounded by the to deal with economic slowdown, enhance reforms, and Asian crisis and the global economic slowdown. tackle the social agenda. These macroeconomic challenges come at a critical The report argues that the major policy issue facing juncture in China's structural reform program. Unem- China is how to respond to the near-term growth pres- ployment and demand for social protection have sures in ways that reinforce structural reform and eco- increased, and corporate debt pressures are building nomic development. As implementation of reform in China, in line with the transition to a more market- proceeds and newstorm clouds emerge, policymakers will based economy. However, the country's large and partly have to focus on pro-growth reforms that support the insulated domestic economy has inoculated it to some development of the labor-absorbing service sector. At the degree against contagion from its less fortunate neigh- same time, restructuring enterprises and strengthening bors. Having weathered the storm so far, China can corporate governance must remain high priorities, in learn lessons from other countries that have experi- order to both tackle the corporate debt problem and enced difficulties and, hence, diminish the risk of a cri- release assets to productive activities. Finally, China's sis in China. strategy needs to support structural measures that This report, China: Weathering the Storm and Learning the increase household demand by raising rural incomes Lessons, analyzes how China has responded to the domes- and providing adequate fiscal support to safety net pro- tic and global challenges of the past two years: macro- grams. Increasing household demand is essential to economic policy stance and effectiveness, reforms in the growth recovery and to successfully transforming China financial and enterprises sectors, and the effects of into a demand-driven economy that serves Chinese macroeconomic shocks on employment and income dis- households. v  Acknowledgments T Ihis report was carried out by the World Bank in Ministry of Foreign Trade and Economic Cooperation; collaboration with the Chinese Ministry of the Ministry of Labor and Social Security; the China Finance. It is based on the work of a mission that National Bureau of Statistics; the People's Bank of China; met with Chinese government agencies during October the State Administration for Foreign Exchange; the 1998.The report was managed from the World Bank's field Industrial and Commercial Bank of China; the State office and written by a team led by Kathie Krumm and Council Development Research Center; the State comprising Carmen Chu, Jianqing Chen, Wei Ding, Peter Economic Reform Office; and various Chinese research Fallon, Albert Keidel, and Xiaofan Liu (World Bank) and and nongovernmental organizations. The Ministry of Xiao Geng (consultant). Additional support was received Finance kindly organized discussions of the draft report from E.C. Hwa, Limei Sun, Wei Wang, and Christine in February 1999. Wong (World Bank) and Tom Richardson and Paul Insightful comments from peer reviewers Andrew Heytens (International Monetary Fund). The report draws Sheng (Hong Kong Securities and Futures Commission), on studies carried out in collaboration with the State Michael Walton (World Bank), and Pieter Bottelier Information Center under the direction of Liu He and the (World Bank) are appreciated. The report was carried China National Bureau of Statistics under the direction out under the overall guidance of Yukon Huang, China of Liu Fujiang as well as on background papers commis- Program Director, and Masahiro Kawai and Kyle Peters, sioned by the World Bank and the Development Research of the Poverty Reduction and Economic Management Center under the direction of Lu Baifu and Lu Mai. Sector Unit of the East Asia and Pacific Regional Office The report benefited from discussions with the State of the World Bank. The report was edited by Barbara Development Planning Commission; the State Enterprise Karni, laid out by Garrett Cruce, and proofread by and Trade Commission; the Ministry of Finance; the Daphne Levitas of Communications Development. vi  Executive Summary T his report builds on the framework and vision laid tackle the corporate debt problem and release assets to out in the 1997 Country Economic Memo- productive activities. China's strategy also needs to sup- randum, China 2020: Development Challenges in the port structural measures that increase household demand New Century, and its companion reports. Although the vul- by raising rural incomes and providing adequate fiscal nerabilities and near-term challenges facing China were support to safety net programs. Increasing household less apparent at that time than they are today, the demand is essential to growth recovery and to success- longer-term framework and vision presented in that fully transforming China into a demand-driven economy report remain largely valid. Building on that framework, that serves Chinese households. this year's report focuses on the near term. The difficulty of dealing with China's main macro- Weathering the Storm: The Effect of the economic challenge-weakened domestic demand-has East Asian Crisis been compounded by the Asian crisis and the global economic slowdown. These challenges come at a critical Unlike other countries in the region, China was not juncture in China's structural reform program. severely affected by the East Asian financial crisis that Unemployment and demand for social protection has began in 1997. Several factors explain its ability to increased, and corporate debt pressures are building in weather the storm. China, as the transition to a more market-based econ- China's economy is driven largely by domestic developments. omy proceeds. However, the country's large and partly Recent economic performance in China has been dom- insulated domestic economy has inoculated it to some inated by trends in the domestic economy, many of which degree against contagion from its less fortunate neigh- preceded the onset of the Asian financial crisis. By 1996 bors. Having weathered the storm so far, China can China had achieved a soft landing by reducing inflation learn lessons from other countries that have experi- dramatically without sacrificing high rates of officially enced difficulties and, hence, mitigate against the risk reported GDP growth. With the outbreak of Asian finan- of a crisis in China. cial crisis in the second half of 1997 and the continued The major policy issue facing China is how to respond weakening of domestic demand, soft landing policies to the near-term growth pressures in ways that reinforce were replaced with a macroeconomic policy mix aimed structural reform and economic development. As imple- at stimulating domestic demand. mentation of reform proceeds and new storm clouds China's economy had a good starting position, which allowed emerge, policymakers will have to focus on pro-growth it to respond to the macroeconomic challenges that emerged in 1998. reforms that support the development of the labor- As a result of the pragmatic stabilization policies adopted absorbing service sector. At the same time, restructur- since 1993, China enjoyed steady growth, low inflation, and ing of enterprises and strengthening of corporate an exceptionally strong external position. Foreign savings governance must remain high priorities, in order to both played only a negligible role in China's financial system,  and most of those savings were in the form of foreign direct With total rural consumption equal to total urban con- investment and long-term loans. Currency inconvertibil- sumption in China, stimulating both rural and urban eco- ity on the capital account provided an additional buffer nomic growth will be critical to recovery. against destabilizing external financial flows. Exports to Asia havefallen, but the balance ofpayments remains The Governmentes Policy Response strong. Regional turbulence has reduced exports to Asian markets and foreign direct investment from traditional In 1998 the authorities responded to the challenges fac- Asian sources. The overall impact on export demand and ing the Chinese economy. Their program relied on stim- foreign direct investment flows has been muted, how- ulating domestic demand (largely through infrastructure ever, by continued growth from major North American and investment) while maintaining currency stability. China's European sources, particularly in the first half of the year. willingness to forgo external stimulus acted as an anchor Exports rose 0.5 percent (8.2 percent in real terms) in 1998, for East Asia economic stability in an environment of foreign direct investment inflows remained roughly at acute crisis. 1997 levels, and the observed trade account surplus Publicsectorinvestment-anda monetaypoligythataccommo- remained large and positive ($43.6 billion). dates it-stimulate demand. The centerpiece of the 1998-99 Illegal capital outflows have increased amidst concerns stimulus package is a public sector infrastructure invest- about the stability of the exchange rate, large-scale ment program, which is being leveraged by additional com- smuggling activities, and the reversal of capital flows, as plementary financing from the banking sector and local gains from interest rate arbitrage in 1997 fell following budget counterpart funds. The program, which represents cuts in yuan interest rates. In response, the government about 2.5 percent of 1998 GDP spread over two years, also recently strengthened its management of capital account increases allocations to various social protection programs transactions and closed loopholes for illegal capital out- and seeks to narrow regional differences by offering more flows under the current account. Overall the balance of attractive on-lending rates to inland provinces. payments position did not deteriorate. The heavy focus on infrastructure investment was aimed partly at meeting China's infrastructure needs and Other Developments in the Chinese partly at avoiding allocating resources to manufacturing, Economy a sector beset with excess capacity The program's invest- ments span water conservation, grain storage, road and Rural income and consumption demand have weakened. China's rail transport, power grids, and urban infrastructure, with agricultural sector represents about 20 percent of GDP; small allocations to housing and poverty relief. Some allo- the nonagricultural rural economy accounts for another cations are financing public goods, such as flood pre- 30 percent. A slight decline in real agricultural growth- vention projects; others are augmenting the equity base from 4-5 percent in recent years to 3.5 percent in 1997 of public enterprises, helping those enterprises qualify and 1998-was compounded by large declines in farm for complementary bank financing. procurement prices in 1996, 1997, and 1998. In the In close coordination with fiscal policy, China adopted nonagricultural rural sectors, rural enterprise growth a more relaxed monetary policy. Interest rates were cut has been slowing since the early 1990s but remains repeatedlyin 1998, and the reserve requirement was low- relatively strong. Labor absorption has weakened con- ered. Lower interest rates spurred fixed asset investment, siderably, however, and may have declined. As a result, alleviated the interest burden on state-owned enter- rural income and rural consumption demand have prises, and discouraged banks from keeping excess liq- weakened, with real household income rising by less in uidity with the central bank. the rural sector than in the urban sector in both 1997 Thestimuluspackagehasprovedeffective,with signsofrevival and 1998 (a reversal of the trends of the previous few emerging in late 1998. Driven by a surge in state-led invest- years). ment, China remains an engine of growth, growing 7.8 CHINA: WEATHERING THE STORM AND LEARNING IrHI. LESSONS 2  percent in 1998, according to official figurps. China's China that could help form the basis for a dynamic econ- strong performance is remarkable given the regional omy as long as progress continues to be made on restruc- crisis affecting its neighbors. To sustain the recovery, it turing enterprises away from inefficient, low value-added will be critical to build additional pro-growth structural activities. Serious problems remain, however. Many enter- reform measures into the program for 1999 and beyond. prises serving the domestic market are uncompetitive, China's countercyclical fiscal stance is appropriate and some large enterprise groups have focused on invest- given the limitations on monetary and external stimu- ment and size rather than profitability and efficiency. lus. Because of conservative fiscal policies in the past, Financial performance has worsened since 1995 across all China's level of government debt remained relatively low groups of medium- and large-scale industrial enterprises. (about 10 percent of GDP). In the medium term, how- Collectively owned and township and village enterprises ever, the fiscal sustainability of the program will depend whose growth had been key in the past decade are having on how the government can contain its additional lia- difficulty transforming themselves into efficient enter- bilities-notably in the banking and pension systems- prises. According to official figures, half of all medium-size and strengthen the central government's revenue base and large state-owned enterprises reported losses in 1998. in order to service those liabilities rather than on the mag- Including underreported losses (often uncovered in audits) nitude of the stimulus package. would raise this figure even higher. Corporate leverage is high, increasing vulnerability to shocks. The average lia- The Government's Commitment bilities to equity ratio is about 2:1 for industrial and state- to Reform owned enterprises and about 4:1 for commercial enterprises. In the financial sector, dependence on the banking sys- The new government installed in March 1998 laid out tem is excessive. China's financial sector is dominated an ambitious agenda that guaranteed growth and com- by the banking system, which accounts for three-quar- mitted itself to reforming state-owned enterprises, the ters of households' financial asset holdings and enter- financial sector, and the government structure within prises' external funding sources. The government three years. The agenda also established five reform continues to interfere in investment decisions. Financial priorities for 1998: grain marketing, investment proce- management of financial institutions is weak. Financial dures, housing, health financing, and fiscal and extra- skills are also lacking; turning bureaucrats and clerks into budgetary financing. Tackling corruption and financial bankers has proved no easy task. Bank portfolios include fraud also received renewed attention. Progress on all of a large share of nonperforming loans. The official esti- these fronts has been made. mate of the proportion of nonperforming loans in bank The Asian financial crisis has highlighted the impor- portfolios (based on the current classification system) tance of addressing systemic weaknesses in China's exceeds 20 percent, of which at least 5-6 percent are con- financial and enterprise sectors. The new government's sidered unrecoverable. These figures probably underes- agenda clearly recognizes that the domestic financial-cor- timate the true scope of the problem. Finally, regulatory porate nexus represents a major source of risk in the near capacity is inadequate. Expansion of the role of the term. Although the external threat of contagion is mod- financial system in China has outpaced regulation and est in a country with a large and partly insulated domes- supervision of the financial system, often leading to ad tic economy, recognition that the triggers for a crisis are hoc government interference in financial decisionmak- hard to predict has lent urgency to China's efforts to ing and inconsistent policy messages. Lack of adequate tackle systemic weaknesses. regulation has allowed many nonbank financial institu- Much progress has been made in China toward reform- tions to take on excessive risks. ing the financial and enterprise sectors. Preliminary analy- Fortunately there are additionalfactors that give China time to sis of medium- and large-scale firm-level industrial data learn lessons and avoid a aisis. Without taking into account suggest that a group of productive enterprises exists in China's continuing ability to support domestic banks and EXECUTIVE SUMMARY 3  enforce foreign exchange supervision, as well as the reform ference, and problems at some small troubled financial initiatives already taken, it might appear that China's institutions were resolved. These measures have only economy is rather vulnerable in the face of risks of finan- begun to address the weaknesses in the sector, however. cial crisis.For China, however, the likelihood of a crisis in Moreover, the pace of financial sector reform continues the near term remains small. The central role of domes- to be constrained by lack of progress on the enterprise side. tic savings, the composition of foreign saving, and the cur- As incentives in the financial sector improve, credit rency inconvertibility on the capital account provide a expansion will be dampened as banks become more dis- buffer against destabilizing external financial flows. The criminating about making loans-a trend that is already major commercial banks are state-owned, and depositor evident. Careful management of these reforms will be confidence in the banks remains high. The level of narrowly needed to ensure that they foster rather than hinder cor- defined government debt is low enough to allow the gov- porate restructuring. ernment to manage the contingent liabilities imbedded in the banking system. Continued attention to resolving the The Need to Address the Social Agenda underlying systemic weaknesses in the corporate and finan- cial sectors is required, however, to prevent an increase in Maintaining employment and ensuring that social pro- the risk of a crisis over the medium term. tections are major challenges for China as it moves to The pace of reform has accelerated since the Fifteenth Party a more market-oriented economy. The slowdown in the Congress ... Steps toward fostering corporate innovation economy has further highlighted the need to address the began in the mid-1990s. Despite progress in many areas, social agenda in China. however, these reforms have only gradually altered the Urban labor market equilibrium is increasingly fragile. basic governance mechanisms that left central govern- Rationalization of the labor force through enterprise ment ministries and local government bureaus in control reform has increased unemployment in China. A growing of operations. Reform accelerated after the Fifteenth Party economy was creating jobs in urban areas at a rate of Congress, held in September 1997, when the government about 7 million ayearbetween 1994 and 1997, manyin the restated the important role for "public" ownership (to be tertiary and informal sectors. Despite this job creation, interpreted more broadly than state control), and acknowl- employment growth has not been sufficient to absorb nat- edged the role of other forms of ownership, including lim- ural urban labor force growth, rural migration, and work- ited liability corporations, stock share corporations, and a ers let go by state- and collectively owned enterprises. As varietyofhybridownershipandcontrolforms.TheFifteenth a result, about 8.1 percent of the urban labor force was Party Congress also called for bolder steps to separate unemployed by mid-1998, according to World Bank esti- government units from enterprises, significant progress mates, with rates of unemployment of 12-13 percent in toward which was made in the second half of 1998. some urban areas. The emergence of urban unemployment ... with recent effortsfocusing on financial reform. Drawing and reduced migration from rural areas means that the partly on lessons from the Asian financial crisis about labor market equilibrium has become increasingly fragile. the financial vulnerability of large enterprises and enter- The problem has been particularly serious because of the prise groups, Chinese policymakers shifted their empha- inadequacy of the safety net. Because of the high unem- sis in 1998, placing greater attention on the financial ployment levels, the government may wish to hold in aspects of state-owned enterprises. Initial steps focused abeyance removal of remaining admistrative impediments primarily on banking sector reforms aimed at managing to rural-urban migration; but over the long term, as the financial risk and reducing the rate of accumulation of non- excess labor overhang is absorbed, removing these imped- performing loans in the system. A risk-based loan classi- iments will be essential to increase labor productivity. fication system was introduced, the central bank's network Regional incidence of external shock not limited to coastal of branches was consolidated along regional lines to area. Based on preliminary analysis through late 1998, enhance supervision and reduce local government inter- the Asian and global crisis has affected not only the CHINA: WEATHERING THE STORM AND LEARNING THE LESSONS 4  better-off coastal provinces but other provinces as well. forcing than they have been. Policies and programs must The direct impact has been relatively mild in the poor- emphasize pro-growth structural reform measures that est rural provinces, more severe in the coastal provinces, increase both demand and supply. The pace of these and most severe among middle-income areas in the reforms will need to be accelerated in order to reduce interior, which are suffering the most severe urban the need for implementing additional expansionary fis- labor problems and have sizable poor populations. With cal and monetary policies. the risks of exports deteriorating further, policymak- ers will need to look carefully at regional impacts. Avoid extremes in growth Funding ofsocialprotection schemes has increased but remains inadequate. During 1998 both the central government Chinese policymakers must try to maintain growth and local governments injected additional funding into within a narrow band. Lower growth-the greater risk the major social protection programs. The central gov- in China at this time-could cripple job creation and ernment subsidized local outlays for guaranteeing a exacerbate financial problems imbedded in the corporate basic living standard for workers laid off from state- sector. Higher growth could cause inflation and the need owned enterprises in central and western areas and old for sharp adjustments in the future. industrial bases. Efforts were also made to reduce pen- Growth will be affected by two major uncertainties: sion arrears. The injection has not yet been on the scale changes in the global environment and the extent to which required, however. As a result, not all laid-off workers eli- the domestic economy-in particular, household con- gible for re-employment services and subsistence sumption and nonstate investment-responds to the allowances and not all lower-income urban households macroeconomic stimulus package. In the base case scenario, eligible for minimum living stipends are receiving them. despite continuing difficult global economic conditions, the Public investments associated with the fiscal stimu- domestic economy responds modestly to the macroeco- lus package are relatively labor intensive, with a direct nomic stimulus package, growing about 7 percent in 1999. and indirect employment impact estimated at about 5 Under the downside scenario the global economy is million jobs over the two-year life of the program. Much assumed to deteriorate sharply, reducing GDP growth in of the investment program is rural based, employs China by 3 percentage points. Assuming that China can unskilled workers, and will stimulate employment in only partly offset this decline through domestic measures, the building materials sectors, which have excess capac- growth would fall to 5 percent a year. This possibility ity. Given the location of provinces experiencing the requires foresight and preparation by the government, largest temporary demand shock, efforts to direct a including stronger efforts to tackle the social agenda. larger share of fiscal financing toward the central and In either scenario some deterioration in the external western regions represent appropriate regional target- trade accounts would be consistent with the Chinese ing. Much smaller amounts have been allocated to sup- authorities' policy of maintaining relatively strong domes- plement poverty relief projects, however, suggesting tic economic performance. Given China's strong external further scope for targeted initiatives. reserves position and modest external debt burden, such developments are not likely to lead to unsustainable exter- Policy Options for the Future nal imbalances or an externally induced crisis in the base case. Policymakers will, of course, need to communicate Although new storm clouds are gathering, lessons of their intentions clearly to the market-by providing as experience-on macroeconomic management, capital much reliable information as possible-so that any dete- account liberalization, the corporate and financial sec- rioration in the external accounts is recognized as a con- tors, and social issues-are emerging. The key chal- sistent part of the government's overall macroeconomic lenge for the near term will be to make macroeconomic stance. Without such recognition, market confidence could and structural reform policies even more mutually rein- decline, setting off disorderly capital account behavior. EXECUTIVE SUMMARY 5  The downside scenario poses more serious risks, Given the large share of GDP accounted for by invest- because a sharper decline in the trade accounts could be ment of the nonstate system (16 percent) and rural and accompanied by short-term capital outflows. It is too urban household consumption (45 percent), sustainable early to assess the extent to which measures to intensify growth will depend on structural measures that can enforcement and scope of capital controls will have a last- stimulate their growth. Further reliance on centrally ing impact. Should such risks materialize, adjustments driven public investment as the primary fiscal instrument would need to be made to both domestic and external of reform could reduce the quality of investment. policies. Additional efforts may be required to remove structural impediments, improve the competitiveness of Transform the financial-corporate sectors-in time exports, and reduce the attractiveness of imports. China would still be well advised to cushion the impact on the Clearly, the way to gradually replace the poorly per- domestic economy with some decline in international forming parts of the economy is to develop the dynamic reserve levels. With current reserve levels standing at sectors of the economy. about I I months of imports of goods and services, there Develop the service and informal sector Nurturing of vig- is scope for such reduction without exposing China to orous enterprises and industries within the service excessive risks. As long as global demand remains weak, sector is a critical element of the pro-growth structural it will be difficult to rely on the external sector as a reform agenda. The same type of dynamism evidenced major source of growth. in the growth of China's external trade in recent years Stimulate domestic demand ifnecessary. Adequate domes- can be equally well used to tap the potential of the tic activity is key to minimizing risks on both the employ- domestic market. ment and corporate-financial fronts, which are likely to In other low- and middle-income countries, the increase in 1999-2000. Should the growth pattern evolve service sector accounts for more than half of nona- as expected, the government may not have to resort to gricultural employment and two thirds in large devel- major macroeconomic initiatives. It nevertheless needs oping countries. In China less than half of to be prepared to stimulate demand further if necessary. nonagricultural employment is generated by the ser- Maneuvering space has existed for short-term fiscal vice sector. Slightly faster growth in that sector could measures, subject to tackling the fundamental prob- add an additional 2 million jobs by 2000, reducing lems affecting fiscal sustainability. Recent World Bank the job shortfall by half. Expansion of service activi- analysis shows that while the government may be able ties could take place in various sectors, such as telecom- to cover its existing contingent liabilities in the banking munications and tourism, which are growing rapidly. and public pension systems, fiscal sustainability requires An array of business-related services-such as account- both successful containment of such contingent liabili- ing, auditing, legal, secretarial, media, public relations, ties and the strengthening of the finance of its central information technology, and communications-needs government. These factors, rather than the magnitude to be developed. Facilitating the development of this of the short term fiscal stimulus alone, will determine package of services is essential to the restructuring fiscal sustainability. While the reform of extrabudgetary enterprises and transformation of corporate culture funds is expected to raise the revenue to GDP ratio by that is the second prong of a pro-growth enterprise up to 5 percent over the next two to three years, the dis- strategy. cretionary allocative power of the budget will not increase, Create afinancial sector that serves dynamic domestic markets. as extrabudgetary funds are currently financing many Excessive attention to centralization and consolidation government activities. More fundamental fiscal restruc- of financial risks can impede precisely the financial sec- turing will have to be implemented, including broaden- tor transformation needed to improve intermediation of ing the tax base to include rapidly growing sectors and domestic savings. Increased financial supervision needs emerging nonstate activities. to be underpinned by a desire to develop the kinds of CHINA: WEATHERING THE STORM AND LEARNING TH] LESSONS 6  financial markets and instruments that help develop for enterprise restructuring, bankruptcy, and debt work- dynamic domestic markets. More vigorous enterprises outs and developing better accounting standards, judi- need greater access to capital so that they can increase cial processes, and other procedures. the returns to the large pool of domestic savings. Such The size and complexity of the Chinese economy access could be increased by approving public issues of defies any one comprehensive overarching strategy for debt or equity for private firms; promoting leasing; intro- tackling these issues, and one would expect to see a ducing a venture capital investment mechanism; sup- large degree of diversity in approaches across localities, porting development of smaller financial institutions, sectors, and institutions. The experience of other coun- which traditionally serve smaller, more dynamic clients; tries suggests that managing such problems is a complex developing over-the-counter equity markets; and expand- and lengthy process that requires some fiscal contribu- ing the corporate bond market. Capital markets can tion (although an emphasis on recovery can reduce the play an equally important role in strengthening corpo- cost to taxpayers). rate governance. A growing economy willfacilitate tackling of systemic weak- Restructure enterprises with excess capacity and strengthen nesses... Addressing systemic weaknesses by developing corporate governance. The corporatization and commer- dynamic industries and increasing growth can-in fact, cialization of state-owned enterprises-and the separa- must-be done simultaneously. Based on analysis of the tion of party politics and government from liquidity position of enterprises in the industrial survey, business-represent steps in the right direction. China's firms with higher productivity appear to have a cushion incentive structures, legal framework, and code of con- to absorb some deterioration in financial performance duct remain inadequate to strengthen corporate gover- without jeopardizing their ability to employ workers or nance, however. Restructuring of physical capacity must service financial obligations. Most firms with low or neg- go hand in hand with financial restructuring and delever- ative productivity, however, are already unable to meet aging of enterprises; enterprise reform must be closely current obligations to workers and suppliers, let alone coordinated with banking reform and capital market financial institutions. More worrisome yet, firms with development. marginal productivity (which control about a third of total A framework must be established for resolving bad assets) have little margin for further stress. The pre- bank debts and attracting investors. The recent increase carious position of many Chinese firms reinforces the in emphasis on financial sector reform is a welcome importance of avoiding excessive declines in growth, start. Unless the quality and allocation of new financial which threaten survival of firms that could remain viable flows is improved within China, however, problems will in a healthier economy. Improving the climate for recur. Strengthening supervision, enforcement, and dynamic firms and sectors is essential to managing the transparency will be critical to improving the incentives difficult balancing act of accelerating corporate restruc- to financial institutions as well as to maintaining confi- turing and maintaining macroeconomic stability. dence of others in the financial system. ... and relieve the strain on the labor market. The strains on The interrelationships between the enterprise and the labor market in China are likely to be unusually financial sector are extremely complex and involve sev- acute in the next two or three years until the com- eral hundred thousand enterprises. Because the bulk of pounding urban overhang has been absorbed. Economic loans are with the four large state-owned banks, the growth can facilitate labor absorption and reduce slack- authorities have selected reform of those institutions as ness. If, for example, the economy grows by 7 percent a the key entry point for tackling the bad debt problem. year, the expected annual urban job shortfall of about 4 The initial impact has been to harden the budget con- million jobs could be equilibrated largely through a siz- straint on state-owned enterprises, which in turn has cre- able absorption by the informal sector. The urban unem- ated pressures in the system for additional reforms, ployment rate could rise by about I percentage point, such as improving the legal and regulatory framework however, and rural labor absorption could fall by about EXECUTIVE SUMMARY 7  a third. Growth ofjust 4-5 percent a year could have a in infrastructure, and introducing clear enabling legisla- more severe effect on employment. tion for foreign investment to help restructure state- Even with growth of 9 percent a year, however, China owned enterprises. is likely to face an employment shortfall of about 2 mil- The Asian financial crisis has shown that caution lion jobs a year. These figures highlight the need to must be used in encouraging international short-term develop labor-intensive enterprises. Reforms that help capital flows. It has also shown, however, that excessive develop the service sector, private sector employment, restrictions over foreign participation in the provision of urban informal sector, processing industries, and non- domestic financial services can impede healthy devel- grain agricultural production are essential to reduce or opment of the domestic financial system. absorb the job shortfall. Given disparities in regional labor markets, the inten- Increase household consumption sity of labor market interventions should vary across regions. Internal migration should be facilitated, but it Growth in household consumption is important both to is likely to have only a marginal equilibrating effect in increase demand and to restructure the economy away the short run in the face of large disparities. Retraining from heavy and supply-driven investments toward a pro- will need to be selective to ensure adequate social returns. duction structure that responds to market demand. The China's labor surplus appears to be a transitory economy has begun to reflect the needs of Chinese problem. If current rates of natural attrition and lay- households, but the legacy of past imbalances remains. offs were to continue, the surplus would disappear by Policies that encourage greater rural and urban con- as early as 2001 and no later than 2004. With the urban sumption are essential to both near-term growth recov- labor overhang exhausted, the flow imbalance in the ery and the quality of that growth. urban labor market would be corrected. The urban Strengthen the safety net. One of the major factors that has labor market would be able to absorb more workers than constrained consumption for many households is uncer- required; the pace of rural-urban migration could be tainty with respect to future income security. Creation of restored, if not accelerated; and levels of structural adequate safety nets for households experiencing tempo- unemployment built up during the transition could be rary adjustment problems would increase public confi- reduced. The right combination of macroeconomic and dence in future household economic security, which in structural policies could allow this transition to be turn would stimulate urban household consumption. accelerated. Building on efforts by both local and central govern- Foreign direct investment can ser7ve these domesticbusiness devel- ment in 1998, the authorities will need to ensure that opments. As the lessons from the recent Asian crisis indi- social protection programs receive adequate fiscal sup- cate, China should remain cautious about portfolio and port. Less than 0.5 percent of GDP would be required short-term capital flows until it is prepared to assume the to fully fund the social protection programs already associated risks. At the same time, it should continue to established by the government. These programs must encourage longer-term flows. China is fortunate to have reach fiscally distressed localities, especially if a contin- sufficient policy levers to continue to attract foreign direct ued slowdown continues to disproportionately affect investment with which it can augment and enhance provinces with the greatest urban labor imbalances. domestic business development. Although overall inter- The 1998 public investment program stimulus pack- est by foreign direct investors has declined since the Asian age, which relied largely on traditional large-scale invest- crisis, there is scope for making up the shortfall by encour- ments, missed the opportunity to use the public works aging investment in the more dynamic sectors of the programs to target areas in need. Funding of small pub- economy (many of which remain on the "restricted" list), lic workfare programs could enhance regional targeting promulgating the build-operate-transfer (BOT) law and and have a strong social impact in depressed urban other steps to liberalize foreign and private investment economies and poor rural areas. CHINA: WEATHERING THE STORM AND LEARNING TMH L1.SSONS 8  Should growth and employment slow significantly, Organization of the Report adequate fiscal support for social protection programs will prove even more vital. To prepare for such a possibility, The report is organized as follows. Chapter I describes the authorities must develop a contingency plan for macroeconomic developments in China in the past two reaching the rising number of distressed rural and urban years in the context of developments since 1991. It also households. reviews China's policy stance, examines the response Increase revenue mobilization. China's macroeconomic of the Chinese economy to the domestic stimulus pro- stance must not threaten key public expenditures over gram, and identifies factors that will affect the success the medium term. To enable the government to finance- of the program in the future. Chapter 2 examines the and expand-its involvement in the social sectors, espe- weaknesses in the financial and enterprises sectors and cially in rural areas, revenue mobilization must be describes the reforms that have been adopted. It also strengthened. Many of the institutional measures describes China's public investment program. Chapter required will take time, but the groundwork must be laid 3 examines the effects of macroeconomic shocks on now. Improvements in budgetary management systems employment and income distribution, looking at labor will be critical to improving the link between the gov- markets, external shocks and the terms of trade, and ernment's priorities and its budget. public spending and fiscal tradeoffs. Chapter 4 exam- Implement other structural reforns. The shift toward con- ines three alternative scenarios for the future, linked sumption has implications for a range of policy issues, to the global picture, and shows how the government many ofwhich China is already pursuing. Housing reform can use fiscal (especially expenditure), monetary, is essential to stimulating demand for housing in the exchange rate, and trade policies to deal with an eco- medium term. The timing is right for monetization of nomic slowdown. Chapter 5 presents specific recom- nonwage benefits. In the rural sector, agricultural policies mendations for reforming the enterprise and financial can enhance rural consumption and benefit domestic firms sectors. Chapter 6 looks at ways in which policymakers producing lower-end goods. Opportunities for continued can maintain employment, support consumption, and rural migration are also essential. These and other pro- increase social protection, thereby tackling the social household shifts in consumption need to be accelerated. agenda. EXECUTIVE SUMMARY 9   Part 1 How China Is Weathering the Storm  Chapter I The Storm Clouds Emerge: Macroeconomic Developments and Policy Response T he structural reform agenda for the medium- and opments since 1991. It also reviews China's policy longer-term was laid out in the 1997 Country response, examines the response of the Chinese econ- Economic Memorandum, China 2020: Development omy to the domestic stimulus program, and identifies fac- Challenges in the New Century, and its companion reports. tors that will affect the success of the program in the Although the vulnerabilities and near-term challenges future. facing China were less apparent at that time than they are today, the longer-term framework and vision pre- MacroeconomicTrends sented in that report remain largely valid. Building on that framework, this year's report focuses on the near China's macroeconomy was in a solid position to respond term. to the shocks that emerged during the past two years. Faced with the combination of a domestic slowdown Problems that developed in 1997 led to a shift to a and regional financial turmoil in 1997-98, China was domestic stimulus program in 1998. The economy forced to make difficult policy choices. Policymakers rec- appears to be responding to that program. Whether the ognized that a sharp slowdown in economic growth could program will generate sustained growth should become cause a decline in employment opportunities and worsen evident in 1999. enterprise financial performance, thereby making the labor and social adjustment more difficult and exacer- Economic Developments in 1 996 ond 1997-A good bating the problems of the domestic financial system. Too stort is half of the success' little stimulus is a risk. At the same time, they recognized that failure to keep up the pace of structural reforms The macroeconomic stabilization program adopted in could exacerbate medium-term problems and reduce 1993 guided the Chinese economy toward a soft land- confidence by households and investors alike in China's ing in 1997. Consumer price inflation fell from 24.1 future. Too much stimulus at the cost of reforms is a risk. percent in 1994 to 2.8 percent in 1997, while growth China's policies and programs in 1998 have tried to momentum remained relatively strong. GDP growth reconcile the tension between maintaining macroeco- in 1997 was officially reported at 8.8 percent, led largely nomic stability and moving ahead with structural by an export-driven expansion during the first half of reform. China has minimized the risk of contagion the year and a domestically driven expansion during the from its neighbors and adopted new structural reforms second half. aimed at preventing financial crisis in the future, China's external position was exceptionally strong in learning from the experiences of other East Asian 1997, with a trade surplus of US$40 billion and foreign economies. investment of US$45 billion. As a result, foreign exchange This chapter looks at macroeconomic developments reserves rose to US$140 billion, almost twice their 1995 in China in the past two years in the context of devel- level of US$74 billion. 12  China's external debt position has been prudent. The The decline in exports to Asia was partly offset by increases in exports majority of inflows have been long-term funds and direct to other markets investment, resulting in an external debt to GDP ratio FIGURE 1.1 of 16 percent by the end of 1997, about a fifth of which Growth in exports by destination, 1996-98 was short-term debt (World Bank 1999a).' Percent The structural reform program continued to move 25 forward in 1997. The Fifteenth Party Congress, held in September, reaffirmed support for continued domestic 20 reform, including nullification of the state guarantee of employment and welfare, endorsement of an important I 5 role in the economy for a wider group of ownership cat- 1 egories, and acceleration of state-owned enterprise reform. The policies adopted in 1996 and 1997 gave China a good starting position from which to respond to the o -* a_ problems that developed. During the second half of m Total * North Asian crisis 1997, with the domestic contribution to GDP growth -s already declining and the effects of the East Asian cri- 0 Asia M Europe sis beginning to be felt in China, the pace of economic -10 D :S| . /,- growth slowed. The Effect of the East Asian Financial Crisis Source: China General Administrabon of Customs. China has probably been the East Asian country least in world commodity prices. China's exports are mainly affected by the regional crisis that began in 1997. China's labor-intensive low value-added goods, and its exports economy is still largely domestically driven. Although are not highly correlated with those of other Asian trade represents about a quarter to a third of GDP (com- economies.3 At the same time, sizable currency depreci- parable to other large countries, such as the United ations by these countries have eroded China's wage cost States and Indonesia), these figures overstate the coun- advantages, increasing both competition in the export sec- try's vulnerability to trade shocks.2 About half of China's tor and the competitiveness of imported goods domesti- exports are generated by enclave operations owned by cally.4 In addition, the anti-smuggling campaign that foreign-invested firms with high imported content. intensified toward the end of 1998 reduced exports in China has nevertheless felt the impact of the East the short term, as enterprises that had relied on smug- Asian crisis. Lower demand, lower export prices, and gled imports need time to search and switch to other reduced competitiveness by domestic producers have legal sources of supply. hurt Chinese exports tojapan, which accounts for 16-17 About 80 percent of foreign direct investment in percent of exports; the Republic of Korea, which accounts China has traditionally come from regional investors, for 5 percent of exports; and other ASEAN economies, with Hong Kong (China) accounting for 55-60 percent which account for about 4 percent of exports. Exports to of the total.5 The reduced wealth and liquidity of China's China's other major markets, the United States and to key Asian investor bases slowed regional foreign direct a lesser extent the European Union, rose, partly offset- investment in China.6 In the wake of the Asian crisis, the ting the decline in demand from Asia (figure 1.1). share of investment from Hong Kong (China) declined Export volume rose 8.2 percent in 1998, while export to 46 percent in 1997 and 41 percent in 1998. The share prices fell 7.7 percent, a decline consistent with the drop of investment accounted for by Taiwan (China) also fell, THE STORM CLOUDS EMERGE: MACROECONOMIC DEVEI.OPMENTS AND Poi.icY RESP'ONSE 13  while the share of investment accounted for by the matically while maintaining high official rates of GDP United States and European countries, such as France growth. By early 1998, however, the growth of domestic and Germany, rose. demand continued to weaken, inflation became negative, The increased perception of risk associated with the and the Asian financial crisis began to affect the Chinese Asian crisis may have reduced interest by North American economy. China's soft landing policies were replaced and European investors, but the backlog of project pro- with a macroeconomic policy mix aimed at stimulating posals provided the authorities with a cushion of invest- domestic demand.The effect of weakening demand is ments on which to draw. Realized foreign direct revealedinChina'sofficiallyreportedGDPgrowthrates, investment from the United States rose 21 percent and which declined from more than 14 percent in 1992 to 7.8 contractual foreign direct investment rose 26 percent, percent in 1998 (figure 1.2). while realized foreign direct investment from Europe rose 3 percent and contractual foreign direct investment rose SECTORAI. TRENDS. Although weaker performance by 40 percent, offsetting the decline among Asian investors. the agricultural sector contributed to the slowdown in Over the past five years realized foreign direct invest- GDP growth, the sharp deceleration in real industrial ment doubled its share in total fixed assets investment. growth was the main cause of declining economic growth It still represents only 15 percent of total investment, rates in 1995-98. Output growth by state-owned enter- however. China relies less on portfolio and other flows prises fell slightly, but the decline was especially pro- most directly affected by external developments. These nounced for nonstate-owned output. Growth in collective, channels are important for certain sectors, such as private, and foreign joint-venture production-which finance, however. had led the industrial output surge in 1992-94-declined During 1996-97 the strong balance of payments put sharply (figure 1.3). incipient pressure on the yuan to appreciate. While The sharp deceleration in industrial output reflects some factors contributed to a deterioration in the bal- both structural factors and the decline in aggregate ance of payments, they offset earlier pressures to appre- ciate and were not sufficient to lead to macroeconomic The end of the soft landing pressure to devalue. Nonetheless, concerns over deval- FIGURE 1.2 uation intensified, particularly as the Asian crisis wors- Official GDP growth, 1991-98 ened, spilling over into other emerging markets. Percent Current account convertibility and off-shore financ- 25 ing contributed to leakages from the capital account, making it more difficult to manage the current and cap- IndusAsian csis ital accounts and implying some vulnerability to capi- 20 onset tal flight. China's external linkages are strong enough to affect 15 Total economic developments. The enormous size of China' s economy reduces its vulnerability to external shocks, X however, and suggests that policymakers' primary focus