Global Economy
Latest Economic Developments in China

Dong Fu and Jahyeong Koo look at economic conditions, financial system reform, foreign investment and trade in China.

The Economy Powers On and Attention Shifts to Sustainable Growth
Preliminary estimates show that the Chinese economy grew close to 8 percent in 2002, up from 7.3 percent in 2001 (Chart 1). In the first three quarters of 2002, fixed investment increased by 21.8 percent, driven mainly by a rise in government spending on fixed assets, a gradual increase in private investment and an influx of foreign direct investment. Consumption grew modestly. Retail sales were estimated to grow about 9 percent for 2002. Exports of goods surged 22.3 percent in 2002, owing largely to the post-WTO trade liberalization.

Chart 1

The Chinese government has used an aggressive fiscal policy to prop up the economy since the Asian financial crisis. Since 1998, it has issued 660 billion yuan of government bonds (equivalent to about 6 percent of the annual GDP in 2002) to support infrastructure upgrades and a banking sector cleanup. Over the same period, the deficit to GDP ratio has risen steadily, reaching an estimated 3.5 percent in 2002 (Chart 2). In addition to the growing government debt, large amounts of bad loans issued by state-owned commercial banks and social-welfare funding shortfalls have added to the government’s potential liability and present a long-run fiscal danger.

Chart 2

The focus of economic policy has now shifted to sustainability of growth rather than the sheer speed of growth. The government continues to cut money-losing, state-owned enterprises and has promoted the private sector’s contribution to the economy in an unprecedented manner. The issues of pollution due to industrialization are also attracting more attention than ever before, partly due to the planned 2008 Beijing Olympics and 2010 Shanghai World Expo.

Financial System Reform: An Increasingly Pressing Task
The Chinese financial system remains fragile, and further reforms are urgently needed. Interest rates are still strictly controlled by the People’s Bank of China, the nation’s central bank. The financial intermediaries remain largely inefficient in allocating funds. Although the money supply (M2) has increased more than 15 percent per year since 1998, deflation still prevails. Interest rate liberalization is at the top of the central bank’s agenda.

Even after transferring 1.4 trillion yuan of bad loans to asset management companies over the past four years, the four dominant state-owned banks continue to be plagued by loan troubles. The official bad loan ratio was 25.3 percent at the end of 2001. Although the latest estimate is lower, around 21 percent for 2002, many suspect the true figure is much worse. A separate banking regulatory commission has been proposed to enhance banking supervision. But the inability of banks to behave like true commercial banks remains the essential problem.

The Chinese stock market plunged in 2001 and 2002, largely because of structural problems (Chart 3). The majority of listed companies were formed by carving out assets from state-owned parent companies. Consequently, about two-thirds of existing shares are still state-owned and nontradable. The plan to unload these shares on the market to alleviate the government's financial burden and to shore up funds for social-welfare reforms backfired in mid-2002 and was eventually abandoned.

Chart 3

WTO Brings a Boom in Trade and Foreign Direct Investment
A year after its accession to the WTO, China has largely stuck to its promises. It lowered the average tariff rate to 12 percent and will lower it to 10 percent by 2005. It has dismantled many nontariff barriers, although recently there have been complaints concerning China’s imposition of new technical restrictions on imports of certain goods, such as genetically modified soybeans from the United States. It appears that China will take a pro-liberalization stance in the upcoming round of multilateral trade negotiations. China didn’t hesitate to use its newly found power bestowed by the WTO to oppose the recent U.S. steel tariff hike.

Accession to the WTO greatly increased China’s trade. Chinese exports of goods jumped 22.3 percent year-over-year in 2002. Imports also increased 21.2 percent (Chart 4). The WTO’s impact on imports has yet to show up in full strength, particularly on farm products, which pose serious threats to China’s labor-intensive agriculture industry. Export growth is likely to slow down from the current breakneck rate. In the long run, the trade surplus is likely to fall.

Chart 4

Foreign direct investment to China reached a new record of $52.7 billion in 2002. China surpassed the United States for the first time to become the world’s leading recipient of foreign direct investment. In manufacturing, an increasing number of foreign companies are moving their production bases to China. Nowadays, not only labor-intensive industries, but also capital-intensive industries and even R&D facilities are relocating to China. In addition to taking advantage of China’s low labor costs to inexpensively produce goods for exports, foreign companies are also targeting the Chinese domestic market. Service industries, including the banking sector, are also opening up to foreign investors in line with China’s WTO commitment.

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