During 2002, there was renewed vigor in investment, stimulated by post-WTO private capital spending as well as public investment in the government's stimulus program. Both imports and exports grew sharply, and China emerged as the favorite destination for foreign direct investment. Foreign exchange reserves rose, reaching almost 12 months of import cover, and the external surplus continues to hold. Debt, though growing, is still low by international standards.

Despite such robust economic performance, serious short- and long-term challenges remain. These were brought into focus during the stocktaking that occurred at the 16th Party Congress of the Communist Party in October 2002 and discussions at the National People's Congress (NPC) in March. Several of these were reiterated in pronouncements by senior officials following the recent change in administration that saw Hu Jintao appointed President, Wu Bangguo as head of the NPC, and Wen Jiabao as Premier.

Among the major highlighted risks are those related to fiscal sustainability, continued growth in inequality (in particular rural distress), and an orderly transition to a market economy with an expanded role for the private sector. The government has renewed its commitment to tackling the toughest economic issues through appropriate policies and a reorganization of government functions, while recognizing the overall risk of attempting radical domestic reforms in the context of an inhospitable international economic environment. It has, therefore, projected a lower growth rate of 7 percent for 2003, and a growth rate of exports that is just one-third of the 2002 outcome.

Recent Economic Developments

Output: The blistering pace of growth of the Chinese economy during 2002 and in the first quarter of 2003 stems from three sources (Table 1). First, as revealed by the 17.3 percent real growth (y-y) of fixed investment in 2002 (and an even higher 25.7 percent in the first quarter of 2003), the economy is receiving a boost from the macroeconomic stimulus program, which is now in its sixth year. The fiscal deficit was 3 percent of GDP, slightly lower than the 3.3 percent deficit of 2001, and was combined with easier monetary and financial policies.

Second, the post-WTO accession effect has played out in increased foreign investment in China, as well as in energizing urban consumer demand for services and some categories of products (such as cars and upscale real estate). Third, the continuing evolution of global cost and demand patterns coupled with the greater access to foreign markets provided by joint venture enterprises re-ignited China's exports, which rose a solid 22.3 percent during 2002. During the first quarter of 2003, they rose by 32.5 percent (y-y).

Sectoral Pattern: The sectoral pattern of this growth is relatively unchanged (Figure 1). However, it should be noted that the performance of the primary sector, mainly agriculture, continues to improve. This is significant inasmuch as 2002 was characterized by poor rainfall, drought, and the first year of liberalized agricultural imports after China joined the WTO. It reflects in part the ability of some farm households to diversify production away from grain to higher value added activities.

Table 1: Basic Economic Statistics

a/ Nominal values b/ World Bank estimate based on Atlas methodology

Source: World Bank and IMF staff estimates and official data

Value-added in industry recorded its highest increase since the Asian financial crisis, led by foreign-funded enterprises feeding the domestic boom in demand for industrial products as well as consolidating production in China for expanded sales in other markets. This strong performance has continued into 2003, with industrial growth during the first quarter of 17.2 percent (y-y). The problem with under-valuation of China's services sector output still exists. While the sector grew by 7.3 percent in 2002, compared to 7.4 percent the previous year, it is believed that some services growth is recorded in the manufacturing statistics, reflecting the high degree of vertical integration of economic activities that exists within Chinese firms, especially the state-owned enterprises (SOE).1

The shape of industrial production changed noticeably during 2001-2002. On the energy front, two developments are worth noting. First, the rapid growth of industrial production is pressuring conventional energy supplies, despite improved pricing, continuing efficiency in production and distribution of power, and diversification to alternative sources. For the first time since 1997, the electricity supply-demand balance has become worrisome, with 18 provinces facing shortages during 2002. Together with water, the availability of adequate supplies of energy is an important determinant of the long-term growth prospects of China. Recent increases in the domestic prices of diesel and gas, in line with the new formulae that track international price developments closely, suggest that alternatives to make up for electricity supply disruptions may become progressively more expensive for retail consumers. Energy dependence on foreign sources is rising, with 2002 imports of crude oil increasing by 15.2 percent to reach 69.4 million tons equivalent. Second, the closure of nearly 60,000 small coal-mining pits in the past few years is having a favorable impact on productivity. The larger state-owned mines now account for 73 percent of the market (compared to 57 percent five years ago). It is expected that, as a result of the better management that is expected, this will have a favorable effect on reversing China's poor mine safety record and on the environment.

The role of automobile production-an increase of 55 percent during 2002-is receiving a lot of attention. Many analysts and some officials identify this industry segment and its ancillary industries as a potential leading sector in the future industrial development of China. Unfortunately, imports are also rising fast-82 percent in 2002. The population of China is large and growing, and increasingly locating in urban areas. Current and prospective purchase patterns among urban consumers suggest that policies to promote the sector will have to be especially sensitive to the costs of environmental pollution and congestion.

Figure 1: Sectoral Composition of Growth

Source: National Bureau of Statistics

Another focus of attention in the industrial sector is the growth of China's exports of light manufactures and household goods in 2003, which the SARS epidemic centered on Guangdong and Hong Kong is likely to affect. The Pearl River economy accounts for nearly $90 billion of exports and 10 percent of the output of China. Therefore, the recent drop in business travel and purchaser-supplier activity, especially during the crucial April-June period when most business transactions in the contract-manufacturing regime are negotiated, is likely to have adverse effects. This comes on top of the squeeze on profitability in China's export-oriented industries that compete fiercely in a relatively slowly growing global market, especially the textile sector, which faces rising prices for cotton.

Demand: Except for the uncertainties associated with the effect of SARS on the growth of domestic and external consumption, general demand prospects are strong. Fixed investment rose by 17.3 percent in 2002, and a slightly higher rate during the first quarter of 2003. The construction of capital projects, which rose by 16.3 percent, contributed 60 percent of the increase. The effect on investment of five years of macroeconomic stimulus spending is evident in the massive new public construction that has taken place in roads and subsidiary transport facilities, in the expansion of utilities, water conservation, forestry, and other public services. However, direct funding from the budget has supported just 14 percent of this increase in investment. Improved enterprise profitability accounted for a large increase in internal financing, but FDI, financial institution lending, and bonds grew rapidly. For example, the corporate bond market provided much needed financing for the railway and telecommunications sector, as well as for the Three Gorges Project. Total issuance amounted to RMB37 billion from 13 issuers and 17 issues, up 106 percent (y-y). In 2003, 3 corporate bond issues have raised RMB6.5 billion from the market. The newer modes of infrastructure finance that have developed in China in recent years will play a critical role in supporting demand as the government gradually reduces budgetary stimulus measures but, more importantly, will help meet the country's huge demand for development projects. Box 1 discusses some issues associated with infrastructure finance.

The efficiency of domestic investment needs to be raised. China's incremental capital-output ratio (ICOR) of 5, although a crude measure, reflects the dominance of long-gestation infrastructure investments in resource use and the reported lower efficiency of investments made (and largely financed) at sub-national levels. It is likely that over the long term China will be able to generate the same level of growth and possibly higher employment from a lower level of investment. An immediate concern related to demand in the economy is the increase in the domestic savings rate. As shown in Table 1, consumption continues to rise at a slower rate than total income (however measured), despite the macroeconomic stimulus program. Over the past five years, it has averaged an increase of 6.7 percent per year, compared to an income growth rate of 7.6 percent. However, during this period, and especially in 2002, the composition of public spending in the stimulus package progressively has targeted areas that would raise consumption directly. Higher transfers for civil service salaries and other government operating costs, pensions, and rural and low-income programs have been successful in propping up consumption as well as investment. Recent official pronouncements suggest that this shift in composition will continue to occur, with emphasis given to allocations that have a quicker and more powerful impact on demand. The use of public funds and policies to resolve rural distress and public sector payments arrears, and for the creation of a better social security program, should have a favorable effect on domestic demand.

During 2002, on average real urban disposable incomes rose by 13.4 percent, and urban consumption rose by 4.8 percent. By contrast, real rural net incomes rose by 4.8 percent (up from 4.2 percent in 2001), while rural consumption rose by 4.4 percent (up from 3.5 percent the previous year). As shown in Table 2, the trend in urban-rural standards of living continues to be disturbing. Widening urban-rural inequality and its potential to undermine growth and social cohesion suggests that better targeting of government stimulus spending toward lower income groups will have a dual payoff-more powerful short term stimulus and long term growth.

Box 1: Infrastructure Finance

A re-examination of infrastructure finance is underway in China. This stems from several factors-large development needs, highlighted by the Western Region Development program; budgetary pressures, including the need for curbing reliance on extra-budgetary resources for infrastructure construction at local levels; recognition of the complex financial needs of capital projects that cannot always be met by conventional loans, true especially of cases involving private-public or foreign participation; and the promotion of urbanization that, at least in its initial stages, tilts the balance towards infrastructure and away from corporate finance.

There are no precise estimates of the likely demand for infrastructure finance, but some conservative estimates place the total at US$1 trillion equivalent for this decade. In the near-term, bank lending for infrastructure will continue to be dominated by China Development Bank (CDB), which extended US$24 billion to state projects in 2002. During 1998-2002, in the context of the stimulus program, CDB lending represented over 40 percent of total infrastructure loans. The four state-owned commercial banks are also significant lenders. In total, therefore, at end-2002 infrastructure loans accounted for 37 percent of total local currency loans.

However, new forms of infrastructure finance have emerged. In 2002, some institutions (for example, Shenzhen Development Bank, Minsheng Bank) debuted "public entrusted loan schemes" by intermediating funds between, on the one hand, retail investors (minimum participation of RMB10,000) and enterprises (RMB500,000) and, on the other, final borrowers for projects such as water sewage processing and industrial parks. By end-2002, such private and public forms of entrusted loans amounted to only RMB240 billion (compared to bank lending of RMB13,980 billion). However, they are attractive vehicles for investors (average return of 3 percent, compared to 1.98 percent in bank deposits), who look to the commercial banks, official project promoters, and other enhancements as risk mitigation mechanisms that permit them to participate in otherwise complex and non-transparent financial packages for infrastructure investment. This instrument is likely to grow, especially if the roles of commercial banks and project sponsors are clarified and disclosure strengthened.

At the same time, controversy surrounds similar "capital trust schemes" offered by the trust and investment companies, the first of which highlighted in its offering document an estimated 5 percent annual return. Individual schemes are restricted to 200 settler and minimum participation of RMB50,000 per settler. Lax disclosure has marked the offerings of such funds, inadequate due diligence, and unclear guidelines for trust administration. This prompted the central bank to issue a warning in October 2002 about the excessive growth of such instruments and inherent product risks.

Clearly, high demand for infrastructure finance and liberalization of the financial sector will stimulate innovation in this market segment. However, the involvement of less sophisticated investors in public or quasi-public financial products warrants closer market supervision and a robust legal framework. Project finance and risk management skills at financial institutions need to be raised. The rates at which CDB and the state commercial banks are accelerating infrastructure lending will heighten their project finance related risks and exposure to public projects. This exposure is higher than suggested by their loan portfolios; commercial banks hold large volumes of government and CDB bonds that were also raised to support infrastructure investment. Eventually, local governments should be able to borrow directly to meet their infrastructure finance needs, conditioned on strengthening the current system of intergovernmental finance. Private investors can also be tapped, but first require a stronger enabling environment for participating in infrastructure investment.

Table 2: Average Urban and Rural Income and Spending (RMB/year per person) a/

a/ Disposable income of urban residents, net income of rural residents. b/ Estimated

Source: National Bureau of Statistics and World Bank staff estimates.

External demand continues to play an important role in promoting growth and employment. Since the third quarter of 2001 the net effect on demand of foreign purchases of China's exports and Chinese residents' purchases of imported goods has been positive, reversing the trend during 7 of the 10 previous quarters. During 2002, exports rose by 22.3 percent, assisted by a 7.4 percent real effective depreciation of the Renminbi, while imports grew by 21.2 percent. However, imports into the processing trade grew significantly faster than exports, 30.1 percent and 22 percent, respectively. The more rapid increase in imports is no longer restricted to the processing regime-the overall import content of Chinese economic activity has risen in the first year after WTO accession. During the first quarter of 2003 imports rose by 52.4 percent (y-y), compared to an export growth rate of 33.5 percent, partly reflecting accelerated purchases ahead of the anticipated conflict in Iraq. Notwithstanding the momentum on trade, several factors-SARS, dampened global trade-suggest that exports will grow slowly over the next few quarters, moderating China's overall economic growth rate. It is difficult to provide reasonable estimates of China's near-term growth prospects given the high level of uncertainty regarding international trade and incomplete information about the economic policy intentions of the new administration in China. Based on first quarter developments, our projections suggest that GDP growth is likely to slow to the 7-7.2 percent range during 2003.

Macroeconomic Policy

Fiscal-Monetary Policy: The coordination of fiscal and monetary policy, but also the pace of economic reform and creation of a better investment climate, will play a key part in determining short and medium term prospects. Fiscal policy has been an important pillar supporting economic activity in China since 1998. High revenue buoyancy-reflecting reforms in taxation and improved collection efforts-facilitated an expansionary budgetary stance. During 2002, total revenues rose by 15.4 percent and the revenue to GDP ratio rose to 18.6 percent (compared to 11.6 percent in 1997). Despite higher government expenditure, the size of the budget deficit has fallen relative to total output in the economy, from a peak 4 percent of GDP in 1999 to last year's 3 percent. Slower revenue growth is projected for 2003, so the budget deficit is expected to rise as a share of total output to 3.4 percent.

Four issues have resurfaced about the size of the fiscal deficit and continuation of the policy of macroeconomic stimulus. First, the rapid increase in public debt, from 11.4 percent of GDP in 1997 to 25.3 percent in 2002, has kept the question of fiscal sustainability on the front burner. The burden of servicing government debt limits the availability of resources for development spending, especially in the social sectors. However, most analysts agree that the prospects for revenue increases in the future make it highly likely that the current level of budget deficits is sustainable.

Second, despite this, the existence of additional liabilities (contingent, implicit, or hidden, for example, banking losses, pension payments, or local government debt) increases pressures for fiscal consolidation. Obviously, the problem will need to be addressed on several fronts-for example, policies to cut costs and improve operations at banks and to implement social security reforms and a better functioning intergovernmental fiscal system; asset sales to improve the financial position of banks and the social security fund. In addition, the rapid growth of the Chinese economy will create favorable conditions for reducing the size of such liabilities. However, it is equally clear that there will be need for fiscal intervention, albeit phased-in over time to match the resources available in the government budget. For example, under most reasonable scenarios the four state-owned commercial banks would find it difficult to simply "grow" out of their current portfolio problems. The size and nature of a fiscal intervention package to support their own efforts to trim costs and improve lending practices to reduce losses is yet to be determined.

The third issue is concerned with the potential for government borrowing and the need for reform in the government bond market. Total borrowings to cover the budget deficit in 2002 reached RMB593 billion (US$72 billion), of which RMB258 billion was for debt servicing, and RMB25 billion for on lending to local government.2 The 2002 borrowing was effected through RMB446 billion of marketable debt and RMB147 billion of non-marketable savings certificates. Despite commendable market building initiatives (for example, appointment of market-makers, desegregation of markets, extension of maturities, fixed rate issues, greater transparency of offerings), under-subscription problems arose for three issues, and government securities turnover stayed at low levels. The essential ingredients for an efficient government securities market are being developed. These include the legal framework, improved sales techniques (market-based pricing through auctions, revised distribution mechanisms, standardization of debt instruments), development of market intermediaries and institutional investors, better clearance and settlement, and effective regulatory and prudential supervision.