INTERNATIONAL MONETARY FUND CHINA ECONOMIC OUTLOOK

February 6, 2012

Prepared by the IMF Resident Representative Office, Peoples Republic of China

Chinas economy is slowing, but remains a bright spot in an unpredictable global economy Growth is expected to stay above 8 percent in 2012-13 Inflation is coming down to more comfortable levels The real estate market is deflating

A storm emanating from Europe would hit China hard Chinas growth rate would drop abruptly if the Euro area experiences a sharp recession But China has room for a countervailing fiscal response, and should use that space Unlike 200910, any stimulus should be executed through the budget rather than the banking system The weak global outlook reinforces the importance of rebalancing Chinas economy This means more private consumption and a diminishing reliance on investment Financial and corporate sector reforms will be critical to achieving this economic transformation

The Baseline Outlook

1. The global recovery is threatened by elsewhere. The latest World China. The Chinese economy has, once again, shown its resilience in the midst of a difficult external environment, buoyed by robust corporate profitability and rising household incomes (Figure 1). However, net exports will prove to be a significant drag on growth in the coming two years, with the current account surplus remaining at 34 percent of GDP. As a result, growth is expected to fall to 8 percent this year (from 9.2 percent in 2011), gathering speed in the latter part of this year and rising to 8 percent in 2013 (Table 1 and Figure 2). 3. Inflation has peaked but will continue Inflation fell to intensifying strains in the euro area and fragilities Economic Outlook (WEO) projections forecast a deceleration in global activity to 3 percent in 2012. This represents a downward revision of about percentage points relative to the September 2011 WEO, largely a result of the euro area entering a mild recession, contracting by percent in 2012. Growth in emerging and developing economies is expected to reach 5 percent this year, percentage point less than forecasted in the September 2011 WEO. 2. This weaker global environment has

led staff to lower their growth forecasts for

to be vulnerable to supply-driven food price increases.

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FIGURE 1. RECENT DEVELOPMENTS

Domestic demand remains strong as stimulus is withdrawn. Household spending has moderated to pre-crisis levels
Retail Sales
(In percent, year-on-year growth)

and private investment has taken over from public stimulus

Fixed Asset Investment
(In percent, year-on-year growth)

20

100

60

Total investment Private

60

10

50

40

Public

40

20
0
Total (LHS) -10 2007 2008 2009 2010 2011 Automobiles Durable goods -50

20

-20 2007 2008 2009 2010 2011

-20

supported by strong profitability. Rising labor costs appear so far to be largely matched by productivity gains.
China Unit Labor Cost and Industrial Profit Margin
8

The government is successfully calming the property market, but underlying construction activity remains healthy.
Residential Property Price and Activity, National
( In percent, yoy, sa)

120

Investment Floor space sold Price

120

20

80
6 10

80

40
4

40

Unit labor cost (4Qma, yoy growth ) Nominal wages (4Qma, yoy growth) Total profit margin (percent 4Qma, RHS)

-10

2000

2004

2009

2011

2000

2004

2009

2011

-40 2007 2008 2009 2010 2011

-40 Dec - 11

Inflation has peaked and is now declining

Inflation
(In percent) 10 8 6 20 4 10 2 0 -2 2007 2008 2009 2010 2011 0 Food contribution (y/y) Non-Food contribution (y/y) CPI (m/m, saar, RHS) 40

while the trade surplus has continued to fall through the global crisis.
Current Account and Components
(In percent of GDP)

Services balance
9

Income balance

9
6 3 0 -3 -6 2011 ytd Q3

30

6 3 0 -3 -6

Net transfers
Goods balance Current account balance

-10

1971

1981

1991

2001

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Table 1: Main Economic Indicators

2011 2012 2013

prices should be regarded as a welcome development, giving household income an opportunity to catch up with housing costs. Nevertheless, the reliance on administrative
8.8 9.3 9.6 8.9 -0.2 3.0 3.8 -1.4

(percent change, unless otherwise specified) Real GDP Domestic Demand Consumption Investment Net exports (contribution to growth) Inflation (average) Current account (percent of GDP)1 General government balance (percent of GDP)1
1

9.2 10.3 10.0 10.6 -0.5 5.4 3.3 -2.0

8.2 9.5 9.6 9.4 -0.9 3.3 3.2 -2.0

measuresto contain leverage and curtail purchasescarries its own risks and could become less effective over time. A more durable remedy to Chinas propensity for property bubbles has to be firmly rooted in policies that raise the cost of capital, provide a broader range of alternative investment vehicles for savers, and institute a broad-based property tax. 5. Upward pressures on the currency

Staff projections for 2011

4.1 percent at end-2011 and will continue to decline steadily in the first few months of this year. However, the tight supply-demand balance for domestically produced food will mean that even small shocks to supplyfrom adverse weather conditions or diseasewill have a disproportionate effect on prices. A durable solution will require broad-based reforms to increase agricultural productivity, improve distribution networks, facilitate food imports, and generally raise the responsiveness of food supply to rising prices. 4. The governments efforts to cool the

have diminished recently. The renminbi appreciated by around 6 percent in real effective terms in 2011. At the same time, the pace of reserve accumulation has fallen due to multiple factors including a smaller trade surplus, higher global risk aversion, and valuation effects associated with a stronger U.S. dollar. However, given the current account still has a sizable surplus in U.S. dollars and FDI remains strong, the pace of reserves accumulation should resume this year. 6. Monetary conditions should be fine-

tuned to allow for some modest additional credit to the economy. Following a tight third quarter last year and a slowing of foreign inflows, M2 growth ended the year at 13.6 percent. In the last few months, the authorities have allowed for a modest increase in liquidity, including through a 50 basis point reduction in reserve requirements in December. This year, an M2 growth target of 14 percent would be prudent and would strike the right

property sector have been effective. The market is beginning to deflate, with price growth slowing and transaction volumes down. Encouragingly, underlying investment remains healthy, in part due to the governments efforts to expand the supply of social housing. At present, there seems little reason to backpedal on the measures put in place to deflate the market. Indeed, a modest decline in property

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FIGURE 2. OUTLOOK AND RISKS

Growth is likely to moderate but will still be at healthy levels.
Contribution to GDP Growth
(In percent, annual average) 20 20 6 4 10 10 2 0 -2 -4 2006 Others Edible Oil Food-related services Residence 2007 2008 2009 2010 2011 2 4

Inflation will fall although volatile food prices remain a significant vulnerability.
Consumer Price Inflation
(In percent) Contibution to Underlying Inflation Forecast 8

-10 2007Q1

Net exports Private investment & change in stocks Private consumption Public GDP growth 2008Q1 2009Q1 2010Q1 2011Q1

Confidence intervals 0 2010 2011 2012

-10 2012Q1 2012Q4

As in 200809, a severe recession in advanced economies would hit China hard through lower exports.
Contribution to Export Growth
(Percent of total) 9 2002-04 2005-07 2008-09 2010-11 9

The real estate market presents the biggest domestic risk.1

China: Potential Effects on Property Downturn
(In percent) Output Bank Distress Corporate Distress -8 Corporate and Bank Distress Real Share Prices

-3
4 4

-3

-8

-1

-1

Asia Africa, LatAm, Oceania Europe North America

Asia Africa, LatAm, Oceania Europe North America

Asia Africa, LatAm, Oceania Europe North America

Asia Africa, LatAm, Oceania Europe North America

-13

Corporate Distress Bank Distress

-13

-18

-18

Historical and international experience would indicate the large credit stimulus of 200910 has increased the risks in the banking system...
Credit/GDP
(In percentage points, change over five years) 35 98 25 94 00 Current (2005-10) Previous banking crises (label indicates year) 81

and could hit bank balance sheets hard in the face of a significant growth and real estate downturn.
China: Macro-Scenario Results
(In percent, end-2009) 12

97

10 8 6

NPL

CAR

15
5 -5 -15

91

98

93

83

94

97 01

89

4 2 0
Growth = Property price decline = Source: PBC/CBRC

CN BR TR NG SG CO IN PE ZA VE ID AR JO

HK CL MY

AR: Argentina; BR: Brazil; CL: Chile; CN: China; CO: Colombia; HK: Hong Kong SAR; ID: Indonesia; IN: India; JO: Jordan; MY: Malaysia; NG: Nigeria; PE: Peru; SG: Singapore; TR: Turkey; VE: Venezuela; ZA: South Africa. Figure shows bank credit to the private sector. For Argentina, calculations are based on official GDP and CPI data. Right scale.

No shock

7 percent ; 7 percent;

Mild

Medium

5 percent; 16 percent;

Severe

4 percent 26 percent

In this scenario, a downturn of the property market causes a sizable portion of credit to local government financial platforms, the real estate sector, and small and medium enterprises to become impaired.
1

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balance between the need to provide modest support to a slowing economy while being conscious of the credit overhang and risks to the banks created by the post-crisis credit stimulus. In particular, a McCallum rule would suggest that an M2 growth target of around 14 percent would be consistent with staffs forecast for growth and inflation. Over the next couple of months, liquidity conditions should be finetuned through open market operations. However, if foreign inflows remain subdued, reserve requirements could also be lowered. Meanwhile, the ongoing decline in inflation should be viewed as an opportunity to raise real loan and deposit rates in order to move the cost of capital closer to equilibrium and increase household financial income. Allowing prices to

play more of a role in clearing the capital market would enable the central bank to rely less on administrative limits on credit to achieve its monetary goals. 7. Given the uncertain global outlook,

some modest fiscal support to the economy is warranted. In particular, for 2012, plans for fiscal consolidation should be deferred and a general government deficit of around 2 percent of GDP should be targeted. Given very buoyant tax receipts, this could be achieved even with a lowering transfers public of social contributions to in the social poor and social and consumption taxes, an increase in (particularly investments

unemployed), and an acceleration of the ongoing housing.

A Clear and Present Danger Emanating from Europe

8. As identified in the latest WEO and the WEO Updatewhich would see global growth falling by 1 percentage points relative to the baselineChinas growth would fall by around 4 percentage points (Box 1). The risks to China from Europe are, therefore, both large and tangible. 10. In the unfortunate event such a Global Financial Stability Report Updates, the global economy is at a precarious stage and downside risks have risen sharply. The most salient risk is from an intensification of feedback loops between sovereign and bank funding pressures in the euro area, resulting in more protracted bank deleveraging and sizable contractions in credit and output in both Europe and elsewhere. 9. Should such a tail risk of financial

downside scenario becomes reality, China should respond with a significant fiscal package, executed through central and local government budgets (Figure 3). At a time when much of the rest of the globe would fall into recession, China should be prepared to tolerate modestly lower growth in the near term while cushioning the impact on the most vulnerable through targeted transfers and unemployment

volatility emanating from Europe be realized, it would drag Chinas growth lower. The channels of contagion would be felt mainly through trade, with knock-on effects to domestic demand. In the downside scenario outlined in

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BOX 1. BRACING FOR THE STORM: HOW WOULD CHINA FARE IF THE EURO AREA FALTERS?
The WEO update envisages a global downside scenario under which intensification in adverse feedback loops between sovereign and bank funding pressures in the euro area results in sizeable contractions in credit and output. It assumes that sovereign spreads temporarily rise and increased concerns about fiscal sustainability force a more front-loaded fiscal consolidation, depressing near-term demand and growth. Bank asset quality deteriorates by more than in the WEO baseline, owing to higher losses on sovereign debt holdings and on loans to the private sector. Private investment contracts by 1 percentage points of GDP and euro area activity is reduced by about 4 percent relative to the WEO forecast. Assuming that financial contagion to the rest of the world is more intense than in the baseline (but weaker than following the collapse of Lehman Brothers in 2008), global activity would be lower by about 2 percent. Chinas closed capital account would provide some protection from financial spillovers. Foreign banks claims on Chinese banks are less than 1 percent of Chinese bank liabilities, while foreign assets of Chinese banksincluding sovereign debtrepresent only 2 percent of their total assets. In addition, given the large deposit base, Chinese banks do not depend on wholesale funding and Chinese non-financial corporations have minimal reliance on external funding. That said, a sharp fall in European and other advanced economies equity markets could affect sentiment, feeding through to Chinas equity markets, and may also create disruptions in the availability of trade credit. China would be highly exposed through trade linkages. Europe and the United States together account for nearly half of Chinas total exports. Lower global demand would, therefore, feed back negatively to corporate and financial sector balance sheets, hampering the performance of firms in the tradable sector (where excess capacity is already prevalent), increasing NPLs, and potentially prompting banks to deleverage. This would further reduce investment, employment and growth and could trigger a decline in Chinas property market. In the absence of a domestic policy response, Chinas growth could decline by as much as 4 percentage points relative to the baseline projections leading to broad-based consumer and asset price deflation. Chinas vulnerability to external shocks was highlighted in the global financial crisis, when global growth fell by around 6 percent. In China, even after a huge credit and fiscal stimulus response, which boosted growth by at least 6 percentage points, growth still fell by 5 percentage points. However, a track record of fiscal discipline has given China ample room to respond to such an external shock . A sizable fiscal stimulus could mitigate, but not fully offset, the decline in its output. In particular, a front-loaded fiscal stimulus of around 3 percent of GDP spread out over 201213 would limit the growth decline to around 1 percent, cushioning the adverse effects on employment and peoples livelihoods.
Effect on China Output
4 4

Effect on China Assets and Consumer Prices

10 Deviation from baseline
Without stimulus, deviation from baseline

20

2 With fiscal stimulus 0

5 CPI inflation (LHS) Share prices (RHS)

0 CPI inflation (LHS)

0 0

-20

-2

-2 -5

Share prices (RHS)

-40

-4

Without fiscal stimulus

-4

-60

-6 1 2 3 4 5

-6

-10 1 2 3 4 5 1 2 3 4 5

-80

(Effects shown in charts represent the impact of the downside scenario in the WEO update on Chinas output, consumer and asset prices,
relative to the WEO baseline)

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benefits. A fiscal packageof around 3 percent of GDPshould be the principal line of defense. Stimulative measures could include further reductions in social contributions or consumption taxes, direct subsidies to the purchase of consumer durables, corporate incentives to expand investments that reduce pollution and energy use, fiscal support for smaller enterprises, advancing plans for social housing, and scaling up investments in the social safety net. Unlike in 2008, the stimulus packageincluding transfers to the subnational level to support their spendingshould pass through the budget and not be reliant upon a public infrastructure package that is routed through the banking system, state enterprises, and local government financing vehicles. Residual concerns about credit quality and bank balance sheets from the 200910 stimulus would mean that any monetary response to an unfolding European crisis should be limited.

11.

The

weak

external

outlook

underscores the importance of accelerating the transformation of Chinas economy to reduce its vulnerability to the vagaries of global demand. China has taken a number of encouraging steps, including appreciating the renminbi, making substantial investments in the social safety net, expanding pension and health care coverage, raising the minimum wage, and beginning to raise the cost of inputs to production (particularly energy). Greater efforts are now needed to raise household income and shift the growth structure from exports and investment toward consumption. As outlined in the 2011 IMF Staff Report on China, this requires measures in a number of areas, including financial and corporate sector reforms that would pave the way for Chinas citizens to share more fully in the dividends from high and sustained growth.

Lingering Domestic Risks

12. China still has a long way to go to 13. A large external shock would bring digest the side effects of the surge of credit unleashed in the wake of the global crisis. In particular, there are balance sheet risks from the slowing real estate and export sectors, as well as possible losses on lending to local government financing vehicles. On their own, the potential costs from these problems appear manageable and could be absorbed without significantly derailing growth. However, this requires that bank regulation and supervision be attuned to proactively identifying and managing these risks. many of these domestic risks more forcefully to the forefront. The biggest concern would be a coinciding, self-reinforcing slump in both the tradable and property sectors. This could precipitate a steeper than anticipated decline in prices, transaction volumes, and propertyrelated investment. The appropriate response would be to boost property demand through the government purchasing homes directly for social housing purposes and selectively relaxing some of the administrative purchase restrictions for

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FIGURE 3. POLICY PRIORITIES

Fiscal consolidation should be deferred to provide support to the slowing economy. Fiscal stimulus should also be the main line of defense if downside risks materialize.
China: General Government
(In percent of GDP) 40 Debt 30 2 20
60

Government debt is projected to remain sustainable even under extreme circumstances.

China: Central Government Debt
(In percent of GDP) 100 Baseline Including contingent debt

Overall balance (RHS)

80

40

10

-2

20

0 2006 2007 2008 2009 2010 2011

-4

0 2011 2012 2013 2014 2015 2016

Unlike in 2008-10, stimulus should be focused less on investment and more on raising consumption and household income.
Domestic Demand
(In percent of GDP)

with monetary policy continuing to normalize, to contain the balance sheet risks associated with the 200910 credit surge.
M2 Growth
(In percent; based on estimated McCallum-type Rule) 30 Actual 30

60

60

25

Desired

25

20
40 40

20

20 1992

Consumption Household consumption Investment

1996 2000 2004 2008 2011

15

15

20

10 2007

2008

2009

2010

2011

2012

10 2012Q4

A property slump could be contained by selectively loosening some purchase restrictionsfor first time buyers, lower income groups, and those seeking to purchase social housingand accelerating social housing construction...

while stepping up rebalancing efforts in order to sustain Chinas growth and make it more inclusive.

Selected purchase restrictions

Minimum downpayment for homes larger than 90 increased to 30 percent m2

Asia: Change in Gini Index, Last Two Decades1

(in Gini points)
China, urban ( 2005, 34.8 ) Nepal ( 2004, 47.2 ) Sri Lanka ( 2006, 40.3 ) Lao PDR ( 2008, 36.7 ) Cambodia ( 2007, 44.4 ) Bangladesh ( 2005, 33.2 ) China, rural ( 2005, 35.9 ) Japan ( 2010, 28.7 ) New Zealand ( 2009, 33.0 ) Hong Kong SAR ( 2002, 49.5 ) Philippines ( 2006, 44.0 ) India, urban ( 2004, 37.6 ) Korea ( 2010, 34.1 ) Indonesia, rural ( 2009, 29.5 ) Australia ( 2008, 33.1 ) Indonesia, urban ( 2009, 37.1 ) Singapore ( 2003, 43.7 ) India, rural ( 2004, 30.5 ) Vietnam ( 2008, 37.6 ) Taiwan POC ( 2009, 31.7 ) Malaysia ( 2009, 46.2 ) Mongolia ( 2005, 33.0 ) Thailand ( 2007, 41.9 )

Minimum downpayment for second homes increased to 60 percent Mortgage loans for third or more homes banned nationwide
Buyers without at least 1 year of local tax or social

security records treated as second home buyers

-4

-2

10

Sources: CEIC Data Company Ltd.; World Bank, PovcalNet database; WIDER income inequality database; Milanovic (2010); national authorities and IMF staff calculations. 1 In parentheses, the latest available year and corresponding Gini coefficients.

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first time buyers, lower income groups, and those seeking to purchase social housing. Limits on lending to property (such as loan-to-value ratios), however, should be maintained to protect the financial system from the impact of a property downturn. 14. into The ongoing migration of resources nonbank means of financial

oversight of nonbank forms of intermediation, and accelerating progress toward financial liberalizationalong the lines proposed in the 2011 IMF Staff Report. 15. Finally, continuation of the current,

very high levels of investment may, over time, undermine bank and corporate balance sheets. Much of the decline in the external surplus, at least so far, has been achieved through very strong investment growth, rather than the more desirable boost to consumption as a share of output. Such a decline in the external surplus due to higher investment would be undesirable, shifting concerns to a growing internal by imbalance that could capacity, ultimately lowering undermine the sustainability of Chinas growth aggravating excess productivity, and generating bad loans. A key measure to address these concerns, and shift to a more consumption-led economy, would be to raise the artificially low cost of capital in China (Box 2).

intermediation casts a widening shadow on monetary control and financial stability. Over the past year, the government has restricted bank lending through administrative means, creating incentives to shift resources into a less transparent and perhaps less well regulated nonbank financial system. In turn, this growing pace of financial innovation is complicating macroeconomic policy and undermining the effectiveness of using monetary aggregates as a policy target. It is also increasing liquidity pressures for smaller banks. While unlikely to create a systemic risk in the short term, left unaddressed, vulnerabilities could steadily build up over time. This underlines the urgency of undertaking a broad rethink of the monetary policy framework, strengthening regulatory

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BOX 2. WHY MORE IS LESS: FINANCIAL REFORM AND HOUSEHOLD SAVINGS IN CHINA 1
In the mid-1990s, urban households in China saved 19 percent of their disposable income on average. By 2009, their saving rate had increased to 30 percent. This increase is puzzling since it occurred during a time when the economy grew rapidly, urbanization proceeded at a relatively rapid pace, and household earnings prospects improved. Such influences could have been expected to dampen savings impulses, rather than trigger them. Although a similar decline in the consumption-GDP ratio has been seen during other economies development, Chinas consumption started at a relatively low level and has fallen further over the past two decades. Rebalancing Chinas economy back toward consumption will require, among other policies, measures that raise household income and induce people to save less and consume more. The evidence indicates that financial reformin particular interest rate liberalization and an increase in real deposit ratescan contribute to boosting consumption. Since a large portion of household savings is placed in banks, the return on bank deposits has the potential to have a large impact on saving behavior. With deposit rates that are well below the rate of inflation in recent years, the real return on bank deposits has declined steadily. As real interest rates have declined, urban saving rates have moved in the other direction. Examining the data across Chinas 31 provinces, it is clear that households save to meet multiple needsselfinsurance, retirement, meeting the downpayment to purchase a homeand appear to behave as though they have a target level of savings in mind. The data suggests that when the return to saving falls, households have a tougher time meeting their target savings and react by increasing the share of their disposable income that they save. Higher interest rates work in the opposite direction, leading households to reduce their savings. Higher real interest rates, therefore, hold significant promise in boosting private consumption. Financial reform and interest rate liberalization should be a key part of accelerating Chinas economic transformation toward a consumption-based growth model. Building on the steps taken in recent years to strengthen Chinas financial system, the next stage of financial reform will need to be sequenced appropriately to minimize the risks of a disorderly liberalization.2 A broad roadmap for reform would include adopting a new monetary policy framework; raising real interest rates; strengthening and expanding regulatory coverage of the financial system; putting in place a broad set of tools for crisis management; developing financial markets and alternative means of intermediation and new instruments for saving; deregulating interest rates; and, eventually, opening up the capital account. Progress is being made in many of these areas and should be accelerated through the course of the 12th Five Year Plan. With higher real interest rates and more market-determined pricing of capital, the returns to household savings will increase. Empirical work would suggest that such a sustained increase in the interest rates on bank deposits and wider access to alternative investment opportunities will induce households to spend more, accelerating the transition to consumption-led growth in China.
1 See Nabar, M. (2011), Targets, Interest Rates, and Household Saving in Urban China, IMF Working Paper 11/223 2 For details on sequencing, see Peoples Republic of China: Staff Report for the 2011 Article IV Consultation.

Urban Household Saving Rate and Real Deposit Rate

(In percent) 30 2

28

26 0 24 -1 Urban household saving rate 3yma real deposit rate (RHS) 20 2003 2004 2005 2006 2007 2008 2009 -2

22

10

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