China's Growth and Integration into the World Economy : Prospects and Challenges

O C C A S I O N A L PA P E R 232
China’s Growth and Integration into
the World Economy
Prospects and Challenges
Edited by Eswar Prasad
With contributions from
Steven Barnett, Nicolas Blancher, Ray Brooks, Annalisa Fedelino,
Tarhan Feyziog?lu,Thomas Rumbaugh, Raju Jan Singh, and Tao Wang
INTERNATIONAL MONETARY FUND
Washington DC
2004

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O C C A S I O N A L PA P E R 232
China’s Growth and Integration into
the World Economy
Prospects and Challenges
Edited by Eswar Prasad
With contributions from
Steven Barnett, Nicolas Blancher, Ray Brooks,Annalisa Fedelino,
Tarhan Feyziog?lu,Thomas Rumbaugh, Raju Jan Singh, and Tao Wang
INTERNATIONAL MONETARY FUND
Washington DC
2004

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China’s growth and integration into the world economy: prospects and
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p. cm. — (Occasional paper, 0251-6365; 232)
Includes bibliographical references.
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1. China—Foreign economic relations. 2. Prices—China. 3. Foreign
exchange—China. 4. Banks and banking—China. 5. Labor market—China.
I. Prasad, Eswar. II. Barnett, Steven (Steven Alan). III. Occasional paper
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Contents
Preface
vii
Abbreviations and Acronyms
ix
I
Overview
1
Eswar Prasad and Thomas Rumbaugh
Rapidly Expanding International Trade
1
Price Dynamics
2
Real Exchange Rate Fluctuations
3
Fiscal Policy
3
Banking System Reform
3
Unemployment
4
The Outlook
4
II
International Trade and the Challenges of WTO Accession
5
Thomas Rumbaugh and Nicolas Blancher
China’s Impact on Trade Patterns
5
WTO Accession: Commitments, Opportunities, and Risks
9
III
Price Dynamics in China
14
Tarhan Feyziog
?lu
Stylized Facts
14
Key Sources of Price Changes
15
Regression Results
16
Appendix: Data Sources and Calculations
20
IV
Exchange Rate Dynamics
21
Tao Wang
Exchange Rate Developments: A Historical Overview
21
Determinants of the Medium-Term Path of the Real Exchange Rate
22
Sources of Real Exchange Rate Fluctuations
25
V
Medium-Term Fiscal Challenges
29
Annalisa Fedelino and Raju Jan Singh
Recent Fiscal Developments
29
Medium-Term Challenges
32
Conclusions
35
VI
Fiscal Federalism
36
Annalisa Fedelino and Raju Jan Singh
The 1994 Fiscal Reform
36
Some Implications of the Current System
40
Conclusions
41
iii

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CONTENTS
VII
Banking Sector Developments
43
Steven Barnett
The Banking System Today
43
Challenges and Risks
45
Recent Reforms
47
Conclusions
50
VIII
Labor Market Performance and Prospects
51
Ray Brooks
Trends in China’s Labor Market
51
Labor Market Reforms
55
Some Illustrative Projections
59
The Road Ahead
61
References
62
Boxes
1.1. China’s Approach to Economic Reform
2
2.1. Selected Aspects of China’s WTO Accession
11
2.2. The International Impact of China’s WTO Accession
12
4.1. Identification of Shocks in a Structural VAR Model
26
5.1. An Assessment of China’s State Equity Share in SOEs
34
6.1. Intergovernmental Fiscal Relations and Market Reforms in China:
A Review of the Literature
37
6.2. Fiscal Risks of Local Governments: The 2002 Audit Report
41
7.1. Developments in State Commercial Banks
48
8.1. Steps Toward Labor Market Flexibility
56
8.2. Hukou Reform
57
Tables
2.1. Market Share in Major Export Markets
6
2.2. Sources of Imports
6
2.3. Exports of Selected Economies to China
8
2.4. Indicators of Export Dispersion
8
2.5. Measures of Dispersion of Exports to the United States
9
2.6. China’s Bilateral Trade Balances with Selected Economies
10
2.7. Tariffs
10
3.1. OLS Estimates of a Reduced-Form Inflation Equation
18
4.1. Medium-Term Determinants of the Real Exchange Rate:
Extended Relative PPP Method
24
4.2. Measures of Underlying Current Account Balance and Norms
25
5.1. Selected Countries: Comparison of Public Debt and Fiscal
Positions, Average 2000–02
29
5.2. State Budget Revenue
30
5.3. State Budget Expenditure
31
6.1. Per Capita Income Levels of Selected Provinces, 2002
36
6.2 Differences in Revenue Performance by Province, 1995 and 2002
38
6.3. Shares of Central and Local Governments in Selected Budgetary
Expenditure, 2001
39
6.4. Transfers from the Central to Local Governments
39
7.1. Deposit Money Banks’ Market Shares
44
7.2. Reported Nonperforming Loans
46
8.1. Population, Labor Force, and Employment
52
8.2. Employment by Enterprise Ownership
54
iv

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Contents
8.3. Employment by Industry
55
8.4. Selected Asian Economies: Labor Productivity, 2000
56
8.5. Industrial Employment and Output
58
8.6. Estimates of Elasticity of Nonagricultural Employment Growth
to Output Growth
59
8.7. Labor Force and Employment Projections
60
8.8. Projections of Jobs for Migrants and Laid-Off Workers from SOEs
60
Figures
2.1. Growth in Trade
5
2.2. China’s Trade with the Region
7
2.3. Exports of Selected Economies
8
2.4. Trade in Electronic Products: Monthly Imports of
Electronic Components
9
3.1. Real GDP Growth and CPI Inflation
14
3.2. Inflation
15
3.3. Components of CPI Inflation
15
3.4. Alternative Measures of Inflation
16
3.5. Variables Used in the Regression
17
3.6. First-Round Impact of the Regression Variables on Inflation
19
4.1. CPI-Based Real Effective Exchange Rate and Its Components
21
4.2. Unit-Labor-Cost-Based Real Effective Exchange Rate and
Its Components
22
4.3. Proxies for Relative Export Prices
22
4.4. Variables Used in the Estimation of the Medium-Term Exchange Rate
23
4.5. Actual and Estimated CPI-Based REER
24
4.6. Accumulated Impulse Response Functions for the Real Effective
Exchange Rate
27
4.7. Decomposition of Forecast Errors of Real Exchange Rate
27
5.1. Revenue, Expenditure, and Fiscal Balance
30
5.2. Government Debt and Its Composition
32
6.1. Revenue Developments
37
6.2. Central and Local Governments’ Budgetary Positions
40
6.3. Extrabudgetary Funds
40
7.1. Selected Economies: Ratio of Domestic Credit to GDP
43
7.2. Financial Institutions’ Renminbi Loans
45
8.1. Employment and GDP
53
The following symbols have been used throughout this paper:
. . . to indicate that data are not available;
— to indicate that the figure is zero or less than half the final digit shown, or that the item
does not exist;
–
between years or months (e.g., 2001–02 or January–June) to indicate the years or months
covered, including the beginning and ending years or months;
/
between years (e.g., 2001/02) to indicate a fiscal (financial) year.
“n.a.” means not applicable.
“Billion” means a thousand million.
Minor discrepancies between constituent figures and totals are due to rounding.
The term “country,” as used in this paper, does not in all cases refer to a territorial entity that
is a state as understood by international law and practice; the term also covers some territorial
entities that are not states, but for which statistical data are maintained and provided interna-
tionally on a separate and independent basis.
v

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Preface
This Occasional Paper provides an overview of analytical work done by IMF staff
as background for the 2002 and 2003 Article IV Consultations with the People’s Re-
public of China.
The authors would like to express their deep appreciation for the valuable guidance
provided by Steven Dunaway, the IMF’s mission chief for China during this period.
They also thank David Burton and Wanda Tseng for their encouragement and advice.
The authors are grateful to the Chinese authorities for the information that they pro-
vided and for the extensive discussions and comments that helped sharpen the analy-
sis and presentation in this paper. Ioana Hussiada provided research assistance for this
project; Yuko Kobayashi and Carolina Klein handled the preparation of the manu-
script; and Esha Ray of the External Relations Department coordinated production of
the publication.
The opinions expressed in this paper are solely those of its authors and do not nec-
essarily reflect the views of the International Monetary Fund, its Executive Directors,
or the Chinese authorities.
vii

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Abbreviations and Acronyms
ABC
Agricultural Bank of China
ASEAN
Association of South-East Asian Nations
ATC
Agreement on Textiles and Clothing
BOC
Bank of China
CARs
Capital adequacy ratios
CBRC
China Banking Regulatory Commission
CCB
China Construction Bank
CNAO
National Audit Office of the People’s Republic of China
CPI
Consumer price index
EIT
Enterprise income tax
EMBI
JP Morgan Emerging Market Bond Index
EU
European Union
FDI
Foreign direct investment
FFEs
Foreign-funded enterprises
GDP
Gross domestic product
GTAP
Global Trade Analysis Project
ICBC
Industrial and Commercial Bank of China
ILO
International Labor Organization
JSCBs
Joint-stock commercial banks
MFN
Most-favored-nation
MOLSS
Ministry of Labor and Social Services
NBS
National Bureau of Statistics
NEER
Nominal effective exchange rate
NFA
Net foreign assets
NIEs
Newly industrialized economies
NPL
Nonperforming loan
NTBs
Nontariff barriers
OECD
Organization for Economic Cooperation and Development
OLS
Ordinary least squares
PBC
People’s Bank of China
PPI
Producer price index
PPP
Purchasing power parity
RCCs
Rural credit cooperatives
RECs
Reemployment centers
REER
Real effective exchange rate
RPI
Retail price index
SCBs
State-owned commercial banks
SITC
Standard International Trade Classification
SOE
State-owned enterprise
TRIMs
Trade-Related Investment Measures
TRIPs
Trade-Related Aspects of Intellectual Property Rights
TSA
Treasury single account
TVEs
Town and village enterprises
ULC
Unit labor costs
UNCTAD
United Nations Conference on Trade and Development
VAR
Vector autoregression
VAT
Value-added tax
WTO
World Trade Organization
ix

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I
Overview
Eswar Prasad and Thomas Rumbaugh
China’s transformation into a dynamic private-
ing system. Interestingly, as discussed in Section II,
sector-led economy and its integration into the
the rapid expansion of China’s trade thus far is not
global economy have been among the most dramatic
unprecedented in either its scope or speed. Other
economic developments of recent decades. Indeed,
Asian economies such as Japan, Korea, and the
China’s growth performance over the last two
newly industrialized emerging economies of Asia
decades has been spectacular, with GDP growth
were able to maintain even higher export growth
averaging almost 8 percent. China now ranks as the
rates, on average, for about a 30-year period. This
sixth largest economy in the world (at market
international experience implies that China could
exchange rates). The expansion of China’s role in
maintain relatively strong export growth for a num-
the world trading system has been no less remark-
ber of years. Given China’s large population and
able, with its overall share in world trade rising
still substantial development potential (as reflected
from less than 1 percent in 1979 to about 6 percent
by its current per capita income of only $1,060),
in 2003.
China could have a bigger impact on the global
There are strong prospects that China’s rapid eco-
economy than the other economies mentioned
nomic growth and trade expansion could be sustained
above.
well into the future. However, a number of macro-
China’s trade expansion in part reflects greater
economic and structural vulnerabilities need to be
specialization in production within the Asian region,
addressed for this potential to be fully realized. Given
with China now serving as the final processing and
the size and complexity of the Chinese economy,
assembly platform for a large quantity of imports
many of these reform challenges are interrelated.
going from other Asian countries to Western coun-
China’s traditional approach to reform has been
tries through China (see Prasad and Rumbaugh,
incremental (Box 1.1) but, in view of its rapid open-
2003). These changes have resulted in a shift in
ing up to the world economy, a more concerted and
China’s bilateral trade balances, with its increas-
multifaceted approach to the reform process will be
ing trade surpluses with Western industrial coun-
crucial to maintain rapid growth and manage the
tries being offset by rising trade deficits with many
challenges associated with the process of global
Asian countries. Reflecting its growing promi-
integration. This Occasional Paper provides an
nence and rising appetite for imports (including
overview of some of the key aspects of China’s recent
for meeting domestic demand), China has been
growth and integration with the global economy and
an important source of growth for the world econo-
discusses some of the main policy challenges that lie
my during the recent global slowdown. During
ahead.
2001–03, China accounted for about 24 percent of
world growth (using purchasing-power-parity-based
GDP). China’s imports are growing rapidly from all
Rapidly Expanding International Trade
trading partners and it is now the third largest
importer of developing countries’ exports after the
The expansion of its international trade has been
United States and the European Union. China has
a particularly noteworthy aspect of China’s rising
even contributed to the recent strength in world
prominence in the world economy. China’s exports
commodity prices; it is now the world’s largest
and imports have grown at an average rate of 15 per-
importer of copper and steel, and among the largest
cent each year since 1979, compared with a 7 per-
importers of other raw materials, including iron ore
cent annual expansion of world trade over the same
and aluminum.
period. This process has been facilitated by trade
While China’s integration into the global trading
reforms and the general opening of the economy
system is likely to benefit both the global and
that have led to a surge in foreign direct investment
regional economies, there will no doubt be some
(FDI) and increased integration with the global trad-
short-run distributional effects across countries. The
1

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I
OVERVIEW
Box 1.1. China’s Approach to Economic Reform
For three decades after the 1949 revolution, China
the organization of farming was decentralized to the
followed a policy of socialist economic development
household level, agricultural prices were raised, and
based primarily on the centrally directed allocation of
some state-owned enterprises were allowed to retain
resources through administrative means. By the late
profits as an incentive for good performance. The suc-
1970s, this approach was increasingly recognized as
cess of the rural reforms encouraged the authorities to
being untenable and unsustainable, and an overhaul of
introduce further reforms to the urban industrial sectors
the economic system was initiated.
in a second phase (1984–88), including some liberaliza-
China’s approach to economic reform has been grad-
tion in enterprise pricing and wage setting, introduction
ual and incremental, without any detailed “blueprint”
of enterprise taxation, and breakup of the monobank
guiding the process. This incremental approach is best
system. Fourteen major cities in the coastal areas were
depicted in a metaphor attributed to Deng Xiaoping as
also opened up to foreign trade and investment.
“crossing the river by feeling the stones under the feet”
The third (1988–91) and fourth (1992–1997) phases
and is still applicable to many of the reforms being car-
continued the reform process, but were also character-
ried out by China today.
ized by the lack of effective institutions and instruments
This incremental approach has been characterized by
for macroeconomic management. Inflation increased
the following features. First, reforms tend to be under-
considerably after price liberalization and, in the third
taken first on a pilot or experimental basis in some
phase, the authorities recentralized many price controls
localities before they are applied to the whole country.
and administered sharp contractionary policies to con-
In the view of the authorities, this minimizes disrup-
trol double-digit inflation, This was effective in stabi-
tions to the economy, allows deficient policies to be
lizing prices but also produced a sharp slowing in the
modified based on experience, and provides time to
economy, mounting losses in state-owned enterprises,
build the necessary institutions for full implementation.
and rapid increases in interenterprise debt that threat-
Second, another strategy frequently employed has been
ened to further destabilize the macroeconomic situa-
the use of intermediate mechanisms to smooth the tran-
tion. In the fourth phase, stimulative policies returned,
sition to a market-oriented economy. One example of
leading the economy into another growth cycle.
this is the setting up of Special Economic Zones in the
More fundamentally, however, the highlight of the
early 1980s as a way of gradually introducing foreign
fourth phase was in 1992, when the Communist Party
capital and technology. Finally, the Chinese leadership
formally embraced Deng Xiaoping’s view that the mar-
has consistently tried to preserve the socialist character
ket system was not incompatible with the ideals of
of the economy while introducing market-oriented
socialism and called for the establishment of a socialist
reforms. For example, even though policies have been
market economy. This provided essential political sup-
conducive to the rapid growth of the nonstate sector,
port for major decisions to restructure the role and func-
state enterprise reform has been gradual with no signs
tion of government, as well as the development of plans
of a mass privatization strategy for large and medium-
to speed up enterprise, financial, and social reforms and
sized enterprises as pursued by other transition
set the stage for a more fundamental “globalization” of
economies.
the Chinese economy, in a fifth phase (1998 to present).
Economic reform since the late 1970s can roughly be
This most recent phase has been characterized by a
divided into five phases.1 In the first phase (1978–84),
broader and more general opening up of the economy,
including more broad-based trade liberalization and
comprehensive commitments in the context of accession
1For a further description of the earlier reform periods see
to the World Trade Organization to open the agricultural
Bell, Khor, and Kochhar (1993) and Tseng and others (1994).
and services sectors of the economy.
countries most likely to benefit from the expan-
Price Dynamics
sion of China’s trade include exporters of capital-
and resource-intensive products, while countries
As a result of increased integration with the global
that specialize in labor-intensive exports similar to
economy and continued domestic price liberaliza-
those of China will have to undergo significant
tion, prices in China are increasingly market deter-
adjustments to increased competition from China.
mined and traded goods’ prices have achieved
Trade expansion will also pose some domestic
substantial convergence with international prices.
challenges within China itself. Expanding trade
Even though not all prices in China are market deter-
could increase regional income disparities, while
mined, understanding the causes of variations in
foreign competition could aggravate social pres-
aggregate prices is important for domestic macro-
sures arising from job dislocation and rising
economic policy management. Characteristic of the
unemployment.
challenges of modeling inflation dynamics in China,
2

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