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Country Commercial Guides for FY 2000: China Report prepared by U.S. Embassy Beijing, released July 1999

II.   ECONOMIC TRENDS AND OUTLOOK

A.   Major Trends and Outlook

China's economic growth continued to slow down in the first half of 1999, and retail prices continued to decline causing concerns about deflation. The government expected GDP to grow by 7% in real terms compared with 1998, when official growth was just shy of the target of 8%. The 1998 result was already the lowest return in the past seven years and would have been much lower without the government's special infrastructure spending package, which helped stimulate the economy in the third and fourth quarters. Official figures put out by the Chinese government are generally acknowledged to reflect major economic trends but are affected with an upward bias by incorrect, often even exaggerated, reporting from the provinces.

Most analysts credit China for having achieved a "soft landing" for its economy -- single digit inflation and stable growth that contrasts sharply with the inflationary expansion of 1993-1994. But structural problems, especially in the industrial and financial sectors, combined with the problem of reducing employment levels in the state enterprise system, pose serious challenges to long-term, economic growth. A tight monetary policy and administrative price controls have reined in inflation, now recorded at negative 2-3 percent per year. Government policy emphasizes keeping inflation well below the real rate of economic growth but seems incapable of stimulating even a modest amount of inflation. Deflation is likely to continue until the government boosts wages significantly.

Some pressure to devalue the currency (renminbi) remains, but China has received international acclaim maintaining the value of its currency since the outbreak of the Asian financial crisis in late 1997. Some financial experts believe that China will have to widen the band in which the currency trades if exports do not pick up, investment flows deteriorate, and deflation continues. Since the crisis began, however, China has enjoyed large surpluses in its trade and investment accounts and has accumulated a war chest of $147 billion in official reserves, more than ample to defend the exchange rate.

The government has stepped up its efforts at downsizing the state sector, but investment in this sector accounted for nearly all of new investment in 1998. State-owned enterprises (SOEs) represent a long-term drag on the economy, a problem which the government recognizes and seeks to correct through such pilot projects as in the plan to downsize 1,000 key SOEs. The SOEs have close linkages to the banking system through delinquent "policy loans" that constrain the pace of financial market reforms. Tight monetary policies and constraints on bank lending have also led to a build-up of inter-company "triangular" debt, estimated at almost RMB 1 trillion. Total inventories in the SOEs at the end of 1998 remained high and grew by 25% in real terms, accounting for 28 percent of total sales. The growth of these stockpiles, which consist of goods that are not marketable because of poor quality or lagging demand, distort data the data on industrial output. SOE sales were up in the first four months of 1998, but profits were down sharply.

The central government acknowledges that unemployment as well as interregional and intra-regional income disparities are serious concerns. The average per capita disposable income of urban residents in 1998 was RMB 5425 (US$656) while rural per capita cash income was RMB 2,160 (US$251), with some areas having incomes of below half that average. The World Bank estimates that as many as 400 million Chinese live below the poverty line.

China's chronic and growing labor surplus is not reflected in the official unemployment rate of 3.2%. The official data do not account for the approximately 23 million considered to be underemployed in the state sector or the 80-120 million surplus rural workers who make up the so-called "floating population" that migrates between agriculture and construction jobs and that are at other times unemployed. A more accurate estimate of urban unemployment, cited by private researchers, would be 10-15%.

B.   Principal Growth Sectors

The value added by industry to GDP rose reached RMB 3.4 trillion in 1998, an increase of 8.9% over 1997, in real terms. Growth rates in different industrial sectors continue to shift the composition of output away from SOEs to the non-state sector, which has grown by two to three times the rate of state-owned industry.

Retail sales in 1998 indicated only a slight growth in consumption. Retail sales of consumer goods reached RMB 2.9 trillion, up 6.8 percent over 1997 in nominal terms and about 9% with deflation taken into account. Retail demand rose only 7% in the first four months of 1999, contributing to deflation.

C.   Government Role in the Economy

Since the beginning of reform in 1980, the role of the government in the economy has been strong. Adjustments in purchase prices for grain and other commodities, wage increases for state workers, and difficulty in collecting national taxes have contributed to a decline in official government revenues as a share of GDP. "Off-budget revenues" in many government agencies, however, may, in some cases, equal official budget allocations.

The current policy of administrative price controls is at variance with achieving maximum efficiency through market-oriented reforms. Controls on the price of transportation services and some grains were eliminated at the beginning of 1996. Further elimination of controls on commodity and energy prices, including coal prices, would benefit lower-income interior areas. The cautious stance on price reform and the importance placed on other state planning functions is likely to continue.

D.   Infrastructure Investment

Infrastructure investment is a key element of China's economic growth potential, with major infusions scheduled for the road, railway, port, telecommunications, oil and gas, and coal sectors. The economy faces a glut of electricity in the coastal areas, but transmission systems and development in the interior will require continued investment. 1998, infrastructure investment grew by more than 20 percent in nominal terms, and the funds earmarked for investment rose by 21 percent, to about RMB 1.1 trillion.

The tight credit policy which Chinese officials have implemented in recent years to control inflation has narrowed the range of projects the central authorities will support. The credit squeeze means that only the highest priority projects, like the Three Gorges Dam, are likely to be approved. Domestic capital accounted for over 90 percent of investment in infrastructure in 1998. These funds come from an increasing variety of sources, including special construction fund, generated from surcharges, for example, on electricity usage and rail freight, provincial and local government sources, and domestic loans from the China Development Bank and other policy banks.

Chinese officials have said they want roughly 15-20% of infrastructure investment to come from foreign sources, but shifting foreign investment away from export-oriented industries presents some difficulties. Infrastructure investments have long payback periods, with no ready source of foreign exchange. Concerns about China's legal structure, enforceability of contracts, access to foreign exchange, the cumbersome approval process, etc., all work against foreign participation in infrastructure projects, particularly in the road, rail and power sectors. But obstacles to foreign involvement in infrastructure projects are slowly being removed. For example, changes in rules governing current account transactions have gone a long way toward solving the problem of guaranteeing foreign exchange convertibility.