ECON-520

China
Macroeconomics
Analysis

1996-Current
 Geoffrey Kau
Ivy Zhao
Shirley Liu
Denise Odaro
Keanu Che

Preface:

How did China get on track to fast becoming a powerhouse the world? From the 1890s
its role in the global economics was reduced significantly. In 1949, the Chinese
Communist party established China's current government which implemented a
transition to a planned economy starting in the 1950s. It was not until the late 1970s
when the Chinese government began a transition from a closed economy to a
somewhat more market oriented approach and in the following 30 years, China has
come a long way from 1978 when Deng Xiaoping laid the groundwork for a reform. At
the time, more than two-thirds of the Chinese population lived in the rural countryside
producing surplus labor through which China could achieve rapid, growth for almost
two decades without facing wage pressures. In addition, China had a trained and
regimented labor force. The percentage of technical experts in the industrial labor
force was higher than in other emerging South-East Asian economies. These unique
elements contributed to a positive foundation for what was to follow.

The economic reform kicked off in 1979 and the established goal was to generate
sufficient surplus value to finance the modernization of the mainland Chinese
economy. It began with a combination of changes in regulation by plans and
introduction of regulation by the market in key areas such as: State Owned
Enterprises (SOEs), finance, taxation, pricing and foreign trade. The initial reforms
included the inauguration of the Household Responsibility System by which farmers
were able to retain surplus over individual plots of land rather than farming for the
collective. This was followed by the establishment of TVEs - industries owned by
townships and villages. Imperatively, an open door policy also begun, by which
international trade and foreign direct investment was allowed.

The second step in the reform program transpired in the 1980s and the objective was
to create market institutions and convert the economy from an administratively driven
to a price driven market economy. This was accomplished by the dual track pricing
system in which some goods and services were assigned state controlled prices and
other goods were at market determined prices. Eventually, goods at market prices
were increased, until they included almost all products by the late 1990s. Concurrently
the government ran the crucial SOE restructuring in four stages:

• 1979-1983: Initiatives were launched including profit retention,

performance related bonus and production outside the mandatory plan;
• 1984-1986: Profit tax replaced profit remittance and SOEs were
permitted to sell their surplus on the free market;
• 1987-1992: A contract responsibility system was introduced
making managers more responsible for the economic state of their
assigned divisions;
• 1993: SOEs were given further autonomy and made more
economically oriented with independent budgets and self-responsibility
policies

These initiatives immediately increased the standard of living for most of the Chinese
population and the poverty rate has decreased significantly, down from 53% in 1981
to 8% in 2001 when China was admitted into the World Trade Organization. China’s
output rate had consistently grown throughout the preceding 20 years. China's
economic revolution has created a large middle class. Although wages have increased,
they still remained below those in the rest of the industrialized world thus keeping
Chinese goods competitively priced.

Now we will introduce China macroeconomic development in recent years from 1996-
present.

Scenario 1: 1996-2001

The growth of the world economy from 1996 to 2001 featured somehow slowdowns,
with various developed countries plunging into economic recessions or economic
downturns synchronously. Against this context, China was able to maintain high
growth. A simple direct comparison of economic growth of all countries shows that
China outshone all the others.
China’s economic growth from 1996 to 2001 exhibits the following features:

1. In general, China’s economic growth has stopped sliding and has tended to
stabilize in the 1996-2001 period, maintaining sustainable stability. For six years in
a row, China’s economic growth operated steadily between 7-8 percent (see Chart
1). Following its 1992 peak growth of 14.2 percent, it slid steadily for seven
successive years from 1993 to 1999. The expansionary fiscal policy helped arrest
the downslide trend in 2000, resulting in a slight recovery. Between 1998 and 2001
China’s economic growth rate stopped sliding and steadied at the level of 7-8
percent.

Chart 1:GDP Growth Rate

%

12

10 9.6
8.8
8 7.8 8
7.1 7.3
6

0
1996 1997 1998 1999 2000 2001
Source:IMF

2. The demand structure for economic growth in these six years shows that the
contribution by external demand exhibited a declining trend while that by domestic
demand began to rise. In 2001, in particular, the contribution by external demand
was negative. Domestic demand alone causes the economic growth. Of the
domestic demand, the ratio of consumption to investment improved in years
between 1995 and 2001, but has not yet achieved the optimal state. Domestic
demand contributed 8 percentage points while net exports contributed –0.7
percentage points (see Table 1).
 Table 1: Demand Structure of China's Economic Growth
Contribut
Contribution by final
Year GDP growth(%) capit
consumption(%)
formatio
1996 9.6 5.1 3.3
1997 8.8 3.3 1.8
The situation from 1996 to 2001 shows that the contribution to economic growth by
1998 7.8 3.2 2.3
net exports in 1997 reached a high of 3.6 percentage points while such contributions
have been 1999 7.1 of 1998, down to 0.0155.4
declining since the beginning percentage points 0.9
2000zero, and further down
by 2000, nearly 8.0 to –0.7 percentage points5.1by 2001. This 2.9
indicates that the Asian financial crisis since 1997 and especially the economic
2001 7.3 4.4
downturn of all major developed economies including the United States in 2001 have
3.6
Source:
had an China
adverse effect on statistical yearbook
China’s economic growth. Since 1998, the contributions by
domestic demand to economic growth has been rising, from 5.2 percentage points in
1997 to 8 percentage points in 2000 and 2001. This indicates the result of the policy
of expanding domestic demand. With regard to domestic demand, the final
consumption contribution rose from about 3 percentage points in 1997 and 1998 to
about 4-5 percentage points in the past three years while the contribution by capital
formation ended the declining situation (dropping from 6.9 percentage points in
1995 to 0.9 percentage points in 1999) and rose to 2.9 percentage points in 2000
and to 3.6 percentage points in 2001.

3. With regard to macroeconomic control by the government, China has been

implementing an expansionary fiscal policy and prudent monetary policy in 1998-
2001. Since 1998 the Chinese government has adopted an expansionary fiscal
policy in order to cope with international financial turmoil, world economic
downturns and inadequate domestic demand. Between 1998 and 2001, the central
government issued more than 500 billion Yuan of special construction bonds. By
2000, the debt receipts of the state had reached 418.01 billion Yuan, 4.7 percent of
the GDP. The central government’s fiscal deficits (not including debt receipts and
expenditure) made up 2.8 percent of the GDP in 2000 and 2.58 percent of the GDP
in 2001 (the warning line commonly accepted internationally is 3 percent). While
pursuing this expansionary fiscal policy, the Chinese government adopted a sure
and steady monetary policy in order to guard against financial risks. The growth of
M0 has dropped markedly in the past two years (See Table 2). The growth of
 narrow money, M1 has assumed a declining trend in 2000 and 2001. The broad
money, M2 has been lingering at below 15 percent over the years from 1998 to
2001.

T able 2: Grow th of Money Supply (%)

Year M0 M1 M2
1996 11.6 18.9 25.3
1997 15.6 22.1 19.6
1998 10.1 11.9 14.8
1999 20.1 17.7 14.7
2000 8.9 15.9 12.3
2001 7.1 12.7 14.4
Source: China statistical yearbook

The most prominent feature of China’s economic growth over 1996 and 2001 as
shown above is that the growth rate has been maintained at a 7-8 percent level for
four successive years. This shows, on the one hand, that the Chinese government has
been successful in its expansionary fiscal policy and prudent monetary policy while
resisting the impact of international economic slowdowns and financial turmoil, and
that it has overcome the inadequacy in domestic demand. These achievements were
hard-won. On the other hand, we see that in increase of GDP is largely driven by
domestic investment, especially the government spending. The real problem is still
the inefficient domestic demand. In order to solve this issue, China government should
take effective policies to encourage non-government investment in the long run.

Scenario 2: 2001-2005
Highlights

In the years of 2001-2005, China experienced high growth with low inflation
development period. The However, the export-oriented economy resulted in the huge
increase on the current account surplus. The tremendous foreign exchange surplus
brought a big pressure for RMB appreciation, which was the driving force of foreign
exchange rate reform.

GDP Growth

China was undergoing steady and fast economy growth in the period of 2001-2005.
The average GDP growth rate is 9.54%, and the average inflation rate had been
controlled below 1.2%. Although the western countries suffered from the apparent
slowdown in 2001 because of Dot.com bubble and the 911 attacks, China experienced
the high growth at that time. Although in 2003, SARS infected the national economy
negatively, China did not stop growing and recovered from the short-term negative
impact soon. Overall, this was a golden developing period, which had high growth rate
with low inflation rate.

Table 3 (RMB 100

Million)

GDP Inflati
Nominal
Year Real GDP Growth on
GDP
Rate rate

109655.17 107449.67
2001 8.30% 0.70%
06 74

120332.68 117208.33
2002 9.10% -0.80%
93 01

135822.75 128958.90
2003 10% 1.20%
61 92

159878.33 141964.46
2004 10.10% 3.90%
79 66
Driving
156775.27
Force of 2005 183217.4 10.20% 1.80%
39
Growth
*Source: China Statistical Yearbook
The major
engine of this strong growth was manufacturing trade, where China was very
competitive, and its industrial production. China’s strides in industrial production have
been phenomenal. Most of China export goods were final consumer goods and raw
materials. The low labor cost provided China strong competitive advantages in global
market after accession of WTO. On the other hand, some natural resource based
exports was very vibrant as well. China’s goods-dominated strategy attracted many
foreign investors came into China to set up factories, some of which were OEM
manufactories and exported the finished goods. This action stimulated both foreign
investment and exports. So the foreign direct investment had significant increase in
this period.

Table 4 (USD million)

Total
Year FDI % of GDP
Exports
 2001 46880.00 267611.18 20.09%

2002 52740.00 327434.99 22.39%

2003 53500.00 438259.66 26.72%

2004 60630.00 593035.02 30.71%

2005 60330.00 777271.71 34.22%

*Source: China Statistical Yearbook

Foreign trade has actually become the real "engine power" to China's economic
growth. In 2004, China became the world's third largest country in foreign trade, with
exports accounting for over 30 percent of the country's GDP. The export oriented
strategy caused the twin surplus: current account surplus and capital account surplus.
On the other hand, the loose monetary policy used by major western countries, such
as US, which continuously implemented the low interest rate policy to stimulate the
liquidity, particularly after Iraq war, caused more international capital to flow into
china. Since China used fixed exchange rate policy at that time, the international
capital inflow impelled Central bank of China to supply huge amount of currency to
meet the increasing demand of RMB.

Table 5: Foreign Exchange Reserve (USD Billion)

Year 2001 2002 2003 2004 2005

Foreign Exchange 212.16 286.40 403.25 609.93 818.87

Reserve 5 7 1 2 2

*Source: State administration of Foreign Exchange

The huge amount of foreign exchange reserve made the RMB face the huge pressure
of appreciation.

Foreign Exchange System Reform:

On July 21 2005, the People's Bank of China, China's central bank, announced that the
exchange rate of RMB VS. USD was traded from fixed 8.28 to 8.11. The RMB to US
dollar pegging system was switched to a basket of foreign currencies. The foreign
exchange system reform brought China economy into new stage. Meanwhile, the
reform directly results in the RMB appreciation gradually in the following years. The
traditional export-oriented economic structure faces the new challenges.
Scenario 3: 2006 – Current

GDP and Inflation during the Boom Years: 2006-2008

From 2006 to 2008, China continues to see tremendous GDP growth. Real GDP growth
in 2006, 2007 and 2008 are 11.6%, 11.9% and 9%, respectively. GDP growth is
mainly fuelled by increases in net export and investments.

Source: EIU

During that time period, global demand rose significantly with the booming markets
and easy credit. Foreign investors’ obsession with emerging markets, especially
China, resulted in a significant inflow of money to China. Foreign consumers also had
an insatiable hunger for Chinese goods. Net export continued to add weight in the
GDP composition from 2006 to 2008. Net export as a percentage of GDP went from
8.8% in 2006 to 11.9% in 2008.
 Source: EIU

GDP per capita started soaring in 2006 and so did property prices and the stock
market. GDP per capita went from $4,796 (USD at PPP) to $6,076 in 2008. The
Shanghai A Share Price Index went from 1,319 at January of 2006 to an all time high of
over 6,000 in October of 2007.China’s foreign reserves during thisperiod also
ballooned from $1,073 billion to $1,956 in two years from end of 2006 to end of 2008.

During this period, China started to see rampant inflation caused by the overheated
economy and its old peg to the dollar. The inflation rates were 2.4%, 4.4%, and 5.9%
(average % YoY) for 2006, 2007, and 2008, respectively.

China took measures to counter this phenomenon by enacting laws aimed at cooling
the stock and real estate markets. It also tightened bank lending and let the RMB
appreciate gradually. The Chinese government imposed new taxes on stock
transactions and added limits to mortgage lending to curb growth in those markets.
Interest rate went from 5.6% (average) in 6.1%, 7.5%, and 7.9%, in 2006, 2007, and
2008, respectively. The Chinese Yuan also appreciated against the dollar, the currency
of its largest trading partner, from 8.1RMB:1USD at January of 2006 to 6.8RMB:1USD
at end of 2008..

The Downturn and a Look into the Future

In 2008 China saw a sharp downturn of economic activities, caused by the global
slowdown and liquidity crunch. As demand slows and investors stop throwing money
in, China’s GDP growth rate went from 10.1% YoY in 2Q 2008 to 6.8% in 4Q 2008. The
majority of the slowdown is caused by the sharp decline in exports, since the
consumption power of its foreign customers have dropped significantly.
 Source: EIU

As the main growth driver for China’s GDP, a decline in export would mean serious
trouble in China. In the forecast by the Economist Intelligence Unit, China’s GDP
growth is predicted to be only 6% with a negative growth rate of 10% in net export.
At the same time, China’s inflationary worries have turned into a fight against
deflation. CPI is forecasted to be at -0.2% YoY change in 2009.

China’s FDI inflow, which saw a CAGR of approximately 20% from 2006 to 2008, is
expected to drop for the first time since 1998. Even though FDI is not as significant to
China as a source of funds for investment today, it is still important for China’s growth.
From China’s policies on FDI, we will be able to see what China’s intentions are for
future development.

In 2008, China changed its policy on FDI in a change of strategy for future
development. The new policies encourage investing in modern and sustainable
technologies. It wants to curb investing in operations that feature out-of-date
technologies and productions that are resource and energy intensive. It is also
directing investment to regions in the less developed western parts of China, as the
disparity in advancement and income between coastal and inner regions is becoming
quite significant. A less expected set of policies are discouraging export-only
enterprises because China wants to control its trade imbalance and excessive
accumulation of foreign reserves.
However, China has more urgent problems at hand: how to prop up GDP growth to
ensure social stability. After all, rising unemployment and sliding consumer confidence
will surely work against the government’s goal to ensure “harmonious growth.” To
make up for the loss in net exports, the Chinese government will likely be focusing on
two things: increasing public spending and boosting bank lending. The central
government has already announced plans for a 4trn RMB fiscal stimulus to boost
public spending, focusing on infrastructure development. China has slowly lowered
interest rates since 2Q 2008, the prime lending rate went from 7.5% in 2Q 2008 to
5.3% in 4Q 2008. It will likely be lowered further in 2009. The main issue with
increasing lending will be to ensure that the funds are allocated efficiently to achieve
maximum effect in supporting growth.

Even though some are hoping private consumption will increase to support growth, it
is unlikely that it will be a significant contributor. In an environment with rising
unemployment, the consumers are likely to increase savings than consuming more,
especially in a country with a weak social welfare system. Cutting taxes and handing
out stipends and cash handouts will likely only achieve marginal effect.

Looking forward, China will need to prove itself in the face of crisis. In fact, some are
counting on China to lead the world out of the recession. Even though it is unlikely
that China alone will be able to achieve this, its actions will impact the global economy
significantly.

Summary of China Macro Economy Development in Recent Years

To sum up, we looked back the past twenty years, it was a rollercoaster experience for
China macro economy. Given all the ups and downs, one thing has clearer and widely
recognized, which is China has played and will continue to play a critical role in global
economy. Especially when the most developed economies have been suffering from
the current financial turmoil and probably or already stepped into recession. China is
one of the few countries who have been the exhibited robust economy growth.

Looking ahead, China has claimed and gained bigger say in global event as China
stands up to be a major power and significant portion of word economy. While the G20
summit is about to convene in London, BRIC and some other emerging economies
insist developing countries should have a bigger say in multilateral financial discussion
and relevant policy-making process. As the global financial crisis unveils defects of the
existing international financial system, BRIC, which include Brazil, Russia, India and
China, more than ever pointed out a few developed economies simply exercise
monopoly in global financial rule making, while developing countries have long been
marginalized unfairly.

Earlier March 2009, Chinese Financial Minister Xie Xuren called for substantial and
overall reforms of the international financial system, and endeavour to a new one
featuring fairness, justice, rich inclusion and order.

The legend continues. China's announced economic stimulus package, amounting to 4

trillion yuan, will work to achieve the economic growth at 8 percent and lay a good
foundation for next year's growth by starting the economy's clean-up process of the
inventory this year.

Chinese government has unveiled a 4 trillion yuan stimulus plan to prop up the
economic growth in a global economic downturn during which China has already
suffered a slowdown of GDP growth from above 11 percent in 2007 to 9 percent last
year.

While the 4 trillion stimulus package is working relentlessly to prop up domestic

economy, China also speaks out to the world in the very time when global financial
crisis is devouring and damaging the world’s wealth.

Chinese central bank governor Zhou Xiaochuan advocated that it was uncertain
whether China's economic slowdown had ended and he urged more financial reforms
in the face of the worldwide slump.

Premier Wen Jiabao said, during the National People’s Congress and National
Committee of CPPCC annual sessions 2009, it is "difficult" to achieve the country's 8
percent GDP growth goal for this year, but said it is still "achievable". The remarks
injected confidence in the national economy and indicated China has taking measures
and is capable to generate 8% GDP growth given the major world economies and
many China’s trading partners have slid into recession or on the edge into it. The
worldwide financial crisis again grants China the chance to lead the economy growth
and showcased the robustness of China Macro economy. We hold very positive stance
on China’s macro economy in the years to come.