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Briefing Series – Issue 35

CHINA’S ECONOMY: 2007 AND THE YEAR AHEAD

Shujie YAO

Minjia CHEN

© Copyright China Policy Institute

February 2008

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University of Nottingham

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Nottingham NG7 2RD

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The China Policy Institute was set up to analyse critical policy challenges faced by China in its rapid development.

Its goals are to help expand the knowledge and understanding of contemporary China in Britain, Europe and

worldwide, to help build a more informed dialogue between China and the UK and Europe, and to contribute to

government and business strategies.

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Summary

1. Despite the government implementing many policy measures to cool the economy,

China’s gross domestic product (GDP) grew faster in 2007 than in 2006. GDP rose

11.4% to RMB24.66 trillion ($3.4 trillion), which is probably slightly less than that of

Germany.

2. The 17 th National Party Congress ­­ the most important political event in 2007 ­­ laid

out the Party’s plan for the following five years and thereafter. Policy initiatives

unveiled at the Congress were: optimisation of economic structure, emphasis on

growth quality rather than quantity, improvement of growth sustainability and

creation of state capabilities for innovation.

3. The industrial sector continued to expand at a faster rate than GDP. Despite an

excellent harvest in 2007, the relative importance of the agricultural sector continued

to decline. The rapid economic growth was primarily driven by investments and

exports, rather than consumption, which clearly suggested a bias in resource

allocation.

4. China has kept up a high growth with low inflation in the past decade. However,

starting in March 2007, the consumer price index (CPI) began to rise rather

unexpectedly, caused by rapid increases in food price. This “structural” inflation has

significantly affected the lower­income groups and may potentially trigger domestic

protests and political instability.

5. International trade continued to expand in 2007. Both exports and imports grew

strongly. The trade surplus increased 48% to $262 billion. As China becomes more

integrated with the world economy, it may also become more vulnerable to external

shocks. The current economic gloom in the U.S. may cause China to slow down,

although China, along with other fast­growing economies such as India, may be able

to withstand a U.S. recession­led economic slowdown in the West.

6. In 2007, China received a record high amount of FDI, totalling $74.8 billion. High

trade surpluses and large FDI inflows had unsurprisingly added to the high level of

foreign reserves. The state initiated active management of its foreign exchange

reserves by launching a sovereign wealth fund.

7. The Chinese yuan, or RMB, appreciated sharply in 2007, although the amount of

appreciation still lagged the demands of the western countries. As before, the Chinese

government indicated clearly that China was willing to work closely with the U.S. or

the EU to tackle the currency and trade deficit issues, but it was unrealistic to expect

a sudden or large­scale appreciation in the short run.

8. Following strong gains in 2006, the stock market enjoyed another bullish year in 2007.

The Shanghai Stock Exchange Composite Index climbed 96.6% in 2007 from a year

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earlier. Housing prices continued to rise, continuing a trend that has lasted for more

than 10 years, despite frequent increases in bank interest rates and the

implementation of many government measures aimed at suppressing housing prices.

High share prices and steep housing prices have spurred inflation and worsened the

country’s income distribution.

9. In 2007, China continued its rapid process of reforms and opening up.

Comprehensive reforms were carried out in key areas, involving the rural areas,

state­owned enterprises (SOEs), financial sector, etc. The 17 th Party Congress called

for a change in the country’s economic development model to one that was less

dependent on investment and trade and to reduce the country’s urban­rural divide by

“constructing a socialist new countryside.” Important new regulations including an

anti­monopoly law, and amendments to corporate taxation and property rights were

passed in 2007.

10.The Hu­Wen government has repeatedly emphasised the significance and urgency of

a balanced growth model. This year, the Chinese government will undoubtedly

continue with tight macroeconomic controls and adjustments to counter the

overheating economy and inflation. China as a rising power in the world is trying to

sustain its high growth and become a better developed society through a gradual and

pragmatic approach. It has to find a more effective way to curb price inflation,

regulate the stock and housing markets, and above all, to reduce income inequality so

as to create a better and fairer society while maintaining a high growth rate with

lesser environmental impact.

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China’s Economy: 2007 and the Year Ahead

Shujie Yao and Minjia Chen ∗

Another Year of Strong Growth and Excitement

1.1 Despite the government implementing many policy measures to cool the economy,

China’s gross domestic product (GDP) grew faster in 2007 than in 2006. According

to the National Bureau of Statistics, the economy grew 11.4% in 2007, compared

with 10.7% in 2006. Measured in current prices, total GDP amounted to RMB24.66

trillion ($3.4 trillion) last year, probably slightly less than that of Germany due to a

strong Euro against the US dollar. China may need another year to overtake

Germany as the third­biggest economy in the world. 1 Last year also saw the

Chinese economy expanding for the fifth straight year at a double­digit pace,

triggering more concerns about the sustainability of China’s growth as well as

potential challenges and constraints.

1.2 In 2007, China hosted a number of important political, economic and scientific

events, including the week­long Chinese Communist Party 17 th (CCP) National

Congress in October and the launch of the country’s first lunar probing satellite,

Chang’e 1, on 24 October. Last year was also characterised by extraordinarily bullish

stock markets, a booming housing market and rapid increases in prices of many

agricultural and consumer goods. China’s plan for the next five years was unveiled

at the 17 th Party Congress. The satellite launch signified China’s ambition to become

a world leader in science and technology. The booming stock and housing markets

show China’s strength as a rapidly growing economic power. Yet put together, the

rising consumer price index, bullish stock and housing markets also send dangerous

signals to policy makers of an overheating economy, indicating the country’s current

rate of high growth may stall due to unforeseeable challenges and difficulties ahead.

1.3 The national fiscal revenue rose to a record high of more than RMB5.1 trillion 2 ,

compared with RMB3.9 trillion in 2006. In order to improve growth sustainability

and create an innovation­oriented state, policy initiatives were introduced at the

17 th Party Congress to optimise the structure of the economy and to shift the

emphasis from growth quantity to growth quality.

∗ Professor Shujie Yao is Head of the School of Contemporary Chinese Studies (SCCS) at University of Nottingham. Minjia Chen is Research Associate of the China Policy Institute, which is a part of SCCS. 1 . Xinhuanet, “China may not be able to surpass Germany in 2007”, 25/1/08. 2 Shanghai Securities News, 20/12/2007, “Fiscal Revenue will Exceed RMB5.1 Trillion This Year, Increasing about 31% Year­on­Year”, http://news.xinhuanet.com/fortune/2007­12/20/content_7282342.htm, accessed on 22 January 2008.

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Economic Growth

2.1 The country’s economic structure and growth pattern remain largely unchanged

compared with a year ago. Industrialisation and urbanisation continued to expand

rapidly, while the leading industry sector grew at a much faster rate than that of GDP.

Industrial output in the first 11 months rose 18.5%, compared with 13% in the

previous year (Figure 1). 3 By focusing on manufacturing and international trade,

China seems to be following the path of industrialisation taken by the developed

western countries in the past.

Figure 1: GDP and Industrial Production Growth Rates (%), 1990­2007

9.2

14.2 14.0 13.1

10.9 10.0 9.3

7.8 7.6 8.4 8.3 9.1 10.0 10.1 10.4

11.1 11.4

21.2 19.9

18.4

13.9 12.1

10.5 8.9

8.1 9.4

8.4 9.8

12.7 11.1 11.7

13.0

18.5

3.8

13.9

3.2 0.0

5.0

10.0

15.0

20.0

25.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year

%

GDP Industrial Production

Source: China Statistical Yearbook, various issues, National Bureau of Statistics. Data for

industrial production growth in 2007 are from January to November.

2.2 In contrast, the importance of the agricultural sector in the national economy has

been gradually declining since the early 1980s. Nonetheless, grain production in

China exceeded 500 million tons last year, which was the highest output since

2000. 4

2.3 Both domestic and foreign factors have contributed enormously to economic growth.

The growth has been primarily driven by investments and exports, rather than

consumption which is the main driver of growth in industrialised economies. Figure

2 presents the comparison of urban fixed asset investment and final consumption

growth from 1990 to 2007. In most years, fixed asset investment played a more

prominent role than consumption. The trend became more distinctive starting in

2000. In the first 11 months of 2007, fixed asset investment increased 26.8% from

a year earlier, compared with 23.9% in 2006. The rate stood well above the final

consumption growth rate of 16.4% in the same period.

3 Source: Statistical Data, National Bureau of Statistics.

4 People’s Daily, 1/2/2008, “Grain Output in 2007 Reached 501 Million Tons,”

http://nc.people.com.cn/GB/61154/6849928.html, accessed on 6 February 2008.

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Figure 2: Urban Fixed Asset Investment and Final Consumption Growth, 1990­2007

13.9 10.3

13.1 16.9

27.7 26.8 26.0 23.9 24.8

13.4 16.8

29.8

6.8 9.7 10.1 11.8 9.1

13.3 12.9 13.7 16.8

61.8

30.4 23.9

44.4

5.1 8.8

14.5 17.5

2.4

30.5

6.8 10.2

20.1 26.8

7.7

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 year

%

Fixed Assets Investment Final Consumption

Sources: China Statistical Yearbook, various issues, National Bureau of Statistics. Final

consumption is based on Total Retail Sales of Consumer Goods, which is used as a proxy.

2.4 Despite the government’s continual encouragement since the 1990s, domestic

consumption has been increasing at a slower rate than investment. In order to

improve living standards and allow people to enjoy the fruits of rapid economic

growth, it is essential that policy makers reallocate incentives from the export and

investment sectors to encourage production of goods and services for domestic

consumption. Such a reallocation would require a change in China’s growth model

and the optimisation of its economic structure.

2.5 Statistical data show that the share of final consumption expenditure as one of the

three components of GDP dropped from 70% in the early 1980s to about 50% in

recent years. 5 China’s growth since the beginning of reform has been depending

heavily on investment and, and to a lesser extent, on foreign trade. The overheating

of the economy that started since 2003 is undoubtedly being driven by

government­led investments. In 2007, the central government used a series of

monetary policy measures to restrict investment and bank loans. The People’s Bank

of China (PBC) ­­ the country’s central bank ­­ raised interest rates on six separate

occasions and the banks’ reserve ratios on 10 occasions in 2007. The one­year

benchmark deposit rate rose from 4.14% to 7.47%, while the banks’ reserve to

deposit ratio rose to 14.5% by 25 December 2007. 6 These moves were mostly

intended to ease growing concerns about rising inflation, though the actual impact

of these policies is yet to be observed in inflation and the economic growth rate.

2.6 However, bank lending only contributed up to 40% of fixed asset investment,

slightly over half of which was funded by firms’ retained earnings mostly in the

newly­flushed state sector. The current rate of return on investment in China is

relatively high, which is why firms have been extremely keen to invest. Although the

5 Source: China Statistical Yearbook, various issues, National Bureau of Statistics. 6 Source: People’s Bank of China.

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monetary policies sent strong tightening signals to the market, they may have little

effect on investment. They are only able to control market liquidity through banks as

they have no access to firms’ internal funds.

2.7 The investment­led growth has clearly led to a bias in resource allocation, favouring

capital, enterprises, and government while neglecting labour. Such a growth model

has generated a class of newly­rich capital owners. This in part explains the

inexorable rising trend of income inequality and the widening urban­rural as well as

industry­agriculture divides. Inadequate social security has led to high levels of

household precautionary savings. The relatively immature financial system has not

been able to provide a comprehensive range of financial tools and channels to suit

the different needs of individuals and institutions. China has become one of the

world’s leading consumers of luxury goods, yet its overall consumption level

remains relatively low. Wealth is concentrated in small groups of people while the

citizens’ purchasing power in general remains low. Consumption has risen at a

consistently slower pace than investment, driving the country onto a vicious track of

‘high investment, high savings and rising inequality’.

2.8 China has one of the best infrastructure systems in the developing world, especially

along its eastern coast. A major proportion of its fixed asset investment is devoted

to building infrastructure. In April 2007, China for the sixth time raised the speed at

which its railway system operates to an average of as fast as 300 kilometres per

hour. According to the 11th Five­Year Plan (FYP) (2006­2010), China will complete

the building of about 5,457 kilometres of high­speed passenger railways within five

years, which would operate at an average speed of more than 300 kilometres per

hour. This will require investments of more than RMB1 trillion (about $138.89

billion). In addition, the state will invest another RMB1.25 trillion to build 17,000

kilometres of new railways, of which 7,000 km will be used to carry passengers. The

expanded networks are designed to run at speeds of between 200 to 300 kilometres

per hour. 7 These plans mark the beginning of an era of high­speed rail travel in

China. These projects will also generate a large number of related business

opportunities for both domestic and foreign investors. It will also drive local

economic development in areas where the railway extensions are planned.

2.9 Over the past 15 years, especially in the period spanning the 10 th FYP (2001­2005)

and 11 th FYP (2006­2010) , China has completed building about 35,000 kilometres

of national motorways. Between 1990 and 2007, investment on the national

highway system totalled more than RMB900 billion. 8 The country now has the

second­longest railway and motorway networks in the world after the U.S., a large

part of which built in the last 20 years.

7 China Business Times, 09/01/2006, “China’s High­Speed Railway Construction Begins, Households and Foreign Businesses will all be Overwhelmingly Satisfied”, http://news.xinhuanet.com/fortune/2006­01/09/content_4026467.htm, accessed on 22 December 2007. 8 Xinhua News, 18/12/2007, “The “Five Latitudinal and Seven Longitudinal” National Main Highway Will Basically be Open to Traffic by the End of this Year”, http://news.xinhuanet.com/newscenter/2007­12/18/content_7274563.htm, accessed on 22January 2008.

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2.10 In 2007, China continued to be the biggest, or one of the biggest producers and

consumers of major industrial and agricultural products such as coal, electricity,

cement, oil and steel. It became the second largest car market in the world after the

U.S., after expanding 24% in 2007. 9

2.11 China has sustained annual growths of over 9% in the past decade while keeping

inflation well below 2%, and achieved an impressive improvement in total factor

productivity. Figure 3 shows the relationship between GDP growth and inflation in

the past 18 years. However, from March 2007, the consumer price index (CPI)

started to rise rather unexpectedly, caused by rapid increases in prices of pork and

other agricultural products. By November 2007, CPI had risen to an 11­year­high of

6.9%. 10 The current inflation is termed as “structural” as price hikes are still mainly

found in the food sector. “Core inflation” remains as low as about 1.5% in 2007.

However, this structural inflation likely seriously affected low­income consumers

based on an Engel coefficient of as high as 50%, which indicates the proportion of

household total expenditures spent on food. The Chinese government has to

exercise caution over high inflation, which could potentially trigger domestic

protests and lead to political instability as a result of the unequal impact of high

inflation on the poor.

Figure 3: China’s Economic Growth and Inflation (measured by CPI), 1990­2007

3.8

9.2

14.2 13.1

10.9 9.3

7.8 7.6 8.4 8.3 9.1 10.0 10.1 10.4

11.1 11.4

3.4

6.4

24.1

17.1

2.8

­0.8 ­1.4 0.4 0.7

­0.8 1.2

3.9 1.8 1.5

4.8

10.0 14.0

8.3

3.1

14.7

­5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Growth Rate (%)

GDP CPI

Sources: China Statistical Yearbook, various issues, National Bureau of Statistics.

2.12 International trade continued to expand in 2007. Both exports and imports saw

strong growths. Figures 4 and 5 illustrate the volumes and growth rates of exports

and imports since 1990. In the data period, both exports and imports grew nearly 20

times. Trade surpluses were recorded in 17 out of the 18 years. The level of surplus

has grown exponentially in recent years, alarming the U.S. and the EU.

9 Financial Times, 14/01/2008, “Chinese Lose Enthusiasm for Smaller Cars”, http://www.ft.com/cms/s/0/0487c65c­c201­11dc­8fba­0000779fd2ac,dwp_uuid=9c33700c­4c86­11da­89df­000 0779e2340.html, accessed on 22 January 2008. 10 Source: Statistical Data, National Bureau of Statistics.

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2.13 In 2007, total trade volume rose 23.5% to $2.17 trillion from a year earlier,

exceeding the 2­trillion­dollar mark for the first time. 11 The gain exceeded 20% for

the sixth year in a row. In 2006, China was the third largest trading nation in the

world, after the US and Germany. In 2007, it probably overtook Germany to become

the world’s second largest trading economy, and the US to become the second

largest exporter. Exports amounted to $1.22 trillion while imports stood at $956

billion, generating a 48% gain in surplus to $262 billion from the previous year. The

rapid growth in exports and trade surplus had arisen despite an appreciation of more

than 8% in the RMB in nominal terms and more than 12% in real terms.

Consequently, allegations that China has been taking advantage of an undervalued

RMB to generate high trade surpluses should be seriously challenged.

Figure 4: China’s Exports, Imports 1990­2007

762

969

1218

53 64 81 116 132 139 142 140 166 225 244 295

413

62 72 85 92 121 149 151 183 184 195 249 266 326

438 593 660

791

956

104

561

0

200

400

600

800

1000

1200

1400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

US$

billion

Export Value Import Value

Sources: China Statistical Yearbook, various issues, National Bureau of Statistics.; Statistical

data, Ministry of Commence. China Custom.

2.4 The growth rates of exports and imports have been volatile. As China becomes more

integrated with the world economy, its openness may also render the economy

vulnerable to external shocks. The current economic gloom in the US may cause the

Chinese economy to slow down, although many people believe that China, along

with other fast growing economies such as India, may not be affected by a U.S.­led

economic slowdown in the West.

11 Xinhua News, 11/01/2008, “China Customs: Total Trade Value in 2007 Exceeds $2 Trillion, Growth Rate Exceeds 20% for the Sixth Year”, http://news.xinhuanet.com/fortune/2008­01/11/content_7405155.htm, accessed on 22 January 2008.

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Figure 5: China’s Export and Import Growth Rates, 1990­2007

­5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Growth Rate (%

)

Export Growth Import Growth

Sources: China Statistical Yearbook, various issues, National Bureau of Statistics. Statistical

data, Ministry of Commence, and China Custom.

2.5 External demand has been mainly for merchandise goods, partially due to China’s

comparative advantage in the manufacturing sector and government policies that

favour export industries. Exports have contributed largely to China’s overall growth,

but also generated controversies, such as those over the country’s huge trade

imbalances, mounting foreign reserves and an undervalued RMB.

2.6 These trade­related problems and disputes have also been politicised given the size

of China’s economy and its resulting influence. The EU recently joined the U.S. in

pressuring the Chinese government to let the RMB appreciate. As shown in Figure 6,

the EU is now China’s biggest export market, but its ballooning trade deficit with

China has raised anxieties among the European member states. The risk of

protectionism may increase should such the high level of deficit persist.

Figure 6: China’s Top 10 Export and Import Destinations, Jan­Nov 2007

Exports US$ billion

Hong Kong, 166.81, 16.9%

Others, 167.48, 17%

India, 19.27, 2%

Russ ia, 23.43, 2%

Korea, 45.07, 5%

ASEAN, 75.28, 8%

Japan, 82.74, 8%

USA, 191.02, 19%

Taiwan, 19.04, 2% Canada,

16.14, 2%

EU, 198.17, 20%

Imports US$ billion

Japan, 121.49, 15.7%

EU, 99.83, 12.9% Australia,

23.15, 3.0%

Russia, 17.61, 2.3%

Brazil, 16.93, 2.2%

Saudi Arabia,

15.64, 2.0%

Others, 130.85, 16.9%

USA, 63.49, 8.2%

Taiwan, 91.61, 11.8%

Korea, 94.74, 12.3%

ASEAN, 97.93, 12.7%

Sources: China Custom.

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2.7 Compared with a year ago, the top 10 export and import markets remain the same,

though the position of each individual market has shifted. China maintained strong

trading ties with major economies in the world, engaging engaged in international

trade of all sorts of goods in all agricultural, industrial and service sectors. Trade in

manufacturing goods accounted for the biggest share. Energy­ and resource­rich

countries and regions, such as Australia, Russia, Brazil, Saudi Arabia and the ASEAN

nations fueled China’s rapid development. Korea and Taiwan were the main

suppliers of primary products, parts and components to China. The EU, U.S. and

Japan were the most important sources of high­tech exports to China. The EU and

the U.S. remained reluctant to export advanced technological products but their

ever growing appetite for merchandise products meant they had to contend with

huge and growing trade deficits with China despite a two­digit effective appreciation

of the RMB against the U.S. dollar in 2007.

2.8 As a world manufacturing centre, China has been utilising its comparative

advantages in labour, facilities and technologies to attract foreign and domestic

investments. It acquires resources and materials domestically and from overseas

and ships its products to the rest of the world. Consequently, it has run significant

trade deficits with economies that supply energy and resources while generating

surpluses with the U.S. and the EU. Its growing economic strength and close trading

relationships with the rest of the world have substantially increased its influence on

world foreign affairs.

2.9 China has been either the world’s largest or second largest recipient of foreign direct

investment (FDI) in recent years. FDI has been one of the most important factors of

growth in China in the past two decades, contributing enormously to general

economic growth and particularly to the export industry. China attracted a record

high FDI of $74.8 billion last year (see Figure 7).

Figure 7: China’s Total Amount of Utilised FDI and Its Growth Rates, 1990­2007

3.5 4.4

11.0

27.5 33.8

37.5 41.7

45.3 45.5 40.3 40.7

46.9 52.7 53.5

60.6 60.3

69.5 74.8

2.9

25.2 22.7 11.111.2 8.5

0.4 ­11.3

1.0 15.1 12.5

1.5 13.3

­0.5 15.2 13.6

151.9 150.0

0

10

20

30

40

50

60

70

80

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

US$ billion

­20

0

20

40

60

80

100

120

140

160

180

Growth Rate (%)

Utilised FDI Growth Rate

Sources: China Statistical Yearbook, various issues, National Bureau of Statistics. Statistical

data, Ministry of Commence.

12

2.10 From 1979 to 2007, total FDI stock, stemming from over 200 countries and

territories, rose to $753 billion. 12

2.11 In the literature, most researchers regard FDI as a main driver of economic growth

as it helps to improve the production efficiency of domestic industries and accelerate

technological progress in China. However, FDI may also have caused various

negative effects. In its early period of opening­up, China’s aim was to accelerate

GDP growth by promoting exports, using foreign capital as a catalyst. Various

problems have followed the inflows of foreign capital and businesses, such as unfair

competition between domestic and foreign firms, unbalanced development between

industries, widening of regional disparity and environmental pollution. Furthermore,

mergers and acquisitions of domestic enterprises by foreign investors have raised

concerns about economic security.

2.12 High levels of trade surpluses and FDI inflows have unsurprisingly added to the

country’s large foreign reserves. Due to tight controls on capital accounts, foreign

reserves have been highly correlated with trade surplus. By the end of 2006, total

foreign exchange reserves had reached $1.07 trillion, breaking the symbolic $1

trillion record for the first time and making China the world’s largest holder of

foreign money. In 2007, the foreign exchange reserves rose 43.3% to $1.53

trillion. 13

2.13 On the one hand, the huge amount of foreign exchange reserves has become a

heavy burden on the country because of the low yields derived from U.S. Treasury

bonds which constitute the main portion of China’s foreign exchange reserves.

Moreover, the value of these assets has declined due to a weakening U.S. dollar. On

the other hand, the huge foreign reserves support China’s increasingly important

role in world capital markets. China in September 2007 launched a sovereign wealth

fund designed to invest more aggressively a portion of its swelling foreign exchange

reserves in foreign companies. The fund initially has about $200 billion under

management, 14 although its investment strategy remains opaque at the moment.

Nevertheless, the launch signals that China has initiated an active management of

its foreign exchange reserves. One of the aims of setting up China Investment

Corporation, the manager of the fund, clearly is to resolve the predicament of the

country’s large foreign exchange reserves and to preserve and increase their worth.

2.14 The Chinese currency appreciated sharply against the U.S. dollar in 2007, although

the gain still lagged that demanded by China’s western trading partners. Based on

an exchange rate of 7.3046 yuan to the dollar on the last trading day of 2007, the

Chinese currency, or RMB, had appreciated a nominal 13.38% against the US dollar

12 Sources: China Statistical Yearbook, various issues, National Bureau of Statistics. Statistical data, National Bureau of Statistics. 13 China News, 11/01/2008, “China’s National Foreign Reserves Reached $1.53 Trillion, Increasing 43.32% From Year Ago”, http://www.chinanews.com.cn/cj/zbjr/news/2008/01­11/1131610.shtml, accessed on 22 January 2008. 14 Financial Times, 29/09/2007, “China Unveils Fund to Invest Forex Reserves”, http://search.ft.com/ftArticle?sortBy=gadatearticle&queryText=China+sovereign+funds+%24200bn&aje=true&i d=070929000048&ct=0&page=8, accessed on 22 January 2008.

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since July 2005, when the RMB was freed from its dollar peg and allowed to float

within managed bands. 15 In real terms, the rate of appreciation should have been

significantly higher because of a rapid increase in CPI, especially in 2007. The EU

recently lent its voice to the U.S.­led campaign to pressure China into letting the

RMB appreciate at a faster pace, because of their ballooning trade deficits with China

which they believed as caused by the relative low value of RMB. China in 2007

overtook the UK as the biggest source of imports into the euro zone. As usual, the

Chinese government indicated clearly to high­profile visitors, led by US Treasury

Secretary Henry Paulson and chairman of the Eurogroup of euro zone finance

ministers Jean­Claude Juncker, that it was willing to work closely with the US or the

EU to tackle the currency and trade deficit issues but it was unrealistic to expect a

sudden or large­scale appreciation in the short run.

Stock and Housing Markets in the Spotlight

3.1 Following strong gains in 2006, the stock market enjoyed another bullish year in

2007. The Shanghai Stock Exchange (SSE) Composite Index rose from less than

3000 at the beginning of the year to reach a historic high of about 6,300 on 5

November 2007 when PetroChina moved its listing from Hong Kong to Shanghai.

The SSE index closed the year at 5,100. Declines in the last two months of the year

indicated a correction of the market’s apparent overheating as the high

price­earnings ratios of PetroChina and other large companies suggested that they

might have been significantly overvalued.

3.2 The bullish stock market attracted large inflows of domestic and foreign “hot money”.

The current number of individual accounts in China’s stock markets totals more than

100 million. Almost one in 10 citizens is directly involved in stock trading. Central

bank data shows that the frequent transfers of household savings deposits between

commercial banks and stock markets correspond to fluctuations in the stock index.

During the bullish period, huge amounts of money flowed from banks to stock

markets and vice versa during the bearish periods. Such fund transfers and wide

market participation have increased market volatility.

15 Source: People’s Bank of China.

14

Figure 8: Shanghai Stock Exchange Composite Index 2003­2008

3.3 Figure 8 shows the Shanghai Stock Exchange Composite Index in the past five years.

It started to rise dramatically from its lowest point in late 2005, gaining 129.8% in

2006 and 96.6% in 2007. Although such huge gains stimulated the world markets,

they are a cause for concern for the Chinese government.

3.4 In 2007, house prices maintained a trend of rapid increases, which has lasted more

than 10 years, despite frequent increases in bank interest rates and the

implementation of many government measures including the tightening of credit to

developers and increased land use supervision. Housing prices in 70 large­ and

medium­sized cities in China continued to rise at a rapid pace, fuelled by robust

investment and demand. For example, between June and November, monthly price

increases 7.1%, 18.6%, 8.2%, 8.9%, 9.5% and 10.5% were recorded

respectively. 16 Investment in the real estate market jumped 31.8% to RMB2.16

trillion in the first 11 months of 2007. 17 Figure 9 shows the housing price index in

Shanghai between 1995 and 2007, which surged to 1925 by the end of 2007 from

691, its lowest level in 1999, giving an increase of about 200%, with the biggest

gains recorded during 2007. Between May and December 2007, average home

prices in Shanghai rose by about 40%.

16 Source: Xinhua news, 20/12/2007, “Housing Prices in 70 Large­ and Medium­sized Cities Increased 10.5% in November”, http://news.xinhuanet.com/house/2007­12/20/content_7285461.htm, accessed on 10 January 2008. 17 Source: National Development and Reform Commission.

15

Figure 9: Shanghai House Price Index, 1995­2007

942

691 691 700 712 777 891

1172

1372 1513

1351 1333 1378 1377 1377 1413

1571 1654

1773 1859 1925

0

500

1000

1500

2000

2500

295

1099 1299 500

1200

1201

1202 1203

1204 505 1205 206 1206 107

207

507

807

907

1007

1107

1207

month & year

China House Shanghai Index

Sources: The Association of Shanghai Real Estate Valuers. The average house price in the

fourth quarter of 1994 in Beijing is assumed to be 1000.

3.5 The extraordinarily high prices have rendered houses unaffordable for the majority

of wage­earners, while real estate developers, speculators and homeowners have

amassed great wealth from the booming market. Such a trend is unlikely to stop in

the coming months, as revenue from selling land forms an attractively large share of

the local government’s income. It appears that bank and government officials as

well as property developers in China have been colluding to manipulate land and

housing prices, producing hundreds of rich and super­rich individuals within a short

span of time.

3.6 High stock and house prices have spurred inflation and worsened the income gap by

making the rich richer and the poor poorer. The fast economic growth has not been

managed in a way to create a fair and commonly prosperous society. Rather, the

current economic framework and policies have been responsible for creating the

seemingly uncontrollable inequalities across the country. The biggest winners from

the booming stock markets have been the government, fund managers, directors of

state­owned enterprises and banks. In 2007, the government collected over

RMB200 billion of stamp duties while stockbrokers earned RMB150 billion in fees.

Stamp duties and brokerage fees constituted over half of the total profits of all the

listed companies in the first half of 2007. Many of the richest Chinese have made

their fortunes through property development.

3.7 The key mission of the 17 th CCP National Congress was to promote a “harmonious

society” and to help the poor. In reality, steep housing prices have excluded the poor

from home ownership, while high share prices have benefited the rich. The bullish

stock and house markets have fueled the high cost of living, hurting the poor far

16

more disproportionally than the rich and making China an even more unequal

society. A “socialist” China under Mao has been completely transformed into a

“bureaucratic capitalist society.”

The 17th Party Congress and Economic Reforms

4.1 In 2007, China’s reform and opening­up continued at a rapid pace. Comprehensive

reforms were carried out in key areas involving the rural areas regions, state­owned

enterprises, financial sector, etc. 2007 was the first year following the transitional

period after the country’s accession to the World Trade Organisation (WTO).

4.2 China is poised to become the third­largest economy in the world, surpassing

Germany. To achieve the economic growth target set by the 11 th FYP (2006­2010),

it only needs to maintain an average annual growth rate of 7­8%. However, to

achieve an all­rounded development, China has to fully implement the policy

initiatives introduced at the 17 th Party Congress which are as follows: enhance the

ability of independent innovation; upgrade industries and optimise their structures;

dramatically improve the efficiency in the use of energy and natural resources and

reduce waste emission so as to increase the capacity for sustainable development;

balance development between rural and urban areas as well as among regions;

build a comprehensive economic system and a modern market system; establish an

effective regulatory system through financial and tax reforms; transform the

country’s growth model and improve the quality of its open economy. All these goals

are still far from being met.

4.3 China is extremely keen to become a leader in science and technology. One of the

main aims of China in encouraging inward FDI was to benefit from the spill­over

effects of technology brought by foreign firms. While China has been a big buyer of

foreign technologies, it also realises that it can never be a leader through

acquisitions. Independent innovation is therefore necessary. The country has made

tremendous progress in many areas over the past few decades. One of the most

significant indicators of technological progress in 2007 was the successful launch of

the Chang’e 1 Moon survey satellite in October.

4.4 The policies introduced at the 17 th Party Congress expanded on and defined the

economic principles laid down in the 11 th FYP, constituting a large part of the

Hu­Wen leadership’s efforts to build a “harmonious society” based on a “scientific

development” approach. However, the effects of those government policies have yet

to show up. Many of the latest government initiatives have been aimed at relieving

social tensions cumulated over the past three decades when China was ruthlessly

promoting GDP growth. Domestic achievements have been followed by intense

external conflicts over issues such as that involving China’s foreign exchange policy.

Precarious internal and external macroeconomic imbalances have resulted from a

strategy of high growth based on high savings, high investments, high exports and

low consumption.

17

4.5 The 17 th Party Congress emphasised the changing of the country’s economic

development model to one that was less investment­ and trade–dependent. It also

aimed to reduce the country’s urban­rural divide by “constructing a socialist new

countryside.” Though the problem of the urban­rural divide has existed for a long

time, it became aggravated following the implementation of economic reforms.

Since 2004, the government under the Hu­Wen leadership has put in place a series

of pro­rural, pro­agricultural and pro­peasant policies, including the abolition of

agricultural taxes in 2006 and the provision of healthcare and other social security

subsidies. In 2007, after carrying out regional trials, the government started

offering free education to all rural children, exempting them from tuition and related

fees, book fees and partial accommodation fees if necessary in their first nine years

of schooling. In 2007, the central government spent over RMB391.7 billion on “San

Nong” (agriculture, peasants and rural areas), representing a 15.3% increase from

2006. 18 China also started reforming the ownership of rural woodlands so as to

further improve agricultural productivity.

4.6 All these measures were aimed at stimulating rural incomes, bolstering rural

economic development and reducing the urban­rural inequality. The ultimate goal of

reform is to establish a unified system for both urban and rural areas. According to

the Kuznets rule 19 , rising inequality is inevitable during the early stage of economic

development, but it can impede growth when the economy reaches a certain level.

If inequality becomes too large then, it causes the economy to become less efficient

and unstable. In order to arrest the growing urban­rural gap, policies slanted

towards the “San Nong” need to be adapted to the processes of industrialisation and

urbanisation.

4.7 Economic growth in China has relied not only on excessive investment but also on

the disproportionate and inefficient consumption of energy and non­renewable

resources, leading to severe environmental degradation. The concept of

“harmonious society” places an emphasis on sustainable development in terms of

energy and resource efficiency. China is trying to employ more advanced

technologies to improve the energy and material efficiencies of industrial processes,

as well as to develop labour­intensive, capital­ and material­efficient and

environmentally­friendly industries.

4.8 So far, the country’s development policies have exacerbated regional inequality and

led to massive migration, which could potentially cause social instability and reduce

the national economic efficiency. Many studies found that the backward central and

western parts of China have not been catching up with their richer counterparts in

the eastern part of the country. The Chinese central government is looking to adopt

a more balanced regional development strategy.

18 Source: Ministry of Finance. 19 Kuznets, S., (1955), “Economic Growth and Income Inequality”, The American Economic Review, Vol. 45, No. 1, 1­28.

18

4.9 One of the most important policy objectives is to build a modern market economy

with Chinese characteristics, in which control remains with the state sector. The

reform of SOEs ­­ a key aspect of China’s economic restructuring ­­ accelerated in

2007. The number of central government­controlled SOEs fell from 159 at the end of

2006 to 151 by the end of 2007. On average, these SOEs performed better than a

year ago measured by some key indices, such as revenue, profit, profit growth and

operational quality. For example, the total profit of these SOEs reached RMB1 trillion

in 2007, representing a 60% growth. 20

4.10 The State­owned Assets and Supervision and Administration Commission of the

State Council (SASAC), which is responsible for carrying out the SOE reform while

acting as an investor in state­controlled firms, continued to make changes in areas

such as ownership, modern enterprise system, personnel, financial management

and to encourage independent innovation capabilities, energy conservation and

pollution reduction.

4.11 However, the huge profits earned by the SOEs have not been shared equally with

the state and taxpayers, due to a lack of relevant regulations. Citizens have instead

been suffering from rising prices of public goods and services, petrol and other

commodities that are sold by state monopolies. In other words, higher SOEs’ profits

most likely exacerbated the problem of social inequality as the profits represent a

reallocation away from public welfare to a small group of people.

4.12 As the market economy matures and takes on a more complex form, the state has

to establish an effective regulatory system by deepening financial and tax reforms.

Financial reforms in 2007, similar to other reforms in China, have been skewed

towards the rural areas. Since the establishment of the first rural bank in the central

province of Sichuan, 24 new specialised financial institutions have been set up to

serve rural needs. This is an important milestone in the reform process. Having seen

the successful experiences of other developing countries, the Chinese government

hopes to use the same approach to stimulate rural economic development and

further reduce poverty, while promoting a new business area for its troubled

banking sector.

4.13 China made great efforts in 2007 to liberalise its financial market. Under the

Qualified Foreign Institutional Investors (QFII) scheme, China tripled the amount of

money that foreigners can invest in the mainland capital market. The long­awaited

announcement was made on the eve of the third Strategic Economic Dialogue in

December between Chinese and US policymakers. The quota for registered foreign

investors was raised from $10 billion to $30 billion. 21

20 China Times, 15/12/2007, “Profits of Central SOEs Soar: the Awkward Logic of a Happy State and an Anxious People.”, http://news.xinhuanet.com/fortune/2007­12/15/content_7253593.htm , accessed on 22 December 2007. 21 Financial Times, 09/12/2007, “China Raises Foreign Investment Quotas”, http://www.ft.com/cms/s/0/fc86f6fa­a688­11dc­b1f5­0000779fd2ac.html, accessed on 22 January 2008.

19

4.14 Similarly, under the Qualified Domestic Institutional Investors (QDII) scheme, the

China Banking Regulatory Commission (CBRC) in December 2007 allowed Chinese

citizens to buy shares and mutual funds in London in addition to those in Hong Kong

through their local banks, representing a further step towards the export of Chinese

capital to global markets. This move indicates the government’s aim to relieve

domestic economic imbalances arising from the build­up of excess liquidity in the

financial system. Through these measures, the CBRC also expects to deepen the

QDII markets and spur domestic banks to improve their overseas investment and

risk management abilities.

4.15 Another important milestone in the opening of China’s financial markets was

achieved in April 2007 when foreign banks were officially allowed to offer local

currency retail banking services to customers in the Mainland. Citigroup, HSBC,

Standard Chartered and Bank of East Asia were among the first foreign participants

in the Chinese market. The gradual process of letting foreign banks into the long

protected local market has been accelerated by the terms of China’s entry into the

WTO. Foreign banks were previously limited to handling foreign currency services

and in some cases, Chinese currency services for corporate customers.

4.16 Competition in the future will be especially intense. State­owned local banks have

been rushing to restructure and to form alliances with foreign partners as they work

on upgrading services, technology, management and in the long run, their operating

efficiencies.

4.17 A fair and effective taxation system together with a fair and efficient central­local

budgetary allocation model are imperative to reducing income inequality and

enhancing regional development incentives.

4.18 To meet the goal of improving the quality of China’s open economy, the 17 th Party

Congress called for the continuation of China’s open policies along with the nurture

of world­class big businesses, development of the international competitiveness of

Chinese products and services, and an improvement in the quality of foreign

investment.

4.19 Such policy shifts however will affect many powerful vested interests, which have

been the main beneficiaries of China’s shift to a market economy. The Chinese

government has to enforce a more comprehensive development and reform of the

economy in order to raise rural incomes and living standards as well as challenge the

élites.

Other Policy Initiatives and Challenges

5.1 A new Anti­Monopoly Law, which was passed on 30 August 2007 and scheduled to

take effect from 1 August 2008, was designed to curb the monopolistic actions of

SOEs and to promote fair competition in the market. A new Enterprise Income Tax

20

Law, which was passed on 19 March 2007 and took effect from 1 January 2008,

imposed the same tax rate on both foreign and domestic firms for the first time since

China’s opening­up policy started in the late 1970s. It ended the tax privileges of

foreign firms and create a fair environment. Another important new law that took

effect on 1 October 2007 was the Property Rights Law, which was passed on 16

March 2007. It clarified the property rights of the state, collective, private

individuals and others and is aimed at maintaining the order of the market economy.

The passage of the law was also viewed as a step towards further ownership reform.

5.2 China’s fiscal revenue surged 31% from a year ago to RMB5.1 trillion in 2007. The

high revenue, which was attributed to rapid and stable economic growth and better

tax collection practices, has been used by the government to finance social policies.

In the first 11 months, RMB557.8 billion was spent on education, up 32.7%

year­on­year, RMB141.9 billion on health and medical care, up 40.6%, RMB412.8

billion on other social security projects, up 28.6%, and RMB117.4 billion on scientific

research, up 33%. 22

5.3 These areas are listed among the top priorities of the current Hu­Wen leadership and

form critical areas of the so­called “harmonious society”. Long­term investments in

education and scientific research are essential for the building of a state that is

capable of innovating, and for improving economic efficiency and quality. Such

investments are particularly important for resolving environmental issues and

enabling the efficient use of energy and natural resources. Investments in social

security areas as well as “SanNong” are critical to the reduction of inequalities in

China.

5.4 In November 2007, China declared that preventing the overheating of the economy

and reining in inflation would be its top tasks in 2008. 23 The subsequent annual

Central Economic Work Conference in December reaffirmed these policy priorities by

listing specific macroeconomic control measures including the reduction of the

country’s trade surplus, more rigorous control on investments, tightening of controls

on liquidity, as well as price stabilisation measures this year.

5.5 Soaring crude oil prices in the global market have pushed up domestic prices and

production costs in China, which is the second largest oil importer after the U.S. To

offset oil supply risks and reduce the impact of fluctuating global energy prices on its

domestic market, China set up a strategic oil reserve programme in 2004. As part of

this programme, the state’s first National Centre for Oil Reserves was formed on 19

December 2007. The establishment of this centre carried strategic and economic

significance, and was expected to influence a wide range of social and economic

affairs especially in the area of energy.

22 Xinhua News, 19/12/2007, “Total Fiscal Revenue from January to November was RMB4.8177 Trillion, Annual Figure Expected to Reach RMB5.1 Trillion”, http://news.xinhuanet.com/fortune/2007­12/19/content_7278767.htm, accessed on 22 January 2008. 23 Xinhua News, 28/11/2007, “What New Information on Economic Development does the Conference of Central Politburo Transmit”, http://news.xinhuanet.com/fortune/2007­11/28/content_7162505.htm, accessed on 22 December 2007.

21

5.6 The Chinese leadership is not insensible of the state’s structural economic problems.

In fact, the Hu­Wen government has time and again emphasised the significance

and urgency of a balanced growth model that takes into account social and

environmental issues. This year, the Chinese government will undoubtedly continue

with tight macroeconomic control and adjustment measures to counter an

overheating economy and inflation. However, as the market mechanism becomes

increasingly efficient in China, the central government is becoming less capable of

implementing bold and radical reform measures.

5.7 Reforming SOEs have proved to be difficult because the familiar issues of efficiency

and agency are far from being resolved, while a new problem of monopoly power is

becoming into a major concern. SOEs constitute a leading force in China’s economy,

especially in key economic areas, Reforming them would considerably affect the

overall economic future. Besides, China’s huge but fragile financial institutions are

now facing unprecedented competition from overseas. Reforming the financial

sector is a critical challenge that if successful, will lead to high­quality and

sustainable growth in China. If not, a financial crisis might ensue.

5.8 In summary, the central government’s recent policies intended to dampen economic

overheating show the leadership’s determination in the short run. In the medium­

and long term, China, a rising power in the world, is seeking to sustain its high

growth and become a better developed society through a gradual and pragmatic

approach. 2008 is expected to be another year of high growth with a projected GDP

growth rate of 10.5%. 24 The country has to find a more effective way to curb

inflation, regulate the stock and housing markets, and above all, ensure the

rich­poor divide does not widen so as to create a better and fairer society while

maintaining a high rate of growth without causing further damage to the

environment.

24 Reuters, 18/1/2008, “China GDP Growth to Ease to 10.5 Percent: Researcher”, http://www.reuters.com/article/ousiv/idUSPEK2960020080118 , accessed on 7 February 2008.