China Quarterly Update, July 2008

China has supported fast growth by setting in place policies to mobilize labor and capital, have an attractive investment and busincess environment, open up and reform the economy to foster productivity increases, and ensure macroeconomic stability. Having started its reform process at low levels of productivity in the end-1970s, these pro-growth policies have contributed importantly to China's rapid sustained growth.

On top of that, China has tended to stimulate an industry lead, capital intensive pattern of growth, by several policies that boost saving and investment and make it very attractive to produce industrial products. In some ways it has become too attractive to produce industrial products in China. Too attractive because energy, land, and other resources have been priced cheaply, environmental degradation caused by factories has not been priced in correctly, and local government officials have been probably overly keen to attract industrial investment as opposed to service sector activity catering to domestic demand.

China's government is currently working on rebalancing this pattern of growth, making growth more led by services and domestic demand, particularly consumption. The challenge is to rebalance the pattern of growth without hurting growth unduly. We think this is possible by getting more growth out of efficiency improvements, in part by better allocation of capital and labor. That is, by pursuing reform in the areas of fiscal policy, financial sector, the labor market, and the policies to rural-urban migration, China should be able to reap efficiency gains that make it possible to continue to grow rapidly along a pattern that is less industry and investment heavy.

I visited earthquake-hit areas of Sichuan last week with some colleagues (see our blog posting at http://eapblog.worldbank.org/content/sichuan-ordinary-life-in-an-extraor... for more on this). I was really impressed with how well the Chinese government has coped so far. Given that a large disaster hit Myanmar at the same time it is hard not to compare the two efforts. While China has good capacity itself, it still welcomed international support of various kinds: expert advice, rescue teams, movable hospitals. China’s response has been much more open than Myanmar’s. Also, Chinese journalists started traveling to the area immediately, and while the government’s attitude was ambiguous for a day or two, it soon welcomed this. So, I think one big lesson is the importance of getting the media to cover these events so that the whole population is informed and involved. The outpouring of individual contributions and volunteerism in China has been remarkable. That said, the reconstruction is a huge effort that will take years. I hope that China draws on some of the good experiences from other recent disasters such as earthquakes in Pakistan and Turkey.

I think China’s environmental problems are growing pains that are gradually being addressed. China in fact has learned from the bad experience of the west and is starting to clean up at a much earlier stage of development. Given China’s economic success, people often forget that its per capita income is similar to the U.S.’s in about 1920. All of the industrial countries created terrible air and water pollution as they industrialized. That is not to say that China should do the same. It is less costly and better for people’s health to industrialize and keep pollution in check at the same time. China’s policy has been along these lines for about ten years now. The result is some progress: water pollution is lower in the south than 10 years ago, and air pollution has improved in most cities. China is one of the few countries in the world that has increased forest cover – by about 70% in the past 20 years. That said, air and water pollution levels are still too high. A recent study by SEPA and the World Bank estimated the health costs of air pollution to be 3.8% of GDP. Many of the measures to control air pollution are not that expensive: converting all taxis and buses to natural gas, investing in public transportation while taxing gasoline and limiting car use. On balance, China is making progress, but it is in the country’s own interest to clean up faster. Jim Fallows has an interesting article along these lines in the recent Atlantic Monthly; see http://www.theatlantic.com/doc/200806/pollution-in-china.

This is a good question, but am afraid it out of my area of expertise. For many countries, metals and energy need to be imported. Many are trying to secure steady supplies of metals and energy, and sometimes this involves direct investment and direct involvement at the source. On other occasions, the approach is more hand-offish. As an outside non-expert observer, in terms of the economic and physical processes, I don’t see large differences between the approach of China and India and other emerging markets on the one hand and that of Western countries on the other hand. I have no expertise in the areas of politics and military issues, sorry.

In recent years China has become a more vocal and active shareholder in the World Bank, something that is welcomed by just about everyone. For example, China was one of the leading countries several years ago arguing that the Bank had made a mistake by moving out of infrastructure financing and focusing excessively on the social sectors. Most developing countries have welcomed the Bank’s shift back toward more balance between social sectors and infrastructure, and credit China with playing an important role. China has also pushed the Bank to remain active and relevant in middle-income countries. This year for the first time China became a contributor to the concessional fund, IDA, that the Bank uses for projects in low-income countries. This brings China into an important forum – the regular meetings of IDA deputies – where key issues of foreign aid are debated and policy for the Bank determined.

Yes, basically we divide the manufacturing wage bill by industrial value added in constant prices. We know of complications with the data, and don't want to make too much out of the unit labor cost estimates. But, we feel how unit labor cost increases develop according to this proxy may still tell us something.

China is the next model in the sense that its success and size has attracted a lot of interest and attention. Recently we helped the Chinese government organize a seminar and study tour of African officials interested in learning from China’s success (see my blog posting on this). The Chinese participants were very careful to say that they do not see China as a model in the sense that other countries should simply copy what they have done. They emphasized that in their view what was distinctive about China was less what it had done, and more how it had reformed. Chinese government is very pragmatic, trying out approaches and then scaling up ones that work. It also encourages competition among provinces and cities to see who can come up with the most successful policies. This practical approach to reform is a good lesson for other countries. In terms of what China has done, it is not that different from what other successful East Asian countries have done before. The Chinese experts emphasized the importance of liberalizing trade and direct foreign investment, creating a good investment climate for the private sector, investing in both cities and the rural areas, and developing infrastructure.

Let me take the first two questions and David can respond to the third. China’s textile and clothing sector still seems to have good prospects, although the low value added part of the sector may come under pressure as China develops further and wage costs rise. The rapidly growing domestic market has become increasingly important and lucrative for the sector. Exports have decelerated but they are still growing. The cost pressures affecting the industry (raw materials, an appreciation against the dollar, rising wages) have received a lot of attention. However, the rate of return of the textile industry has continued to improve last year. I am no expert on this sector, but I would think that, as in other parts of China’s economy, upgrading the product package and production process will become increasingly important.

David Dollar

Regarding your third question, China recognizes that it is likely to be a big loser from global climate change (more rapid desertification in the north, drop in agricultural productivity, more severe rains and flooding in the south). In response, it has set an ambitious target of improving energy efficiency by 20% during its current five-year plan. That would make a big contribution to controlling greenhouse gases. In the first two years of the plan it made modest progress, mostly through administrative measures such as closing inefficient power plants and increasing fuel-efficiency standards for vehicles. More recently it has significantly increased energy prices, which is the surest way to get households and firms to economize. China also has an ambitious target to increase use of renewable energy. Wind power is spreading rapidly. China has drawn on the global carbon market to support some of these developments. Last year China accounted for 70% of all the carbon reduction sales in the world. The World Bank is the intermediary for some of these deals. For example, we financed the first big wind power station in China, which was only economic because we sold the carbon reduction to European and Japanese firms that can use the carbon reduction credits to meet their emission reduction commitments under the Kyoto protocol.

We noticed these stories too. The economics of trade are interesting. For good that are relatively low end in terms of $ per kilo or $ per square foot, transportation costs matter a lot. So, a venture to build boilers in China instead of the US--which looked attractive at shipping rates of 2 years agaoo--could become uneconomical at shipping rates three times as high (boilers was the example I remember reading in the newspaper). We have not done detailed analysis, but it is our understanding that the types of goods for which shipping rates can make or break an arrangement to manufacture in China make up a modest share of China's exports. Thus, while moving back production to the US does seem to happen in some cases, we have the impression that it is not a systemic trend.

Let me respond to this and to your other question "Can the rural village changers be valued by world bank? Since some developing countries could.".

There are a number of ways that the World Bank is helping with rural community changers. First, we have promoted the development of water users associations among farmers. This has been a very successful innovation that helped farmers self-organize and manage one of the scarcest resources in China – water. Second, in some cases these WUAs have broadened out to become full-fledged farmer collectives, which did not previously exist here as independent bodies. This is important to give the farmers market clout and to promote innovation. Third, in some of our rural projects in poor parts of the country we have successfully introduced participatory approaches in which the village votes on which small-scale investments to pursue. Fourth, our China Development Marketplace raises money from the private sector and makes small grants to grassroots NGOs, many of them in rural areas working on environmental and social issues.

We feel that relying on increases in reserve requirement ratios for the sterilization of foreign inflows is not consistent with the government’s objective of a more commercially oriented banking system. Raising reserve requirement ratios (RRRs) is asking commercial banks to set aside part of their assets at low interest rates at the central bank. The low interest rates lower profitability, compared to a scenario of not raising RRRs (although not necessarily compared to a scenario without the inflows). Moreover, the frequent and unpredictable changes in RRRs complicate business for banks.

What alternatives are there? You note that raising interest rates would increase speculative inflows and domestic saving. I think the first best is tighter capital controls, especially at the short end, and have more—not all--of the inflows be absorbed by appreciation. Knowing that there will still be a need for sterilizing, open market operations—just selling government or central bank paper in line with market conditions—are more market friendly and neutral.

What is the impact of the present monetary policy on access to financing by SMEs? I don’t know good data on SME lending available. I would have expected that, with credit controls actively used, banks would have an incentive to find higher interest rate clients, including SMEs. However, I understand that has not happened: the average interest rate of loans has not increased much recently.

On the (somewhat) recent bankruptcy law, our November 2006 quarterly had a discussion of it; see http://go.worldbank.org/NZLENK2LK0.

It is our impression that so far during the 11th 5YP (2006-2010), significant progress has been made in both improving the rural health service delivery system and the urban community health care system. In rural areas, the goal is to strengthen the 3 tier health service delivery system, with facilities at county level, township health centers, and village clinics. The target in the 5YP of the Ministry of Health is one public THC in each township and at least one village clinic in each administrative village. It is too early to say whether this target will be met, but the amount of financial resources and effort put in it so far has been encouraging. In urban areas, the goal is to establish a well-developed urban community health service system for cities at the prefecture level and above, and for the cities at county level by 2010. Based on progress so far, it is expected that these goals can be met. However, it is still too early too say what the impact of the community health centers on accessibility and affordability of the health services.

Both in urban and rural areas, improving accessibility and affordability are likely to be the main challenges in the coming years.

Progress in the past two years has been pretty good. China had a target to role out the new National Cooperative Medical System to 80% of counties by 2010; in fact, they reached 86% of counties last year. This has been possible because of large increases in the central government budget for rural health and education. They have also increased the per capita funding of the NCMS. That said, the challenges ahead are still daunting. What each rural family can get from the NCMS is not sufficient to address catastrophic illness, which is still a leading cause of falling into poverty. (Expansion of the rural minimum income program – Dibao – helps some here.) The World Bank just approved an innovative rural health project that provides grants to poor counties in different parts of China to experiment with different approaches to rural health reform – with the idea of trying to find on the ground some cost-effective ways to improve actual services (link to press release).

China has built up some insurance during its long boom because its fiscal policies have been pretty conservative and on the external side it has built up large reserves. This gives it the space to allow the exchange rate to appreciate, which takes the wind out of inflation's sails. China still has moderate inflation of around 8% but it has been able to avoid the much higher inflation in Vietnam or other Asian countries. I think one lesson is to save during good times, so that you have more flexibility when times turn bad. On the growth front, China has been able to maintain growth up near 10% this year. But it will face a bigger challenge in future years -- the decline in its trade surplus will be a subtraction from growth, and there is a risk that as that occurs Chinese households and firms will become tentative. So, things are good so far, but I think the world economic situation will be challenging through 2009. So Chinese policymakers have to stay on their toes in case there is any slowdown. There is still some risk of hard landing.

Higher energy prices are driving up costs and prices around the world, including as you notice of shipping Chinese goods. Note Richard Price's question and my answer. I am note sure whether, in the face of cost pressures felt all around the world--as opposed to cost pressures unique to your country--it is obvious to depreciate the currency. We think that, considering China's macroeconomic situation, which include inflation, it makes more sense to appreciate the currency so as to dampen price pressures. Also, China is getting a lot of growth from the domestic economy, and China's overall growth can withstand a slowdown of exports. Thus, I do not think that China's policymakers would choose to depreciate the currency.

The Northern half of Chin has been becoming more dry, and probably global warming is accelerating this trend. The resulting desertification and decline of agricultural land is a big problem. China has several responses. First, some people have been relocating out of rural areas to cities. So far China's overall agricultural production is fine, so this seems a good economic choice. Second, the World Bank has sponsored a very successful set of projects in the Loess Plateau that have helped communities shift to water-saving crops and more ecological practices (see http://go.worldbank.org/1YDIIWHNA00). The result has been remarkable regreening in some areas. So, there are parts of the north that can stay green with the right policies and practices. China can produce enough food with a much smaller rural population, so the migration to cities makes sense. Also, because China is land and water scarce it is more efficient at certain types of crops, and not so efficient at wheat, soy beans or corn. A key question for Chinese policymakers is whether they can accept that the country become a large net importer of grain while farmers concentrate more on high value crops such as nuts, fruit, vegetables, and animal husbandy. Some Chinese worry that this will lead to food insecurity. My view is that if the country still has large overall agricultural production, then importing grain is not a problem. If there were some problem in the world grain market, then China could easily shift land back as necessary.

Yes, the data we use is all published by China's authorities. Of course, there are things that are not published but that we construct using existing data: for instance, trade in constant prices we calculate using values and prices; unit labor costs we calculate using information on wages and production.

The World Bank and IFC are beginning to work with Chinese companies and banks on environmental and social safeguards in China's overseas investment, but this partnership is at an early stage and we do not have anything written up on it yet. We signed a memo of understanding with China's EXIM bank to cooperate in developing countries in different ways. As part of this my staff in Beijing have provided training courses to EXIM staff on the Bank's approach to environmental and social safeguards. Several EXIM staff are currently seconded to the Bank. And we have had a couple of joint missions to Africa to try to identify projects that China and World Bank could support together. But as I said, this is all at an early stage. For this to work really depends on the recipient developing country valuing this kind of collaboration between China and the Bank. On the IFC side, IFC has lots of private clients in China in industries such as banking and cement. IFC is trying to help some of these private Chinese companies go global, to Africa and elsewhere. Any such collaboration between IFC and a Chinese company in a third country would have to follow the Bank Group's safeguards for environmental and social protection. Within a few months I think we will have some papers on this topic that will be available.

Good question. There have been reports about labor cost pressures and pressures to move manufacturing out of China's coastal areas. However, these are largely anecdotal. I have heard people saying they see a lot of business men flying from Shanghai and Hong Kong to check out Vietnam, but very few actually decide to pack up in China and move to Vietnam. It will happen eventually for products at the lower levels of sophistication. However, China's competitiveness position is still very strong. We have a box on it in the June Quarterly (see http://go.worldbank.org/YKOY275UH0). The other part of the question is on the still large number of people who have not yet been "absorbed" by the modern economy. As you rightly say, China is still at a low level of development. In the September 2007 Quarterly we have a Special Focus where we discuss why China's surplus labor in rural areas is not drying up yet. And, that is where the bulk of poverty is in China. We think that China still needs a lot of urban growth and migration to cities to absorb these people. China's government thinks likewise and is actually trying to shift the pattern of growth to one where more growth comes from (more labor intensive) services and domestic demand and less from industry.

China is quite prone to natural disasters. In recent years it has had some serious floods (about one a decade, really serious along the Yangtze), the freak snowstorm earlier this year, desertification and sandstorms in the north, typhoons along the coast, and of course earthquakes -- most recently the devastating one on May 12. China has been able to survive all these disasters and still grow very rapidly. The country is fortunate to be large and diverse, so the disasters usually just affect one part of the country. Other parts of the economy continue to function, and can help the damaged area. But looking ahead, it is very much in China's interest to develop better insurance markets and more systematic response to disasters. For example, almost none of the more than 5 million houses destroyed in Sichuan by the earthquake had insurance. So, the government has to step in and help each household. It would be more efficient to have private insurance markets supplemented by government protection. Turkey responded to its big earthquake by overhauling the whole system of disaster management and relief financing. This is a good example to learn from.

This is largely because China's economy was growing faster in 2007 and early 2008 than we all thought. China's bureau of statistics revised GDP data in April, revising up overall growth and services growth for 2007. We have not changed our views about the underlying growth prospects, but did reflect this upward revision. Table 1 in our quarterly shows our projection according to the unrevised and the revised data.

If you asked me a month ago I would have said that the Olympics are likely to have a small effect on the Chinese economy. They are a big event for Beijing, but in economic terms they are not a big event for the Chinese economy. They could have some modest positive effect by bringing in new tourists and sharing more information about China around the world - usually better information leads to more trade and investment. But these effects are likely to be small for China as a whole. However, the second part of your question raises issues that I have become more aware of in recent months. What I hear informally from foreign investors is that delays in getting visas and more importantly, bottlenecks at ports and in transport with additional security is slowing business down. Ironically, this is not a bad thing for China. The government would like to see some slowing in export growth and in industry so that some temporary bottlenecks might actually help China slow the economy a bit and keep inflation under control. Once the Olympics are over, the manufacturing firms that were having some problems are likely to work double-time to catch up with production, so the overall effect for the whole year is still probably modest.

I am afraid that we are not the best source of information on individual companies such as Sinopec. I do know that foreign investment in oil, minerals, and mining is quite limited, so developments in these companies are probably not driven by foreign investment. China has become by far the largest seller in the global carbon market, accounting for 70% of sales last year. I think good data on the carbon market are available. China has many good opportunities for emission reductions, and that's what they are selling in global carbon market. The World Bank is an intermediary in many of these transactions. Environmental lending is developing as a good business in China, and I don't see monetary policy hurting this. For example, quite a few banks ae developing energy efficiency lending as a specialized business. The banks have technical staff who help firms -- especially small and medium ones -- identify energy saving investments that pay for themselves. Then the banks can make money lending for these investments at commercial interest rates.

Exports from China to the US are hardly growing at the moment, in US$ terms. This means that in real terms they may be falling (yoy). That must be the explanation for what you observe. A pick up in US growth, and thus demand for Chinese products, should lead to a pick up in this freight market, I would think.

Please see my answer to Brian Gomez, and the box in our June 2008 quarterly. We think that China's competitiveness for manufacturing is still strong. Costs are rising in China. But, costs are rising everywhere, and it is not clear that costs are rising faster in China than in other countries. By the "outcome" indicators that we look at--export market share, profitability of core manufacturing--China's competitiveness still seems solid. China's manufacturing will feel the negative impact of a weaker global economy this year and next. At the same time, China's manufacturing will be supported by a relatively strong domestic economy. Forecasting is always difficult. But I would think that the strong fundamentals supporting China's manufacturing will continue to benefit it in the coming years.

1. Wages are rising rapidly in China. Average wages are not rising as fast as the official data suggest, but still seem to rise significantly. A wage - price spiral is not our central forecast, and so far it appears that wage growth has not picked up a lot in response to the higher food prices. But it cannot be ruled out. That is why we think the PBC is right to have a relatively tight monetary policy.

2. We discuss this in our June quarterly. The PBC keeps monetary policy relatively tight by sterilizing foreign inflows and using credit controls. Interest rates have also increased. However, they are still not very high compared to inflation. We think that it would be good over time to use interest rates more actively rather than credit controls. But, so far the bottom line monetary conditions do not seem overly loose, which is important. In addition, the authorities are letting the exchange rate appreciate, which helps dampening price pressures. Finally, they have introduced several types of administrative and trade related measures on food markets, to make imports cheaper; discourage exports--which also dampens domestic prices even though it is distortive; and contain food prices.

The first part of the 2000s has been a period of good global growth and until recently, low inflation. Energy and food prices were low. That has now all changed. China was smart to save during the boom time -- most importantly through the accumulation of reserves, but also through prudent fiscal policy. Many developing countries make the mistake of borrowing and spending on consumption during the boom times. Then, when growth slows down -- and in this case, with high energy and food prices -- many developing countries have the typical problems of high inflation, balance of payments deficits, and unsustainable debt. China is of course affected by the global slowdown and higher commodity prices. But China's strong savings position gives it several important options. First, China is introducing the higher energy prices gradually. This prevents any big shock to the economy. It requires some subsidy from the budget. But in China's case (1) it can easily affort the subsidy and (2) it is keeping the subsidy under control by gradually raising prices to the international level. Second, China's strong balance of payments position enables China to appreciate its exchange rate in this situation which keeps inflation at bay and eases the pain of higher prices for domestic consumers. Contrast this with developing countries that borrowed and dissaved during the boom. Now the slower growth means they have to cut back spending, while their weak balance of payments leads to devaluation, exacerabating high inflation.

We do not expect a hard landing. We forecast a moderation of growth, as the world economy slows down. I think that exports is slowing down much more because of a weaker world economy than because of price competitiveness reasons. The fact that processing trade is slowing down much more than "normal" exports--see our quarterly-- is consistent with this. But, yes, a slowdown in exports will also lead to weaker investment, particularly in the tradable sector. We have seen this moderation of investment already in the first 5 months. I would expect to see more of this. I personally think the impact of weaker exports will be larger on investment than on consumption. Thanks, will check out the article on the textile sector.

The relatively tight management of the exchange rate means that China has little monetary independence. This leads the authorities to use monetary instruments that are "non-standard" in that developed countries tend not to use them. It has also contributed to making manufacturing in China very attractive, both compared to manufacturing abroad and to doing service type activities. This has pluses and minuses. One issue is that China now runs a very large current account surplus. This is a reflection of an unbalanced pattern of growth. We think that a stronger exchange rate is one measure among a range of measures that is necessary to bring more balance in China's growth.

In general China is having positive spillover effects for other Asian developing countries. When the multifibre arrangement that governed global trade in textiles was phased out a few years ago, there was a fear that China would take over the whole market and countries like Cambodia would lose out. That has not happened. Wages are rising in China and are much higher than in Cambodia, Bangladesh, or Vietnam. So these other countries can compete with China in labor-intensive manufactures. In fact, Chinese producers in many cases are opening factories in Cambodia and elsewhere. China has also added a lot to global demand for commodities, so that commodity exporters including Cambodia have benefited by exporting to China. Cambodia has been growing well in recent years, and I have no doubt that the effect of China in the neighborhood is one reason for this.

As in many other countries, IPR had traditionally not been on the top of the policy agenda in China. Difficulty, and, some say, lack of incentive, to enforce IPR had a significant impact on the incentive to pursue innovation. As you note, more and more of China's companies are starting to invent and innovate. This creates a domestic constituency for IPR protection, in addition to the need to respond to international pressure. In other words, China has an increasingly strong incentive to enforce IPR.

China has legislation against child labor. Moreover, China has a 9 year compulsory education and China's families value education a lot. As a result, child labor is not as common in China as it is in many other developing countries. However, child labor does occur, and in the last 12 months the domestic media has uncovered some terrible cases of child labor, including in a mine. As you note, implementation is key. Implementation tends to be weaker in poorer areas far from China's major cities. On the working conditions of employees, these are generally getting better. That is both because of market forces and government action. More competition for the favorite types of employees in China's rapidly growing economy means employers have an incentive to offer better working conditions in order to reduce turnover. In addition, as part of China's 11th Five Year Plan, the government is focusing more on people and their living standards. For instance, a new labor contract law was introduced early this year. This improved employees' rights. China is still a poor country, overall, which is why large numbers of people still have jobs that would be very unattractive for anybody from developed countries. However, working conditions do seem to have improved in recent years.

China has become a large net importer of oil. And more oil will be needed to fill the tanks of all the new cars that will appear on China's roads, implying significant additional oil consumption. At the same time, China has a lot of coal, and most experts think that coal will remain very important, particularly to fuel power generation. Nuclear, hydro, and wind energy are very actively stimulate by the government. But, these will continue to play a small role overall in the coming decades. The high growth of activity and energy demand in China and other emerging markets will continue to put upward pressure on global energy markets. The impact on energy prices will depend on how much progress can be made world wide with energy efficiency improvements and on the supply response. Oil at $140 per barrel makes for expensive fuel. Thus, with energy and fuel prices in China eventually expected to be adjusted to world prices, high oil prices would make transportation and heating expensive for China's still relatively poor households. If oil prices stay high, public transport may get a boost. On companies, the impact should be broadly similar in China as in other countries. The OECD has done interesting research recently on the impact of high oil prices on the pace and structure of economic growth. I recommend that for more background (in their latest Economic Outlook).

Tough question, because there are many positives. If I had to pick one, I would pick the openness to foreign trade and investment. China has very open, competitive markets, which puts pressure on firms to improve productivity. It also uses direct foreign investment cleverly to bring in new technology, management skills, and access to global marketing networks. The most open markets in China such as electronics and much of machinery have seen extraordinary productivity growth and expansion. The more protected markets have generally lagged behind.