Structural Measures and Rebalancing

In considering further policy initiatives, the key to sustained recovery and growth will be successful rebalancing of the economy, from one led by investment and industry to one led more by consumption and services.

The government has recently reconfirmed its commitment to rebalancing. In a presentation to the 10th session of the Standing Committee of the 11th National People's Congress in August, Zhang Ping, Minister of the National Development and Reform Commission (NDRC), stressed the need for economic restructuring and said "China would (i) accelerate reform of the income distribution, pricing of resource products, and fiscal and tax systems; (ii) in evaluating officials, put more weight on increasing people's living standards and ensuring the quality of growth; (iii) continue to conserve energy and curb emissions and pollutants; and (iv) reduce the income gap between urban and rural residents and between western and eastern regions in a bid to expand domestic demand."

Some further steps have been taken in recent months to rebalance and boost domestic demand. These follow on earlier initiatives, including progress with land reform (see our December 2008 Quarterly Update), the announcement of a health care reform plan (see our March 2009 Quarterly Update), and other initiatives increasing the presence of the government in health, education, social safety and rural areas (see Chapters 5 and 6 of our Mid-Term Evaluation of China's 11th Five-Year Plan).10 More recent steps included (i) increasing further the presence of the government in health, education, and social safety; (ii) improving access to finance in rural areas and for SMEs and SME development more generally; and (iii) mitigating resource use and environmental damage. Regionally, poorer regions away from the coast receive emphasis in government-led investment (Box 2). The remainder of this report discusses the recent reforms, as well as key challenges in their implementation, in greater detail. In all, the measures taken and announced so far are substantial. However, as concluded in our Mid-Term Evaluation, significantly more rebalancing measures are needed to shift the course of China's overall pattern of growth, given the strong momentum of the existing pattern.

I. Increasing the Presence of the Government in Health, Education, and Social Safety

A rural pension program was introduced more widely this year. The three pillar system resembles the urban pension system and had been launched in some areas since 2003. Under the first pillar, the central and local government provide a basic pension at the level of the minimum living allowance (55 yuan per month). Under the second pillar, individual contributions (4 to 8 percent of average local rural income) accumulate in individual accounts. Under the third pillar, voluntary individual accounts are held at the National Social Security Fund. The government has targeted coverage of 10 percent of China's counties by end-2009 and 100 percent by 2020. Challenges include ensuring the transferability of accounts across regions in China's segmented system, integrating the rural scheme in the existing pension scheme, and overcoming the difficulty faced by many local governments in poor areas in making their contribution.

An additional rural pension program for currently older farmers was piloted in August. After paying a one-off fee (of around 1.5 times annual income), farmers over 62 are meant to receive a life-time pension. The scheme is subsidized by the central and local governments. The coverage targets are similar as for the first scheme. Challenges include ensuring the financial sustainability, given the fairly large subsidy element, particularly in poorer regions. During the pilot, many people also said they cannot afford the one-off fee.

Progress is being made in implementing the health care reform plan that aims to make health care more accessible and affordable (see our June 2009 Quarterly). Enrollment in medical insurance programs increased to 337 and 830 million urban and rural people by end-June, up 19 and 160 million from end-2008, respectively. The aim is to cover more than 90 percent of the population by 2011. The Ministry of Health (MOH) recently issued a list of 307 essential drugs as part of an effort to improve people's access to essential drugs and cut their medical costs. Free provision of basic health care is expanding, including of free hepatitis B vaccinations for certain cohorts. Progress has also been made with (i) building and upgrading township hospitals, community health centers and stations and (ii) setting up health files for the rural population to improve their quality of health care. The MOH also intends to speed up reimbursement under the rural cooperative medical insurance system. Health care assistance will be expanded over the next three years by helping more needy families in both rural and urban areas.

These measures in health are important steps, but more is needed. They increase health care provision in rural areas and improve medical insurance coverage. They could have a significant impact on out-of-pocket healthcare spending and could help reduce precautionary savings. However, most out-patient services and medicines are not covered by the insurance. Another remaining challenge is to ensure portability of benefits. Proper and flexible implementation of the strategy will be critical to changing the deep-rooted distortions and achieving the goals. As part of this, monitoring and evaluation will be critical to track what is and is not working.

In all, spending in health, education, and social security has been rising significantly in recent years (Table 3). Commitments made by the government, notably on expanding systems and initiatives in health care, medical insurance, and pension insurance imply further spending increases in the future.

II. Improving Access to Finance in Rural Areas and for SMEs and Providing Other Support to SMEs

The China Banking Regulatory Commission (CBRC) is seeking to encourage the establishment of additional financial institutions in rural areas. To boost rural development it is also studying the possibility and desirability of preferential tax policies to encourage rural financial services.

Steps have also been taken to improve access to finance for SMEs. The CBRC has been pushing for special SME divisions at banks in order to overcome traditional difficulties SMEs have in obtaining finance because of a lack of collateral and credible accounting records, higher lending risk and default rates, and smaller loan sizes. By end-June, the five large state-owned commercial banks and 12 shareholding commercial banks had such divisions. The specialized divisions are meant to speed up SME lending, and to ensure better risk control and higher efficiency. The authorities are also trying to encourage smaller commercial banks to expand into regions with lower bank density, such as west and northeast China. The CBRC also raised the permitted non-performing loan ratio in SME lending and eased requirements on SMEs for loan applications while the government is planning to subsidize banks for the higher risk of lending to SMEs.

In September 2009, China also launched other measures to support SMEs. For very small enterprises, the government will lower the income tax rate and give a one-year exemption on contributions to the Social Security Fund, although this may be difficult to implement.11 In addition, the government pledged to: assist with technology upgrades, help develop new markets, improve the quality of infrastructure support, help improve management expertise among small enterprises, strengthen the government's leadership role, and generally improve the macro environment for SME development.

Box 2. Regional Developments—What Explains Recent Growth Developments Across Regions?

The fall in exports has been across all regions. Since the intensification of the global financial and economic crisis late last year, exports declined dramatically. The eastern region accounts for about 90 percent of China's total exports. However, all parts of China saw exports fall by more than 20 percent.

The overall economy has also slowed in all parts of China, although less so in the western region. In the Eastern region, the economy is much more directly exposed to the world economy, and thus to the global crisis, than in the other parts of the country. In the eastern region, exports were more than 50 percent of GDP in 2008, compared to less than 10 percent in the rest of the country. However, the western and central regions are not isolated from the outside world. Most of China's provincial economies are increasingly integrated with each other—although less so in case of the western region. Moreover, the central region, with its high dependency on heavy industry, was also hit by the real estate weakness that kicked in mid-2008. Thus, the export slowdown and real estate weakness lowered growth in the western and, in particular, the central regions (Box Figure 1).

Variation in the role of government-influenced investment is another reason for differences in the intensity of the slowdown across regions. In line with China's policy of regional rebalancing, government-led investment is tilted towards the western and central regions (Box Figure 2). Fixed asset investment growth in the western region jumped to about 50 percent (yoy) in the early of this year, probably reflecting earthquake zone reconstruction efforts. In all, in the western region, the direct exposure to the global economy is low, integration with other regions relatively modest, and the weight of rapidly growing public investment is high, in part because of regional rebalancing efforts. As a result, GDP growth has been less affected. In the central region, the direct exposure to the global economy is also low. However, this region is more integrated with the eastern region, was more exposed to the real estate weakness, and the weight of government-led investment is smaller here than in the western region. Therefore, GDP growth came down quickly during 2008.

However, some other recent policy initiatives were unfavorable to SMEs. For example, in Shanxi Province, private coal-mining firms producing less than 300,000 tons per year were to be nationalized or merged into larger firms. Also, the newly adopted Postal Law grants the state-owned China Post a monopoly on delivery of mail weighing less than 50g in the same city and 100g inter-city.

III. Mitigating Resource Use and Environmental Damage

Some progress has been made in reforming resource pricing. First, after having been constant since 2003 in many areas, water prices have now been raised in many cities, to stimulate water conservation and allow for enhanced cost recovery of water utilities.12 Second, China's fuel prices now more closely reflect global oil prices.13 On September 2, 2009, the government raised the prices of gasoline and diesel for the seventh time since introducing the new mechanism. Third, the National Development and Reform Commission(NDRC) is considering a pilot to raise hydropower electricity prices to the level of coal-fired power. Electricity from hydropower plants is currently cheaper than electricity from coal-fired power plants. Such price differentials are meant to reflect differences in operational costs of various power plants and a reasonable profit margin. More general increases in electricity tariffs are also under discussion. China also shut down small coal-fuelled power plants with a total capacity of 54 million kw from 2006 to the end of June this year. Because of the closures, the average coal consumption by plants has fallen by 30g to 340g per kw.