China Economy

Economy—overview: Beginning in late 1978 the Chinese leadership has been trying to move the economy from a sluggish Soviet-style centrally planned economy to a more market-oriented economy but still within a rigid political framework of Communist Party control. To this end the authorities switched to a system of household responsibility in agriculture in place of the old collectivization, increased the authority of local officials and plant managers in industry, permitted a wide variety of small-scale enterprise in services and light manufacturing, and opened the economy to increased foreign trade and investment. The result has been a quadrupling of GDP since 1978. Agricultural output doubled in the 1980s, and industry also posted major gains, especially in coastal areas near Hong Kong and opposite Taiwan, where foreign investment helped spur output of both domestic and export goods. On the darker side, the leadership has often experienced in its hybrid system the worst results of socialism (bureaucracy, lassitude, corruption) and of capitalism (windfall gains and stepped-up inflation). Beijing thus has periodically backtracked, retightening central controls at intervals. In 1992-97 annual growth of GDP accelerated, particularly in the coastal areas—averaging about 10% annually according to official figures. In late 1993 China's leadership approved additional long-term reforms aimed at giving still more play to market-oriented institutions and at strengthening the center's control over the financial system; state enterprises would continue to dominate many key industries in what was now termed "a socialist market economy." In 1995-97 inflation dropped sharply, reflecting tighter monetary policies and stronger measures to control food prices. At the same time, the government struggled to (a) collect revenues due from provinces, businesses, and individuals; (b) reduce corruption and other economic crimes; and (c) keep afloat the large state-owned enterprises, most of which had not participated in the vigorous expansion of the economy and many of which have been losing the ability to pay full wages and pensions. From 60 to 100 million surplus rural workers are adrift between the villages and the cities, many subsisting through part-time low-paying jobs. Popular resistance, changes in central policy, and loss of authority by rural cadres have weakened China's population control program, which is essential to maintaining growth in living standards. Another long-term threat to continued rapid economic growth is the deterioration in the environment, notably air pollution, soil erosion, and the steady fall of the water table especially in the north. China continues to lose arable land because of erosion and economic development; furthermore, the regime gives insufficient priority to agricultural research. The next few years may witness increasing tensions between a highly centralized political system and an increasingly decentralized economic system. Rapid economic growth likely will continue but at a declining rate. Hong Kong's reversion on 1 July 1997 to Chinese administration will strengthen the already close ties between the two economies.

GDP: purchasing power parity—$4.25 trillion (1997 estimate as extrapolated from World Bank estimate for 1995 with use of official Chinese growth figures for 1996-97; the result may overstate China's GDP by as much as 25%)

GDP—real growth rate: 8.8% (1997 est.)

GDP—per capita: purchasing power parity—$3,460 (1997 est.)

GDP—composition by sector:
agriculture: 20%
industry: 49%
services: 31% (1996 est.)

Inflation rate—consumer price index: 2.8% (1997 est.)

Labor force:
total: 623.9 million (1995)
by occupation: agriculture and forestry 53%, industry and commerce 26%, construction and mining 7%, social services 4%, other 10% (1995)

Unemployment rate: officially 4% in urban areas; probably 8%-10%; substantial unemployment and underemployment in rural areas (1997 est.)

Budget:
revenues: $NA
expenditures: $NA, including capital expenditures of $NA

Industries: iron and steel, coal, machine building, armaments, textiles and apparel, petroleum, cement, chemical fertilizers, footwear, toys, food processing, autos, consumer electronics, telecommunications

Industrial production growth rate: 13% (1996 est.)

Electricity—capacity: 250 million kW (1997 est.)

Electricity—production: 1.135 trillion kWh (1997 est.)

Electricity—consumption per capita: 1,100 kWh (1997 est.)

Agriculture—products: rice, wheat, potatoes, sorghum, peanuts, tea, millet, barley, cotton, other fibers, oilseed; pork and other livestock products; fish

Exports:
total value: $182.7 billion (f.o.b., 1997)
commodities: electrical machinery, clothing, footwear, toys, mineral fuels, leather, plastics, fabrics (1997)
partners: Hong Kong, US, Japan, South Korea, Germany, Netherlands (1997)

Imports:
total value: $142.4 billion (c.i.f., 1997)
commodities: mechanical appliances, electrical machinery, mineral fuels, plastics, iron and steel, fabrics, cotton and yarn (1997)
partners: Japan, Taiwan, US, South Korea, Hong Kong, Germany, Singapore (1997)

Debt—external: $131 billion (1997 est.)

Economic aid:
recipient: ODA, $1.977 billion (1993)

Currency: 1 yuan (¥) = 10 jiao

Exchange rates: yuan (¥) per US$1—8.2796 (December 1997), 8.2898 (1997), 8.3142 (1996), 8.3514 (1995), 8.6187 (1994), 5.7620 (1993)
note: beginning 1 January 1994, the People's Bank of China quotes the midpoint rate against the US dollar based on the previous day's prevailing rate in the interbank foreign exchange market

Fiscal year: calendar year

Summary: China's Economy in 1995-97

Since 1995 China's economy has maintained rapid growth while inflation has steadily declined, allowing China's top leaders by yearend 1996 to claim success in their program to secure a soft landing for the economy:

• The 12-month increase in retail prices--China's headline inflation statistic--dropped steadily from over 21 percent in January 1995 to zero by September 1997, almost certainly exceeding the Chinese Government's expectations for lowering inflation.
• Real growth in gross domestic product slowed gradually from 12.6 percent in 1994 to 9.7 percent in 1996. Despite widespread expectations of an economic upturn this year, in the first three quarters of 1997 the growth of GDP, investment, and prices continued to slow.
• Foreign trade's contribution to growth dropped sharply in 1996 but has rebounded this year, pushing China's global trade surplus to $30.5 billion for the first nine months. Continuing large foreign investment inflows also helped push official foreign exchange reserves to over $134 billion by the end of September 1997.

Although senior leaders touted the soft landing, Beijing's tighter macroeconomic policies exacted a cost. Unsold inventories of industrial goods increased to 520 billion yuan at the end of last year--about 8 percent of GDP. Excess capacity and rising inventories contributed to deteriorating state enterprise performance. Industrial state enterprises recorded a net loss in 1996, according to Chinese statistics, for the first time since economic reforms began in 1978. In addition, tighter credit policies led to higher unemployment and increasing numbers of labor disturbances.

In part because of the structural problems exposed by tighter credit policies, senior leaders increasingly promoted economic restructuring--and in particular state enterprise reform--as the new top policy priority:

• Beijing since 1996 has started implementing the new strategy adopted in 1995 under which the central government focuses its support and supervision on 1,000 of the largest state enterprises while granting local governments greater leeway to pursue ownership reforms in smaller state firms. A substantial proportion of new bank lending in 1996, for example, went to 300 large state enterprises selected as the best performers among the 1,000 "backbone" enterprises.
• Central authorities also gradually reduced subsidized lending to smaller state firms and endorsed locally initiated reforms for smaller state firms including sale, lease, merger, and transformation into shareholding companies. A dominant theme of Beijing's enterprise reform plans in 1997 has been preparing for more "bankruptcies, mergers, and reemployment."
• In addition, Beijing has continued to implement reforms intended to gradually transform the state banks into commercially viable operations. In August 1996, for example, Beijing issued new loan regulations tightening loan criteria, and this year authorities have taken a series of measures to prevent bank funds from flowing into stock markets, with the aim of reducing risk in the financial system.

Today Beijing faces a series of difficult tradeoffs. Central leaders' policies and statements show that, in their view, the government must push ahead with difficult reforms to sustain long-term growth. These reforms risk social unrest--such as plant closings and increased unemployment--and may slow growth in the short term. Putting off these reforms, however, will merely raise their ultimate cost; nonperforming loans are already equal to over 18 percent of GDP, according to Chinese statistics. At the same time, policymakers seek to maintain rapid enough growth to avoid destabilizing levels of unemployment, while avoiding a new cycle of economic overheating and high inflation. The Ministry of Labor estimates that employing displaced workers and new entrants into the labor force will require 54 million new jobs in urban areas during the Ninth Five-Year Plan (1996-2000), but that, without government intervention, the economy will only generate 38 million.

Although the recently concluded 15th Communist Party Congress reaffirmed the leadership's commitment to market-oriented reforms, what type of market economy eventually results is still undetermined. Many of the current enterprise reform initiatives that President Jiang Zemin endorsed in his keynote address at the Congress--the stress on mergers and building large enterprise groups or conglomerates, for example--appear likely to raise the concentration of economic power. These reforms could yield a system dominated by state-affiliated conglomerates in which a few interest groups have an inordinate effect on government policy. On the other hand, Beijing continues to pass new economic legislation and establish institutions that may help to limit arbitrary government intervention in the economy and promote more open competition. Developments during the next three years--a time frame identified by senior Chinese officials to make substantial progress in economic reforms--will help to determine whether China moves toward an economy in which power is concentrated in a few interest groups, or a more transparent system with greater reliance on the rule of law.

Figure 2. China: Macroeconomic Performance
 

Macroeconomic Policy Success . . .

The unprecedented drop in inflation probably exceeded even the Chinese Government's expectations. Average retail price inflation in 1996 was 6.1 percent, almost 4 percentage points below the 10-percent target the government set early in the year. In the first three quarters of 1997 continued declines have pushed retail price inflation close to zero and led government officials to lower forecasts for the year to 2 percent--which would be the lowest rate since 1983. Beijing's successful negotiation of an economic soft landing is in marked contrast to the historical trend. During the last two decades, the inadequacy of Beijing's traditional administrative policy tools in an increasingly market-oriented economy had led to increasing volatility in China's business cycles, culminating in a severe downturn of 1990, followed by an investment boom that peaked in 1993. The soft landing is all the more surprising in light of the weakness of Beijing's policy tools; in China's transitional economy, both administrative levers and incipient market-oriented instruments are limited in their effectiveness.

Beijing in 1995 and 1996 employed a combination of administrative and market-based measures to steer the economy to a soft landing, including credit quotas, investment restrictions, changes in interest rates, price controls and subsidies, slower growth of government expenditures, and interventions in food markets to boost supplies. Several factors stand out, however, in the anti-inflation program.
 
 

"Relatively" Tight Monetary Policies

Although Beijing's monetary policies since 1994 have been markedly tighter than those in 1993 and 1994, China's monetary authorities have avoided a repetition of the severe credit crunch that stalled growth in 1990. Senior officials have repeatedly stressed that the "relatively" tight policies should be applied flexibly, and indeed during the last two years Beijing has alternated between tighter and looser policies on almost a quarterly basis, apparently trying to balance the goals of reducing inflation and avoiding excessive unemployment. For example, central authorities eased credit policies both in the second half of 1995 and the second half of 1996 but in each case sharply tightened policies in the first quarter of the following year to avoid a resurgence in inflation.

The central bank twice cut interest rates in 1996 in part, according to Chinese official press, to ease pressures on state firms.

Chinese Statistics: Seeing Through a Glass Darkly

• Official figures severely underestimate urban unemployment. In addition to the 5.5 million workers registered as unemployed in early 1997, there were about 9 million workers who had been laid off, according to Chinese press.
• Official statistics probably overestimated rural residents' per capita income growth in 1996 because of delays--perhaps politically motivated--in recategorizing suburban areas with high average incomes from rural to urban.

• For example, a decennial industrial census completed this year led the State Statistics Bureau to cut the official number of industrial enterprises from 10 million in 1994 to 7.3 million in 1995. The Bureau also lowered figures for the industrial output of township enterprises by almost 30 percent to correct false reporting, according to Chinese press.
• As a result of such errors, Chinese official figures probably somewhat overestimate the growth of total industrial output and GDP, particularly for the early 1990s when collective sector output boomed.

Controlling Investment

Central authorities have also tried to limit new investment projects and promote the completion of existing projects; the Ninth Five-Year Plan, for example, calls for "strict control" of new construction. The central government's control over project approvals is limited, however; in the second half of 1996 localities sharply increased new project approvals in response to a loosening of credit.

Central authorities have also called for changes in the sectoral allocation of investment funds. The Ninth-Five-Year Plan advocates concentrating investment in "focal points," such as agriculture, infrastructure and the "pillar" industries--machinery, petrochemicals, electronics, automobiles, and residential construction.

Chinese statistics for 1996 show Beijing achieved some progress in these goals; investment in agriculture, energy, and machinery, for example, grew faster than total investment. Ironically, however, Beijing's industrial policies probably contributed to the sharp increase in new project approvals by local governments in the second half of 1996, which central officials decried in the official press late in 1996 as "blind investment." Since late 1996, Chinese central government officials have attributed state-sector problems to such blind investment by localities, many of which have invested in the same industries trying to gain an early advantage in sectors expected to receive favorable treatment from the center. According to Chinese official press, 23 of China's 30 provinces have their own automobile plants, most of which are far too small to achieve efficiencies of scale.
 
 

Lower Food Price Inflation

Beijing employed a variety of methods to boost agricultural output. Higher prices improved incentives for farmers; an average 40-percent hike in 1994 in state-set procurement prices for grain helped boost output in 1995, and Beijing hiked grain prices another 20 to 30 percent in 1996. In addition, the central bank raised credit allocations--channeled through the Agricultural Bank of China to grain purchasing agencies--to fund state purchases of grain and ensure that farmers received at least the state price for their crop. Such purchases pushed state grain reserves up by 35 million tons last year to reach a record 149 million tons--equal to 30 percent of the 1996 harvest. In 1997, in response to a record summer grain harvest that deflated market prices, central officials ordered local grain bureaus to continue to buy grain at the state floor price to maintain incentives for farmers. Central authorities during the last two years have also taken steps to increase supplies and lower costs of inputs into agricultural production. These include raising credit allocations for investment in agriculture in 1996 and 1997, strengthening supervision of prices for chemical fertilizers last year, and tightening regulations to restrict the loss of farmland to urban development. In May 1997, the State Council issued a directive freezing any new nonagricultural construction on farmland--apart from exceptions formally granted by the State Council--for one year.

In addition, central and local authorities since 1994 have increasingly relied on more direct intervention in food markets to ensure adequate supplies for urban consumers and to moderate inflation. Measures include raising the government share of grain and vegetable retailing, establishing price regulation funds to smooth market fluctuations, subsidizing grain shipments between provinces, using stored grain reserves to ease local shortages, and increasing emphasis on price "supervision." Vice Premier Li Lanqing in June 1996 at a national conference for price control called for stronger supervision of prices for basic necessities, for example. Reversing the long-term trend toward price liberalization, the proportion of retail goods sold at controlled or "guided" prices marginally increased in 1994 and 1995, according to Chinese statistics, and there are signs that reliance on price supervision is increasing. Authorities in Heilongjiang Province in March 1997, for example, announced they would increase price supervision of 30 commodities and services that account for 80 percent of household consumption, according to Chinese official press. Finally, central authorities since 1994 have raised local authorities' incentives to expend effort on agricultural issues by making it part of their job descriptions; under the so-called rice sack and vegetable basket systems provincial governors are held personally responsible for provincial grain supplies and mayors for municipal vegetable supplies.

Figure 3. China: Agricultural Growth and Food Prices

Chinese Agriculture: An Uncertain Future

• These observers point to China's shrinking arable land and serious water shortages. They also note that China's continued economic development will raise living standards and thereby increase demand for animal byproducts, such as meat and eggs, that depend heavily on grain inputs.
• The pattern of uneven grain harvests and rising demand that caused the country to become a net grain importer in the late 1980s and again in the early 1990s may reinforce these concerns.

• Premier Li Peng told a press conference in early 1996 that Westerners had been mistaken in the past about China's ability to feed its population and they would be proved wrong again.
• A study published by the State Council in October 1996 asserts that China will be able to feed itself in the years ahead by enhancing agricultural production through such measures as land reclamation and improved grain storage and transportation.

• As things now stand, China is trying to feed 22 percent of the global population with only 7 percent of the world's arable land, according to Chinese official statistics.
• Efforts to ensure a stable water supply are complicated by the fact that 60 to 80 percent of China's rainfalls during the three months from July through September.
• According to an official report, 16 percent of the agricultural workforce is illiterate or semi-illiterate, making expanded use of scientific farming methods problematic. Currently, farmers in developed countries are more than twice as efficient in their use of fertilizers as their Chinese counterparts.
• As a result of such problems, some Chinese agricultural experts accept that China will have to import 10 percent or more of its grain in the coming decades.

. . . But Tighter Policies Expose Structural Problems

Excess capacity and rising inventories have contributed to deteriorating state enterprise performance. Over 40 percent of state industrial enterprises were in the red during much of 1995 and 1996, according to Chinese statistics, and the proportion would almost certainly be higher if performance were assessed by international accounting standards. Chinese official press reports acknowledged that another 30 percent of state firms were barely profitable, and only one-fifth were securely in the black. Moreover, Chinese statistics(1) showed that in 1996 losses in state industrial enterprises surged 39 percent, and state industry recorded a net loss for the first time since 1949, adding impetus to Beijing's plans to improve state-sector performance.

The combination of declining state enterprise profits and tighter credit policies has led to rising unemployment since 1995. Many state firms, short of operating capital, have sent workers home at sharply reduced or no wages. Although the official urban unemployment rate at yearend 1996 was just 3 percent, this does not include these laid-off workers, many of whom are still technically affiliated with state enterprises. Chinese officials' estimates of the number of these workers suggest actual urban unemployment is at least 7 percent and may be over 10 percent. In some areas of the country, such as the industrial centers of the Northeast, unemployment probably is considerably higher. Rising unemployment and delays in payments of wages have led to increasing numbers of strikes and worker demonstrations; international press, for example, in mid-1997 reported on several separate incidents involving thousands of workers in midsized cities in Sichuan Province. Probably responding to such incidents, Chinese leaders since mid-1996 have stepped up pressure on local authorities to provide more retraining programs for the unemployed and raise unemployment compensation.

Stepping Up Structural Reforms

Restructuring State Enterprises

Figure 4. China: Cost of the Soft Landing

The New Enterprise Reform Strategy. The groundwork for Beijing's new push was laid in the fall of 1995, when the leadership adopted a new compromise approach, since described in Chinese official press as grasping the large and letting go of the small:

• Under this approach, the central government focuses on reforming a limited number--nominally 1,000--of the largest state enterprises while granting local governments greater leeway to pursue ownership reforms in the over 90,000 smaller state firms. The agreement seeks to allay orthodox concerns about the decline of the state sector by strengthening Beijing's supervision and financial support for larger state firms--the "backbone" of the economy.
• At the same time, it shifts a large part of the burden of maintaining employment levels from Beijing to local governments--small enterprises employ about 60 percent of state enterprise workers, according to Chinese official press.

Beijing started implementing this strategy in 1996 by focusing government support on 300 large state enterprises picked by the State Economic and Trade Commission as the best performers among the 1,000 "backbone" enterprises. Much of new bank lending probably went to these enterprises; the head of the China Construction Bank, for example, claimed that fully half its new loans for working capital in 1996 went to 214 large enterprises and enterprise groups, according to official Chinese press. In addition, central officials started the so-called bank sponsor system. Almost all the 300 selected enterprises signed cooperative agreements with individual state banks ensuring them preferential access to credit, according to Chinese official press. Chinese officials also touted progress on a pilot program involving 57 enterprise groups aimed at developing "transregional and intertrade" conglomerates that combine production, marketing, research, and international trade functions. Chinese leaders in 1997 have called for continued focus on selected large state firms. The number of enterprises with special client relationships with state banks will be raised from 300 to 511, according to Chinese press reports. In addition, Beijing raised the number of these experimental enterprise groups from 57 to 120 in May 1997.

Letting the Little Ones Go. The second plank of the new enterprise reform strategy, the "letting go" of smaller state enterprises, could open the door for a substantial increase in "destatization"--the transfer of state assets to collective, private, and foreign firms. Since the fall of 1995, Chinese leaders have endorsed a range of ownership reforms for smaller state firms. Premier Li Peng in his government work report in March 1997, for example, claimed some local governments had "revitalized" many small state firms through means including sale, lease, merger, and transformation into shareholding companies, and President Jiang Zemin in his speech at the recent 15th Party Congress called for faster reform of small state firms through these methods. "The "letting go" strategy also provides a rationale for Beijing to gradually reduce state bank lending to smaller state firms. Because the central government has placed the responsibility for small enterprises squarely on local governments, tighter credit policies will push local governments to press ahead with reforms.

Figure 5. China: Shares of Industrial Output by Ownership, 1978-96

China's Emerging Social Security System

The Pension System. In the past, state enterprises have been responsible for providing old-age pensions to retired workers on a pay-as-you-go basis, using pension premiums allocated for active workers to fund the retirement of older employees. However, the declining ratio of workers to retirees and the growth of the nonstate sector--accounting for more than half the employment in many localities--have prompted officials to launch a set of changes designed to relieve state enterprises of their traditional pension burden:

• The Communist Party Central Committee in 1994 urged the establishment of a multipillared system consisting of a basic pension supplemented by enterprise-sponsored pensions and individual retirement savings. Most efforts to date have focused on developing the basic pension, which is meant to provide a minimum standard of living and be financed by contributions from employees, enterprises, and government.
• The State Council issued a circular in March 1995 calling for all urban workers to be covered by a single pension system with common standards by the turn of the century. Council members are currently working out the details. A unified plan, however, is problematic partly because the same circular proposed two possible models for the pension system and central officials have allowed localities to choose between the two or any combination.
• Recently, groups of enterprises at the regional level have pooled their pension resources to spread risk-sharing and ensure that enterprises with heavy financial burdens are able to pay their retirees. According to the World Bank, different localities have begun offering varying retirement plans to differentiate their schemes from others and retain control over their pooled pension system and its funds.

Unemployment Programs. China has a national unemployment insurance system that is intended to provide relief funds for up to two years for workers who have lost their jobs. It extends, however, only to the outright unemployed and does not cover the millions of underemployed workers at state-owned enterprises receiving subsistence wages:

• National leaders recognize the shortcomings of the current system, which are principally its failure to extend benefits to many workers idled by state-owned enterprise reform and its lack of funds. According to a State Council report on poverty, workers and enterprises contribute only 2 percent of the total wage bill toward unemployment insurance. With these problems in mind, officials have made reforming unemployment insurance one of the goals of the Ninth Five-Year Plan.
• In the meantime, many localities, such as Beijing, are offering their own unemployment insurance to enterprises. They provide both limited relief funds and help with job training and job placement.

Many local and provincial governments claimed to have made substantial progress in implementing ownership reforms in small state enterprises in 1996 and 1997. Over 70 percent of small state firms in Liaoning Province, for example, underwent some type of property rights reform in 1996, according to the provincial work report. Beijing's major contribution to small enterprise reform was sustaining fairly tight credit conditions for smaller state firms, forcing more layoffs of state workers. In addition, central officials have called for emulation of some localities--such as Yibin in Sichuan Province--that have aggressively restructured small state firms. Senior leaders clearly prefer some reform options: Li highlighted sales of state enterprise shares to employees--the so-called joint-stock partnership system--in his government work report in March 1997, for example, and in March 1996 claimed that only a minority of state firms would be sold to the private sector. President Jiang Zemin at the 15th Party Congress also endorsed the joint-stock partnership system.

Expanding Pilot Programs. Premier Li Peng in his government work report earlier this year called for expanding a number of existing pilot enterprise reform programs. In 1997 the number of enterprises with special client relationships with state banks will be raised from 300 to 511 and the number of experimental groups from 57 to 120, according to Chinese official press. In addition, the number of cities chosen for a broader reform program that includes provisions for worker retraining, debt relief, and increased bankruptcies of state firms--referred to in Chinese press as the experiment to "optimize the capital structure"--will be increased from 58 to 111.

While China has made some progress on aspects of state enterprise reform--increasing layoffs, for example--property rights reform has proved difficult. Fundamental issues, such as which government agency is ultimately responsible for enterprise performance or has the authority to remove incompetent management, remain unclear. The lack of progress on the so-called 100-enterprise program to pilot the "modern enterprise system"--touted in 1994 as the centerpiece of Beijing's enterprise reforms--reflects the difficulty of sorting out these issues. Most of these enterprises only started implementation of their reform plans in 1996, and an editorial in the flagship People's Daily in late 1996 acknowledged that none were close to establishing the system.

Stepping Up Restructuring. A dominant theme of Beijing's reform plans in 1997 has been preparing for more "bankruptcies, mergers, and reemployment." Two national conferences on the topic were held early in the year, for example, and in mid-April Beijing published a directive announcing a new group--headed by the State Economic and Trade Commission--to coordinate plans for bankruptcies, mergers, and reemployment in 111 cities chosen to pilot enterprise reforms. The directive calls for city officials--with the input of the state banks--to submit plans to the new group specifying enterprises to be bankrupted, to be merged, and to receive public assistance. It also contains detailed regulations for bankruptcies and mergers. Resolving the inevitable disputes among the center, the cities, and the banks during the planning process, however, will probably take some time, and rising unemployment may slow the pace of implementation.
 
 

Restructuring the Financial Sector

Figure 6. China: Stock Markets, 1991-97

China's Growing Stock Markets

• Official endorsement of the markets appeared to increase in early 1996, as authorities sharply expanded new issues. The Shanghai and Shenzhen markets listed 63 new firms in the first half of 1996, the fastest rate of new listings in five years.
• Stock markets appeared relatively more attractive in 1996 as two interest rate cuts, the repeal of inflation-linked subsidies on savings accounts, and crackdowns on the futures markets reduced returns on other investments.
• The widespread perception among investors that Beijing would take measures to ensure a buoyant stock market--and would not intervene to curb speculation--in advance of Hong Kong's reversion also helped boost growth early in 1997.

• Central authorities in the second half of 1996 issued a series of directives to curb market manipulation and strengthen central supervision. In mid-December 1996, in response to a surge in stock prices that started in October, the official People's Daily published a front page editorial criticizing excessive speculation, precipitating a sharp fall in stock prices. Beijing's announcement in mid-December that new stock issues in 1997 would be 10 billion yuan--double the previous year's quota--also served to cool the markets.
• Starting in early May 1997, central authorities implemented a series of moves to halt illicit trading and the flow of bank funds into the markets, including banning state banks, state enterprises, and listed firms from trading stock on the exchanges; replacing the heads of the Shanghai and Shenzhen bourses; and suspending four brokerages from trading. In August, authorities formally announced that the China Securities Regulatory Commission would henceforth directly control high-level personnel appointments at the exchanges.

• China's central bank governor Dai Xianglong, noting the volatility in Thailand's stock markets, recently stressed the importance of avoiding speculative bubbles in the stock market.
• The development of China's stock markets continues to be hampered by the unclear regulatory and institutional structure. Beijing's steps to tighten control during the last 18 months have helped clarify lines of authority, but the passage of a proposed securities law has been long delayed.

Figure 7. China: Government Budget

Senior officials at the annual national banking conference in January 1997 declared reducing financial risk the top priority for the banking and financial sectors in 1997. As part of this drive, Vice Premier Zhu Rongji called for reducing the percentage of nonperforming loans in bank portfolios by 2 percentage points annually, according to official Chinese press--a goal that will entail further tightening of lending to money-losing state firms. In addition, central authorities have tried to tighten financial regulation of China's trust and investment companies, some of which have incurred large losses because of ill-advised lending. In January 1997 the central bank announced it was closing the second-largest trust and investment company because of mismanagement. Beijing has also, since May 1997, implemented a series of measures to prevent state bank funds from fueling stock market speculation.

Central bank officials also made some progress during the last two years in the bank's long-term program to replace credit controls with more market-oriented policy tools:

• The central bank started open-market operations in April 1996 and the following April issued new rules governing the operations and expanded the number of participants. The program is largely symbolic, however--the volume of tradable treasury bonds is still too small to significantly influence the money supply.
• The central bank also opened a national interbank market for short-term loans--electronically linking 35 regional lending centers with 14 banks--in April 1996. Central bank officials touted the move as the first step in a long-term plan to gradually liberalize interest rates. Market-determined rates for deposits and loans are probably a long way off, however, in part because raising rates to market levels would reduce state enterprise profits.
• In addition, the central bank expanded its use of other indirect methods of credit control, such as rediscounting commercial bills. The bank rediscounted 725 billion yuan of bills in 1996, up 60 percent from the previous year. Nevertheless, credit quotas remain Beijing's primary policy instrument. Lending by the four largest state banks--which was limited by quotas--accounted for half of total new loans in 1996.

China's Tax Revenues: Finally Turning the Corner?

Central authorities' shift since 1993 to financing the budget deficit through government debt rather than through central bank lending--essentially money creation--has helped the central bank control monetary growth and ease inflationary pressures. Domestic debt levels are still moderate at 5 to 6 percent of GDP, in part because Beijing during the last decade used government-directed lending rather than budget allocations to fund public investment. If Chinese policymakers ultimately resort to budget allocations to recapitalize the state banks and allow them to write off bad loans, debt levels probably would sharply rise. The Ministry of Finance has set a target of eliminating the deficit by the year 2000, but pressures to spend more on infrastructure investment, social security programs, and state enterprise transformation probably will prevent the Ministry from achieving this target.

Central authorities have also taken steps to help transform the state banks into commercially viable operations. In August 1996 Beijing issued new "general rules" on bank loans that tighten lending criteria. The rules, for example, limit loan extension periods, prohibit loans for investment in equities markets, and require banks to assign a credit rating to each borrower. Implementation of the rules is far from perfect--the use of bank loans to invest in stocks is still rampant--but the rules provide the banks with another tool to discourage ill-conceived loans. The central bank has also taken steps to gradually replace the practice of assigning credit quotas to each state bank with more flexible policy instruments. By yearend 1995 the central bank had shifted from using credit quotas to asset-liability ratios--which allow banks to lend more if deposits increase--to control credit issuance in smaller commercial banks. Central bank officials started using asset-liability ratios to help determine loan quotas for the four biggest state banks in 1996 and in 1997 have allowed the banks to use the ratios instead of quotas to manage working capital loans, according to Chinese official press.

Central authorities also implemented some measures to encourage competition in the banking sector:

• Beijing in 1996 expanded a program to transform existing urban credit cooperatives into commercial banks, increasing the number of cities authorized to open such banks from 35 to 100. Twenty-three cities have opened or started construction on such banks, according to Chinese press; the rest are still in the planning stage.
• In addition, the central bank, in a long-awaited move, approved eight foreign banks to start domestic currency business in Shanghai's Pudong economic area in early 1997. The scope of the business is sharply restricted: the banks may not conduct yuan transactions with Chinese enterprises or individuals.
• Another step that could, in the long term, promote financial-sector opening is Beijing's commitment in December 1996 to maintain convertibility of the yuan on the current account. Chinese senior officials continue to stress, however, that Beijing has no timetable for achieving capital account convertibility.

Export Growth Volatile, But Trade Surpluses Continue

The changes in tax and credit policies primarily affected state enterprises and state trading companies. Foreign-invested enterprises, many of which are not eligible for export tax rebates, were largely unaffected by the changes in rebate policies. The growth of their exports slowed only gradually from 37.5 percent in 1994 to 31 percent in 1996, in part because of increasing competition in many labor-intensive export industries from other emerging markets. The growth in foreign-invested firms' exports compensated for a 12-percent drop in domestic--that is, nonforeign-invested--enterprises' exports. Foreign-invested enterprises' share of total trade--exports plus imports--rose from 39 percent in 1995 to 47 percent in 1996 because of an absolute drop in domestic enterprises' total trade.

Figure 8. China: Foreign Trade

The changes in tax and credit policies sharply increased costs for Chinese exporters and eroded their competitiveness, which already had been weakened by relatively high average inflation--higher than that of China's major trading partners--and stable exchange rates since 1994. In addition, increasing production capacity in other East Asian and Latin American economies contributed to poorer performance in some of China's traditional labor-intensive exports. Exports of textiles, for example, dropped 2 percent in 1996--the first decline in over a decade.

China's dismal export performance in the first half of 1996--exports dropped 8 percent year-on-year--prompted authorities to take steps to encourage exports, and export growth recovered to 10 percent year-on-year in the second half. The recovery accelerated in 1997, as export growth in the first nine months surged to 24 percent year-on-year. Chinese officials have attributed the surge in large part to Beijing's efforts, starting in the second half of 1996, to speed payments of export tax rebates, which helped cut payments in arrears by about half by yearend 1996. In addition, Chinese banks provided exporters in some favored industries such as machinery, electronics, and textiles with preferential access to credit.

Central authorities have also adopted other measures to encourage exports. For example, China's Foreign Trade Ministry in March 1997 expanded the number of domestic enterprises eligible to apply for independent trading rights--and thereby circumvent the state trading companies--and granted producers with annual exports over $10 million the right to establish independent trading corporations. Another trade liberalization measure Beijing undertook in September 1996--which President Jiang Zemin had announced at the Asia Pacific Economic Cooperation organization meeting in September 1995--was the enactment of new policies allowing some foreign firms in partnership with Chinese enterprises to form joint-venture foreign trade companies, albeit under tight restrictions. The new regulations, for example, restrict establishment of such ventures to Shanghai's Pudong district and Shenzhen.

Beijing has focused on expanding exports of medium-technology goods, in part as a response to increasing competition from other East Asian and Latin American economies in labor-intensive exports. Exports of machinery and electronics in 1996 increased almost 10 percent, compensating for a 2-percent drop in other exports, and now account for almost one-third of total exports, according to Chinese statistics. The increase was in part due to preferential credit and tax rebate policies for exporters of these goods. A State Tax Administration directive in June 1996, for example, called for exporters of machinery and electronics to get preference in receiving payments of tax rebates. In addition, excess capacity in the machinery industry pushed producers to expand sales to overseas markets. Beijing in 1997 has continued to promote exports of machinery and electronics. China's Export Import Bank, for example, will expand credit to exporters of machinery and electrical equipment, according to Chinese press reports.

Import growth also slowed from 14.2 percent in 1995 to 5.1 percent in 1996. The decline was largely due to continued tight credit conditions and slower economic growth, which led to excess capacity in many industries and limited demand for imports. In addition, an almost 30-percent drop in cereal imports, prompted by a second straight bumper harvest and rising stores of grain, shaved several percentage points off import growth. Cereal imports had almost tripled in 1995 as authorities tried to raise supplies to slow food price inflation.

Slower industrial growth and faster agricultural growth resulted in a 8-percent decline in domestic enterprises' imports. Foreign-invested firms' imports, however, grew 20 percent in 1996, slightly up from 19 percent the previous year. The increase was largely due to firms accelerating imports of capital equipment to take advantage of lower taxes before the planned elimination of tariff exemptions on foreign-invested enterprises' capital imports--announced in April 1996 and originally scheduled to take effect in December 1996 or December 1997, depending on the size of project. China's Foreign Trade Ministry ultimately extended the deadline for exemptions through December 1997 for projects worth less than $30 million and through June 1998 for larger projects.
 

China's Growing Reliance on Imported Oil

China's oil output has failed to keep up with rapidly growing domestic demand. Total apparent consumption--production plus imports minus exports--exceeded 3.5 million b/d in 1996, and many industry analysts expect consumption to grow 5 to 7 percent per year. China produced only 3.2 million b/d of oil in 1996:

• Onshore production, which accounts for 90 percent of total output, crept up barely 1 percent in 1996. Production from the Tarim Basin in western China rose 24 percent to some 62,000 b/d, but less than China expected.
• Offshore production--80 percent of which was from the South China Sea-- reached 300,000 b/d in 1996. South China Sea production is near peak, however, and will start to decline in about two years unless new fields are discovered and put on stream. Some foreign oil companies regard the Bohai Gulf as having the best prospects for future offshore China oil development.

Figure 9. China: Foreign Direct Investment (FDI)

The drop in import growth occurred despite some import liberalization. Beijing on 1 April 1996 cut tariffs on almost 5,000 items, lowering the average nominal tariff rate from 36 percent to 23 percent, and lifted quota restrictions on 176 commodities. These moves failed to stimulate import growth in part because the tariff cuts on manufactures, which account for about 80 percent of Chinese imports, were relatively small. The cuts, generally deepest for raw materials and high-technology items, benefited many domestic industries by lowering costs of imported inputs. The tariff cuts for raw materials, however, also failed to accelerate imports, largely because rapid agricultural growth limited demand for food imports and slower industrial growth limited demand for inputs. Imports of primary goods grew just 4 percent in 1996, down from 48 percent the previous year.

The combination of rapid--though volatile--export growth and a steady decline in import growth has led to substantial trade surpluses during the last two years. The annual trade surplus dipped slightly from $16.7 billion in 1995 to $12.2 billion in 1996 as a result of slower export growth, but in the first three quarters of 1997 alone the surplus surged to $30.5 billion--almost twice any previous annual surplus. An upturn in the economy, which both Chinese Government and foreign private forecasters project for late 1997, would stimulate import demand and slightly reduce the surplus. In the medium term, however, several of Beijing's current policy emphases may help to limit import demand in the next three years and could keep the trade balance in surplus--extending the trend since 1993. These include Beijing's emphasis on restrain new investment; central authorities' goal of maintaining food self-sufficiency and attendant policy of subsidizing grain production, which will limit grain imports; and the government's stress on increasing layoffs and bankruptcies, which will increase job uncertainty and may restrict consumption. In addition, foreign investment is slowing down--many of the projects in which foreign companies invested during the early 1990s are now operational and exporting finished products, rather than importing capital equipment. Beijing's repeal in April 1996 of duty-free treatment of imports of capital equipment by new foreign firms would also probably slow these imports.
 

Foreign Investment Remains High Despite Efforts To Direct It

Although China has continued to record increases in foreign direct investment, the rate of growth is slowing as declines in new investment contracts begin to show up in actual inflows; these grew by 17 percent in 1996--the slowest growth rate this decade. Although the Chinese press claims that the reversion of Hong Kong to the mainland will spur increases in foreign direct investment--to reach $49.5 billion in 1997, 17 percent greater than in 1996--China's changes to preferential tax policies for foreign investors and steps to further control inflows may further slow foreign direct investment growth in 1997 and 1998.

Figure 10. China: Official Foreign Exchange Reserves
 
 

Encouraging Inland Investment

Changing Composition of Investment Sources

Challenges Ahead: Sustaining Growth While Deepening Reforms

Indeed, the widely anticipated economic upturn did not materialize in the first three quarters of 1997. GDP growth was 9 percent year-on-year, down from 9.7 percent for all of 1996. Moreover, this slight decline masked a more substantial shift in the sources of growth. The surge in exports in the first three quarters of this year--which accounted for 3 to 4 percentage points of GDP growth--compensated for slower domestic investment. Slower domestic growth was in part due to Beijing's decision to accelerate difficult structural reforms. Central authorities' stress on layoffs and bankruptcies, for example, probably helped restrain wage increases; real urban per capita income in the first three quarters grew just 3 percent year-on-year, as compared with an average 7-percent annual increase since 1990.

China's economic performance in the first half of 1997 illustrates the trade-offs facing Beijing. Central leaders' statements and policies show that, in their view, the government must move ahead with difficult reforms to sustain long-term growth. These reforms have costs--such as plant closings and increased unemployment--and may slow growth in the short term. Putting off these reforms, however, will merely raise their ultimate cost and, in the long term, increase the chance of a crisis in the banking sector. Nonperforming bank loans are already equal to over 18 percent of GDP, according to estimates cited in the Chinese press--far in excess of what Beijing could cover through budgetary allocations without steep increases in taxes or government debt.

At the same time, Chinese policymakers seek to maintain rapid enough growth to create jobs for new entrants and displaced workers and thereby avoid destabilizing levels of unemployment. The Ministry of Labor estimates that 54 million new jobs will be required in urban areas during the Ninth Five-Year Plan (1996-2000) but that the economy will only generate 38 million. In addition, a slowdown in growth, by increasing loan defaults, could precipitate the very financial crisis Beijing is trying to avoid. Banking officials may view sustaining fast development--and, if possible, boosting the growth of performing loans--as the easiest way to recapitalize the state banks. Further complicating economic decision making, Beijing retains an ideological commitment to public ownership--although the nature of that commitment is changing.

These conflicting goals have shaped Beijing's approach to economic reform since 1995, and the main elements of economic policy probably will continue. China's central bank governor in August 1997, for example, stressed Beijing will sustain "moderately" tight monetary policies for several years, and the 15th Communist Party Congress in September 1997 strongly reaffirmed the two-pronged approach to state enterprise reform under which Beijing focuses support on larger state firms.

Recent public statements suggest, however, that senior leaders intend to accelerate structural reforms during the next three years. President Jiang Zemin's keynote speech at the Congress, for example, constituted the strongest official endorsement to date of more aggressive ownership reforms--in particular, the conversion of state firms into joint-stock companies. Moreover, senior officials have cited ambitious targets for restructuring the state sector. Vice Premier Zhu Rongji, for example, recently said that by 2000 most money-losing large and medium-sized state firms should be profitable, while other officials have predicted that the reform of small state enterprises will be complete by that date, according to press reports.

Although rising unemployment pressures and bureaucratic opposition may temper progress on these goals, Beijing appears likely to continue market-oriented reforms. What type of market economy will result, however, is still unclear. Many of Beijing's enterprise reform initiatives--the wave of mergers sweeping the country, the experiments with enterprise groups and holding companies, and the cooperative agreements between banks and large enterprises, for example--appear inspired by the Japanese keiretsu or Korean chaebol systems. Although there are plausible reasons for these initiatives--takeovers of money-losing firms may improve management, for example--they may yield a system dominated by state-affiliated conglomerates in which economic power is highly concentrated and a few interest groups have an inordinate effect on government policy. On the other hand, Beijing continues to pass new economic legislation and establish institutions that may help to limit arbitrary government intervention in the economy. Developments during the next three years will help determine whether China's economy will be characterized by close linkages between government and industry and a high concentration of economic power, or whether it will be a more transparent system with greater reliance on the rule of law.
 

Appendix: China's Bilateral Trading Relationships in 1995 and 1996

Meanwhile, despite some market liberalization over the past few years--including tariff reductions, elimination of nontariff barriers, and expansion of trading rights--China's trading partners saw most key sales grow only slightly or decline because of continued Chinese import restrictions on many items--such as autos and chemicals--and macroeconomic factors, such as slow economic growth and investment. As a result, over the past two years, most of China's major trading partners have experienced growing trade deficits with China--with the exception of South Korea, whose producers have rapidly expanded exports to supply their growing manufacturing investments in China.
 
 

Rapid Expansion of US Trade

The rapid growth in US sales to China in 1995 was driven primarily by exports of agricultural products, particularly cereals and vegetable fats and oils, which outstripped global sales of these goods. Indeed, exports to China of vegetable fats and oils--primarily soybean oil--almost tripled, while cereal sales--dominated by corn and wheat--grew almost sixfold. Large buildups of food stocks and improved harvests, however, combined to reduce demand for agricultural imports in 1996; corn purchases from the United States, for example, dropped 98 percent from the previous year. In contrast to the general trend, however, US farmers saw dramatic annual increases in sales of soybeans to China in both 1995 and 1996.

US producers of high-technology goods recorded increases in their sales to China and roughly maintained their market share in 1995 and 1996. For example, the United States held between 7 and 9 percent of China's market for industrial machinery and mechanical appliances in those two years. While aircraft sales--which tend to be volatile because of the large dollar value of individual shipments--continued to decline in 1995, they grew 45 percent in 1996, outstripping the growth of US sales to the world in this sector by nearly 20 percentage points. US pharmaceutical manufacturers are also recording some success; their share of China's imports of pharmaceuticals has steadily increased and reached 15 percent in 1996, up from 6 percent in 1992.

Figure 11. US Trade Balance With China, Hong Kong, and Taiwan, 1987-96

China saw mixed success with its exports of labor-intensive goods to the US market. China's exports to the United States of furniture and toys grew by more than 20 percent in 1995 and 1996--outstripping the growth in China's global sales of these goods. Chinese apparel sales to the United States--which fell in both 1994 and 1995--showed a modest recovery in 1996, growing 8 percent; this increase stopped the gradual erosion of China's share of US clothing imports. Leather goods, on the other hand, were unable to keep pace with their rapid growth earlier in the 1990s and grew less than 5 percent in both 1995 and 1996; Chinese producers, however, still hold an almost 50-percent share of US imports in this sector.

Growth in Chinese sales to the United States of more technology-intensive goods--which have been among the most dynamic of China's export sectors--slowed in 1996 after another year of fast growth in 1995. Some of these products--including machinery and photographic and measuring equipment--in 1996 grew at less than half the rate they did in 1995. Nevertheless, China's exports of technology-intensive goods to the United States expanded faster than overall Chinese exports to the United States and, in addition, outstripped the growth of US global imports in these sectors. Chinese sales of electrical equipment and appliances--primarily small electrical appliances such as radio receivers and space heaters--now account for 8 percent of US imports of these goods.

Figure 12. The Structure of Sino-US Trade
 
 

Japan Remains Important Export Market

Continued increases in Chinese exports to Japan in such areas as apparel, leather goods, toys, and prepared meat and fish allowed Chinese producers to capture roughly one-third to two-thirds of Japan's total imports of these goods by yearend 1996. China's success in the Japanese market, however, continues to create tension in the bilateral relationship as Japanese textile producers again sought action from Tokyo to limit imports of Chinese products. Despite claims that Chinese manufacturers failed to abide by voluntary quotas agreed to in 1995, Beijing and Tokyo established a similar system in 1996.

Goods higher up the technology ladder continue to rank among China's fastest growing exports to Japan--probably as a result of growing Japanese manufacturing investments in China. Chinese sales to Japan of machinery roughly doubled in 1995 and increased 80 percent in 1996. Parts for office machines and computers and computer parts--which make up the bulk of Chinese sales to Japan in this sector--together grew 130 percent in 1995 and nearly doubled in 1996. Moreover, in 1996 China surpassed South Korea as the second-largest supplier to Japan of imported electrical equipment and now accounts for 12 percent of all Japanese purchases in this sector. Exports of photographic and measuring equipment also grew rapidly in 1995 and 1996. China--whose sales in this category were dominated by photocopiers and still cameras in 1995--surpassed both Taiwan and the United Kingdom to become the third-largest supplier to Japan of this category of goods; nevertheless, China has only a 6-percent share of this market, which remains dominated by the United States.

In the future, China's success in this market may have drawbacks as some producers become dependent on the Japanese market. Japan already purchases more than half of all Chinese sales to the world of knitted apparel and wood products and over 40 percent of Chinese nonknit apparel and umbrellas and walking sticks. China's more technology-intensive products--driven in many cases by Japanese investment on the mainland--face similar patterns; roughly 20 percent of Chinese exports of electrical equipment as well as photographic and measuring equipment are destined for Japan.

Declines in total Japanese exports to China were driven by falling sales of electrical equipment, iron and steel, and iron and steel products--all of which rank among Japan's top-five exports to China. Japan still holds roughly one-quarter of China's market for these goods, although its share in some cases is declining. Japan's share of Chinese imports of iron and steel products fell from 42 percent in 1993 to 23 percent in 1996. Despite the poor showing in these sectors, some Japanese producers continued to score gains, possibly because their goods are used as inputs for Japanese-invested factories on the mainland. Machinery imports in 1996 from Japan were up a modest 5 percent, while woven fabrics increased more than 15 percent and plastics almost 13 percent.
 
 

EU Sees Growing Trade Deficit With China

China's trade surplus with France grew by almost 90 percent from $1.9 billion in 1994 to $3.5 billion in 1996 as Chinese sales to France surged. Machinery exports to France--particularly computer parts--more than doubled in 1995 and grew by more than 75 percent in 1996, raising it from the seventh- to the third-largest category of exports to France. Chinese efforts to develop its chemicals industry appear to have achieved success; exports to France of organic chemicals grew 60 and 87 percent in 1995 and 1996, respectively.

Figure 13. Chinese Gains in US Market Drive US Trade Deficit

French exports to China remain relatively small--accounting for less than 1 percent of France's global sales and only 2 percent of China's total imports--and declined by more than 10 percent in 1996 after a sharp upswing in 1995. The drop in 1996 was led by declines in French sales of machinery--particularly internal combustion piston engines--and electrical equipment. Increased Chinese domestic demand for foodstuffs in 1995 coupled with improved Sino-French relations spurred Beijing to purchase more than $280 million of French wheat and barley in 1995--after buying virtually no French cereals in 1994. Nevertheless, in 1996, French cereal exports plummeted more than 90 percent as China's domestic harvest improved. French aircraft sales, however, which--like US exports--suffered from the 60-percent decline in Chinese global aircraft imports in 1995, were up 40 percent in 1996.

China's surplus with the United Kingdom reached over $6 billion last year--up by over one-quarter for each of the last two years. Footwear has consistently been among the fastest growing Chinese exports to the United Kingdom, and in the past two years China has surpassed suppliers such as Brazil and Ireland to become the fourth-largest supplier of shoes to the British market--accounting for almost 10 percent of British imports of these goods. China--which with Hong Kong is the top exporter of apparel to the United Kingdom--saw its clothing sales to the United Kingdom rebound in 1996 after two years of stagnant or declining exports. British sales to China, on the other hand, fared less well, growing only 3 percent in 1995 and falling 11 percent in 1996. UK exports of machinery, electrical appliances, and scientific and measuring instruments--three of the top four categories of British exports to China--all faced declines last year in purchases by Chinese customers.

A dramatic slowdown in Chinese sales to Italy led to a 5-percent decline in China's surplus with Italy in 1996, following a 43-percent increase in the surplus in 1995. China registered 3-percent growth in exports to Italy last year; sales were hindered by the second straight year of falling Italian purchases of Chinese goods. The 6-percent increase in Chinese imports from Italy in 1996 was led by a 16-percent increase in machinery sales--primarily textile-related machinery. Machinery accounts for more than two-thirds of all Italian exports to China.

German exports made a strong showing in the China market in 1995--up more than 17 percent--that they were unable to repeat in 1996. Vehicle sales, for example, were up almost one-third in 1995 but fell more than 36 percent in 1996. Machinery, Germany's top sector for exports to China, increased 9 percent in 1996, falling short of 1995's 15-percent rise. Chinese clothing exports rebounded in 1996--knit apparel was up 13 percent--after declining in 1995. Sales to Germany of machinery and electrical equipment, on the other hand, declined in 1996 after a strong performance in 1995. German purchases of Chinese machinery--dominated by office machine and computer parts--for example, rose 63 percent in 1995 but fell by 7 percent in 1996.
 
 

South Korea Shows Biggest Gains Among Other Trading Partners

China, however, ran a $3.4 billion trade deficit with South Korea in 1996, in part because Korean companies are benefiting from demand from their investments in China. Contracted South Korean investment in China increased 41 percent in 1996--making South Korea China's fastest growing investor. South Korean sales to China of parts of footwear, for example, increased 67 percent last year and were up 87 percent in 1995. Exports of manmade filaments and fabrics as well as impregnated textile fabrics both grew more than 40 percent in 1995 and 1996. South Korea is also gaining ground in areas traditionally held by Western and Japanese suppliers; by the end of 1996, South Korean producers accounted for 12 percent of Chinese imports of iron and steel and 7 percent of Chinese imports of electrical machinery.

China's trading patterns with South Korea reflect its global export trends. China's success in moving up the technology ladder, for example, is evident in increases of between 60 and 100 percent in exports to South Korea of machinery, electrical appliances, and photographic and measuring instruments in 1995 and 1996. Sales of iron and steel to South Korea, on the other hand, fell by 11 percent last year--at the same time that Chinese iron and steel exports to the world fell by more than one-third. Despite this drop, South Korea now absorbs roughly 33 percent of all Chinese iron and steel exports--up from 17 percent in 1993.

High-level visits between Russian and Chinese officials have sought to reverse declining bilateral trade. These diplomatic initiatives appear to have benefited Russian exports to China, which increased more than 35 percent in 1996, according to Russian statistics. Chinese purchases of Russian military equipment have also contributed to growing bilateral trade. Chinese sales to Russia, however, continue to be hindered by Russian perceptions that Chinese goods are low in quality, according to Russian press reports. Indeed, Chinese exports to Russia fell in 1995 and grew less than 2 percent in 1996. Nevertheless, China is Russia's third-largest trading partner outside the countries of the former Soviet Union. Moreover, official estimates of trade do not include border trade, which Russian press reports claim may account for $500 million to $2 billion worth of goods, or between 7 and 30 percent of officially reported trade in 1996.

Cereals account for roughly 35 percent of Canada's exports to China and--despite relatively smooth political relations--changes in Chinese domestic grain supplies led to large swings in the Sino-Canadian trade balance. Chinese imports of Canadian cereals increased 91 percent in 1995, cutting Canada's trade deficit with China by one-fifth despite a sharp decline in Chinese purchases of Canadian electrical equipment--the second-largest category of imports from Canada. With improved harvests in 1996, however, imports of Canadian cereals fell 13 percent. This decline, coupled with another large drop in Canadian electrical equipment exports, led to a 15-percent decline in overall Canadian sales to China in 1996 and a two-thirds increase in Canada's bilateral trade deficit. Growth in sales to Canada of Chinese electrical equipment--its largest export category--slowed in 1995 and 1996; exports in this sector were up only 6 percent in 1996, down from 42 percent growth in 1994. Chinese machinery sales to Canada, however, continued to grow rapidly--up by 50 percent in 1995 and 45 percent in 1996--and displaced nonknit apparel, footwear, and leather goods to become China's third-largest export to Canada in 1996.

Despite tensions in the Taiwan Strait in March 1996, cross-strait trade increased 4 percent last year, according to estimates by Taiwan's Board of Foreign Trade. The increase was probably spurred by increasing purchases by the island as Taipei made some progress in liberalizing restrictions on imports from the mainland. Taipei also eased limitations on visits by economic and trade personnel from the mainland. At the same time, several major categories of Taiwan exports to China transshipped through Hong Kong--including textiles, electrical equipment, and plastics--declined in 1996, according to Hong Kong statistics. The mainland, however, continues to run a large trade deficit with Taiwan; Chinese exports to the island are roughly one-sixth of imports.

Hong Kong domestic exports to China fell in 1996, reflecting the 8-percent drop in Hong Kong sales to the world. Telecommunications equipment and automated data-processing machines and parts were particularly hard hit and fell for the second year in a row. Apparel and textile sales to China, however, increased despite declining global Hong Kong sales in these products, suggesting that Hong Kong companies have not quite completed the gradual transfer of production in this sector to the mainland.

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