Monetary Policy Analysis Group of

the People's Bank of China

May 11, 2004

Executive Summary

The global economy witnessed a good start in the first quarter of 2004 with more and more countries joining the economic recovery and growth. China's economy continued to grow rapidly. The GDP in Q1 of 2004 grew by 9.7 percent, household income, corporate profits and fiscal revenues all increased in a large scale, agricultural sector developed healthily and the growth of foreign trade maintained strong momentum.

At end March, the balance of broad money M₂ reached RMB23.2 trillion yuan, up 19.1 percent from a year earlier. New loans issued in Q1 totaled RMB835.1 billion yuan, which is equivalent to 32 percent of this year's projected loan increase of RMB2.6 trillion yuan, year-on-year rise of RMB24.7 billion yuan. Systemic risks inherent in the financial institutions such as "borrow short and lend long" should receive good notice. At end March, the balance of all kinds of deposits in financial institutions was RMB23.3 trillion yuan, up 19.6 percent. The base money of the People's Bank of China (PBC) stood at RMB5.05 trillion yuan, down by RMB178.8 billion yuan from the end of last year. The average excess reserve ratio of the financial institutions was 4.28 percent, 0.84 percentage points lower than that recorded at the end of last March. Official foreign exchange reserve reached USD439.8 billion, up USD36.5 billion over the end of last year, with a stable exchange rate at RMB8.2771 yuan per US dollar.

In Q1 of 2004, guided by the Central Economic Work Conference, the PBC kept strengthening and improving its management over the financial sector by leverage of various monetary means. The Central Bank kept the growth of monetary aggregate in check to ward off inflation pressure. Meanwhile, measures were taken to institutionalize macro financial management. First, open market operations were strengthened to almost fully sterilize the liquidity growth caused by foreign exchange repurchase in the market. Second, required reserve ratios were generally raised by 0.5 percentage points. Third, the positive incentives were introduced to adopt differentiated required reserve ratio system for the financial institutions. Fourth, interest rate of central bank lending was floated to redefine the funding relationship between the Central Bank and its borrowers. Central bank lending rates at every tranche were all raised by 0.63 percentage points with the rediscount rate escalating by 0.27 percentage points. Fifth, window guidance was strengthened to promote credit structure in the commercial banks. Sixth, in order to support economic development in the rural area, reform of the rural credit cooperatives was accelerated. Seventh, the development of money market was promoted and its management and service were upgraded. Finally, the balance of China's payments was promoted while the renminbi exchange rate was maintained basically stable at an equilibrium and adaptive level. 

On the whole, measures of macroeconomic management introduced since 2003 have continued to bear fruit. Despite new achievement in the social and economic development, difficulties and problems have emerged in the economic operation, particularly overinvestment in fixed assets and the resulting fast growth of credit.

The economic growth rate of China in 2004 is projected to reach about 7 percent, and CPI to rise about 3 percent. It should be noted that growth of GDP and CPI will likely remain high in the second quarter and a slowdown is expected in the second half of the year due to two facts. First, with the influence of base period, GDP growth in Q2 of 2004 is likely to reach a relatively high level based on the merely 6.7 percent expansion recorded in the same period of last year as a result of SARS epidemic. CPI is expected to first rise after April and then fall in Q3, affected by seasonal factors. Second, it will take some time for the macro-control policies and measures adopted since 2003 to begin to deliver their effects in the second half of 2004.

In line with principles stipulated by the Central Economic Work Conference and the Government Work Report, the PBC will take a scientific approach to economic development and carry out all plans of the central government. Measures consistent with economic and financial development will be timely applied to appropriately control the growth of credit and improve transmission mechanism of monetary policy. The target of money and credit supply projected early this year is still attainable, i.e. broad money M₂ and narrow money M₁ both grow by 17 percent, and new renminbi loans by all financial institutions reach about RMB2.6 trillion yuan. The stance of sound monetary policy in the coming periods should be for "appropriately tight", aiming at avoiding hard brake on the economy. First, excessive growth of money and credit will be controlled through tightening liquidity in the financial system. Second, close attention will be paid to price movement and steadily promote the market-based interest rate reform. Third, efforts made to economic restructuring will be strengthened to prevent one-size-fits-all solutions. Fourth, initiatives will be taken to promote financial market development and expand direct financing. Fifth, exchange rate will be kept basically stable at adaptive and equilibrium level. Sixth, renminbi pilot reform of rural credit cooperatives will be advanced to transform their operational mechanism.

 

 

Part One  MONETARY and Credit Performance

In the first quarter of this year, the Chinese economy maintained its rapid growth momentum. However, overinvestment in fixed assets intensified pressures on inflation, continuous increase of capital inflow and fast growth of money and credit all pose formidable challenges for macro financial management.

I . Rapid growth of money supply

Broad money M₂ grew by 19.1 percent to RMB23.2 trillion yuan at end March, representing an acceleration of 0.6 percentage points over the growth recorded a year earlier or 0.5 percentage points down from end 2003. Narrow money M₁ was RMB8.6 trillion yuan, growing by 20.1 percent on a year-on-year basis, with the growth rate equivalent to that recorded at the same time of last year, or 1.4 percentage points higher over the end of 2003.  Cash in circulation M0 amounted to RMB1.9 trillion yuan, increasing by 12.8 percent. Cumulative net cash withdrawal in Q1 totaled RMB44.9 billion yuan, RMB27.7 billion yuan more than that recorded for the same period of last year.

II . More increase of loans by financial institutions and maturity mismatch poses a concern

In the first quarter of 2004, loans by all financial institutions (including foreign-funded ones) in both renminbi and foreign currencies increased by RMB913.1 billion yuan, representing an added growth of RMB59.6 billion yuan over the same period of last year. The renminbi loans grew by RMB835.1 billion yuan, indicating an added growth of RMB24.7 billion yuan on a year-on-year basis. Loans in foreign exchange rose by USD9.4 billion, representing an acceleration of USD4.2 billion over the same period of last year.

At end March, loans by all financial institutions in both renminbi and foreign currencies amounted to RMB17.9 trillion yuan, growing year-on-year by 20.7 percent, 1.2 percentage points higher over the same time of last year or 0.7 percentage points lower than the growth recorded for 2003. The renminbi loans reached RMB16.7 trillion yuan, indicating a growth of 20.1 percent on a year-on-year basis, which was up by 0.2 percentage points over the same time of last year and down by 1 percentage point from that of 2003. Foreign exchange loans reached USD140.2 billion, representing a growth of 29.9 percent, with the growth rate accelerated by 17.3 percentage points over end-March of last year or by 3.2 percentage points over 2003.

Increased renminbi loans mainly came from short-term agricultural loans and medium or long-term loans for capital construction etc, while discounted commercial paper loans decreased. In Q1 of 2004, agricultural loans increased by RMB120.3 billion yuan with an acceleration of RMB35.2 billion yuan over the growth recorded from the same period of last year. In particular, agricultural loans issued by rural credit cooperatives amounted to RMB115.8 billion yuan, accelerating by RMB33.4 billion yuan. Since the beginning of this year, with the increase of farmers' income and further reform of rural credit cooperatives and post saving system, rural credit cooperatives has witnessed an upturn of both deposit and lending business and strengthened credit support for spring plough and agricultural development. Due to the stimulus effect of rapid growth of investment in fixed asset, the medium or long-term loans such as loans for capital constructions continued to grow. The loans for capital constructions grew by RMB170 billion yuan, RMB33.7 billion yuan more than the growth recorded for the same period of last year. Other medium or long-term loans grew by RMB188.7 billion yuan, representing a year-on-year increase of RMB36.2 billion yuan. Notably, the proportion of medium or long-term loans has continued increasing since 1998.  It reached 40 percent at end March 2004, up 20 percentage points over the end 1997, while the proportion of time deposits in the fund sources of financial institutions continued to fall, posing a maturity mismatch concern.

In terms of institutional distribution, the state-owned commercial banks saw a decrease of new loans in the first quarter while new loans issued by other financial institutions generally increased. On the year-on-year basis, loans issued by rural credit cooperatives grew by RMB173.9 billion yuan, accelerating by RMB51.4 billion yuan; loans issued by joint-stock commercial banks grew by RMB160.2 billion yuan, an acceleration of RMB27.3 billion yuan; loans granted by city commercial banks rose by RMB45 billion yuan, an acceleration of RMB18.9 billion yuan; loans extended by policy banks grew by RMB29.7 billion yuan, accelerating by RMB10.8 billion yuan; while loans issued by state-owned commercial banks increased by RMB399.9 billion yuan, decelerating by RMB98.4 billion yuan.

In terms of regional distribution, in the first quarter of 2004, new loans issued mainly flew to the provinces or municipalities of Jiangsu, Zhejiang, Guangdong, Shanghai and Shandong, involving RMB400 billion yuan which accounted for 47 percent of the total new renminbi loans. The top five provinces or municipalities which witnessed rapidest growth of loans were Tianjin, Zhejiang, Jiangsu, Ningxia and Guizhou.

III . Significant growth of deposits and rapid growth of corporate deposits

In the first quarter of 2004, on the year-on-year basis, deposits of financial institutions both in renminbi and foreign currencies increased by RMB1.23 trillion yuan, representing an acceleration of RMB108.7 billion yuan. In particular, renminbi deposits rose by RMB1.25 trillion yuan, accelerating by RMB112.8 billion yuan; household renminbi deposits surged by RMB824.6 billion yuan, an acceleration of RMB66.4 billion yuan; and corporate deposits went up by RMB200.3 billion yuan, accelerating by RMB28.4 billion yuan.

At end-March, deposits both in renminbi and foreign currencies of financial institutions increased to RMB23.3 trillion yuan, growing year-on-year by 19.6 percent. In particular, household deposits increased to RMB11.87 trillion yuan, expanding by 16.4 percent, and corporate deposits soared 20.7 percent to RMB7.93 trillion yuan.

IV . Net withdrawal of base money and decline of excess reserve ratio of financial institutions

At end-March, the balance of base money of the PBC totaled RMB5.05 trillion yuan, a decrease of RMB178.8 billion yuan from the beginning of this year. The average excess reserve ratio of financial institutions was 4.28 percent, down 0.84 percentage points from a year earlier. In particular, the wholly state-owned commercial banks carried a ratio of 3.75 percent, 1.47 percentage points down from a year earlier; rural credit cooperatives excess reserve ratio averages at 4.75 percent, almost equivalent to that recorded at end-March of last year; the joint-stock commercial banks took a ratio of 6.33 percent, 0.88 percentage points higher over a year earlier.

 

Box 1  Definition and Statistics of Base Money

 

Base money, also called monetary base, is capable of increasing or decreasing money supply in a multiplied manner, therefore, dubbed "high-powered money". According to the definition in Monetary and Financial Statistics Manual (2000) of IMF, base money includes all kinds of liabilities provided by the central bank for broad money and credit expansion, which mainly refers to in-bank money (cash in vault) and out-bank money (cash in circulation) and deposits by both banks and non-bank institutions in the monetary authority.

 

Different definitions and statistics of base money can be found in different countries; even in the same country there can be different definitions varying with its analysis purposes. The definition and statistics in China also evolved gradually.

 

In 1994, China began to compile statistics of base money. Base money for statistics was then defined as base money=cash in vault of financial institutions +cash in circulation +reserve deposits by financial institutions + special deposits by financial institutions + post savings converted deposits + deposits in the PBC by governmental organizations and public institutions. Vault cash of financial institutions includes cash held by commercial banks, policy banks, urban and rural credit cooperatives and finance companies. Special deposit by financial institutions was a special account setting up to withdraw excessive liquidity of rural credit cooperatives. The balance is usually small and inactive.

 

In January 2002, the PBC restructured the Balance Sheet of the Monetary Authority and the concept of reserve money was first introduced. It includes money issued by the PBC, reserve deposits in the PBC by all financial institutions, post savings deposits and deposits of governmental organizations and public institutions, and thus is equivalent to base money in theory. The inclusion of all post savings deposits in the reserve money statistics was consistent with the function of post savings institutions as special institutions on behalf of the PBC to withdraw money from households and enterprises because they had neither access nor ability to operate the absorbed funds.

 

In August 2003, with the reform of fund management system for post savings deposit, came the way for post savings deposit institutions to invest on their own and to entrust their assets management, resulting in an increasing gap between total deposits of their liabilities and converted deposits in the PBC by their financers. It is therefore more appropriate to introduce converted post savings deposits in the PBC in place of the deposits of post savings institutions in the statistics of reserve money. After January 2004, when a modification was made correspondingly, the figures in the statistics of base money have been identical with those in the statistics of reserve money issued in the PBC's Quarterly Statistics Report .

V . Stable market interest rate

After the interest rate cut on February 21, 2002, the interest rate for 1-year time deposit has remained at 1.98 percent, the lowest in more than two decades of reform and opening. The interest rate for the 1-year loan stands at 5.31 percent, and for required reserve at 1.89 percent. From 25 March, floating interest rate for central bank lending was introduced by the PBC to raise slightly the interest rate charged for liquidity support to financial institutions. In particular, the interest rate for 20-day central bank lending stood at 3.33 percent, up 0.63 percentage points, and 3.24 percent for rediscount, representing a growth of 0.27 percentage points. In the first quarter of 2004, the interest rates of negotiated deposits in commercial banks (over RMB30 million yuan per deposit) rose slightly, with the interest rate for 61-month deposits ranging from 3.6 percent to 3.8 percent, indicating an increase of 0.2 percentage points over the beginning of this year, and the rate paid for 37-month deposits ranging from 3.6 percent to 3.7 percent, a growth of 0.5 percentage points over the beginning of this year.

 

Influenced by international markets, the interest rates for loans in foreign currencies dropped slightly. In March, the weighted average interest rate for one-year large-amount US dollar deposit (with amount above USD3 million) in commercial banks was 1.39 percent, increasing by 0.4 percentage points over the beginning of the year. The weighted average fixed interest rate of one-year US dollar loan and the weighted average floating interest rate were 2.44 percent and 2.17 percent respectively, declining by 0.11 and 0.03 percentage points over the beginning of the year. At the beginning of the year, inter-bank market rates in Hongkong saw persistent fall, pushing commercial banks in the mainland to cut interest rate for small-amount Hongkong dollar deposit on January 19th, with interest rate for one-year time deposit sliding from 0.5 percent to 0.1 percent, down 0.4 percentage points.

VI . Stable exchange rate

At end March, official foreign exchange reserves reached USD439.8 billion, USD36.5 billion more than 2003. The renminbi exchange rate remained stable, being at RMB8.2771 yuan per US dollar.

 

Part TWO  Monetary Policy Conduct

In line with principles stipulated by the Central Economic Work Conference and the Government Work Report, the PBC, in Q1, 2004, strengthened and improved financial management by adjusting money and credit aggregates and structure with various monetary policy instruments, and attached great importance to preventing inflation while accelerating the establishment of institutional framework for macro financial management.

I . Intensifying open market operations and fully sterilizing liquidity increase caused by foreign exchange purchase

In Q1 of 2004, the PBC released base money of RMB291.6 billion yuan through open market operations and withdrew base money of RMB281 billion yuan through open market operations in securities transactions, a net release of base money reaching RMB10.6 billion yuan, almost with fully sterilizing the base money increase as a result of foreign exchange purchase. Meanwhile the money market interest rates were maintained stable. In the first quarter of 2004, the PBC offered RMB435.2 billion yuan in 28 issues of central bank bills, among which, RMB131.27 billion yuan was 3-month bills, RMB143.97 billion yuan was 6-month bills and RMB159.96 billion yuan was 1-year bills, with the outstanding reaching RMB615.45 billion yuan at end March.

 

Open market operations saw two phases in Q1. The first one ran from the New Year to the Spring Festival, in which defensive operations were conducted to meet the seasonal liquidity demand of the commercial banks and ease the pressure on short-term liquidity of commercial banks. Along with the proper issues of central bank bills, the PBC provided short-term funds to commercial banks through 14-day reverse repurchase operations. During this period, the PBC released RMB127.3 billion yuan of base money through open market operations. The second phase ran from the Spring Festival to the end of March. In face of persistent growth of base money as a result of foreign exchange increase, acceleration of cash withdrawal and an overall excess liquidity of the commercial banks, the PBC launched aggressive operations by increasing central bank bills issuance and extending the bills' maturity dates to withdraw excess liquidity. During this period, the PBC withdrew RMB408.3 billion yuan of base money through open market operations.

 

Based on the market transactions volume, asset size, management and liquidity of financial institutions in Q1, the PBC approved two securities companies, four insurance companies, two rural credit cooperatives and one city commercial banks as primary dealers in open market operations and established an annual evaluation system for those dealers, to broaden and deepen the influences of open market operations and to further improve their effectiveness.

II . Raising required reserve ratio by 0.5 percentage points to prevent overgrowth of money and credit

In view of the limitations of open market operations as a regular, short-term and flexible tool in sterilizing the persistent growth of money resulted from foreign exchange purchase, the PBC, with the consent of the State Council, decided to raise required reserve ratio by 0.5 percentage points from 7 percent to 7.5 percent effective on April 25, 2004. This action was taken to maintain a stable, rapid and healthy development of national economy and ward off excessive growth of money and credit. The increase of required reserve ratio will freeze liquidity of financial institutions by about RMB110 billion yuan. At present, the balance of required reserves and excess reserves of financial institutions in the PBC is more than RMB2 trillion yuan, in addition to RMB3 trillion yuan of highly liquid assets such as treasury bonds, financial bonds and central bank bills. After the increase of required reserve ratio, commercial banks still maintain their payment capability and are able to increase loans steadily.

III . Introducing positive incentives to apply differentiated required reserve ratio system

With the consent of the State Council, the PBC decided to adopt differentiated required reserve ratio system, effective from April 25, 2004, under which required reserve ratio of financial institutions should correlate with such indices as capital adequacy ratio and asset quality, etc. The lower asset adequacy ratio and the higher proportion of bad loans will result in higher required reserve ratio, and vice versa. Differentiated required reserve ratio and capital adequacy ratio are complementary and can improve the transmission mechanism of monetary policy, which constitutes a particular financial system in China.

 

Box 2  System of Differentiated Required Reserve Ratio

   

The system of differentiated required reserve ratios is a policy arrangement in line with China's actual financial developments, and embodies the following 4 aspects. First, the determinants for differentiated required reserve ratios. They include such factors as the capital adequacy ratio, NPL ratio, the status of internal control, major violations of regulations and occurrence of severe risks, obvious worsening of the ability to pay and the risks that are likely to damage the safety of the payment system of financial institutions. Second, financial institutions subject to differentiated required reserve ratios. The arrangement of differentiated required reserve ratios adopts a uniform framework design and standard classification. All depository financial institutions are subject to this arrangement. Given financial institutions are undergoing different stages of restructuring, the wholly state-owned commercial banks that have not carried out share-holding reform and Urban and Rural Credit Cooperatives will put off implementing the arrangement of differentiated required reserve ratios. Third, the methodology for determining the differentiated required reserve ratios. Financial institutions will be classified based on 4 quality indicators including capital adequacy ratio. In line with the need of macro financial management, differentiated required reserve ratios will be applied to the financial institutions of different categories. Fourth, adjustment operation of required reserve ratio. The PBC will regularly adjust the required reserve ratio of financial institutions based on such indicators as their quarterly average capital adequacy ratio and NPL ratio of the previous year calculated by the China Banking Regulatory Commission (CBRC). Where there are major violations of regulations, occurrence of severe risks or payment problems in a financial institution, the PBC will, in consultation with the CBRC, timely adjust its required reserve ratio.

 

The differentiated required reserve ratio system helps facilitate the stable and healthy development of China's financial sector. The overall framework and the incentives contained in the arrangement of differentiated required reserve ratios will provide clear direction and applicable standards for the reform of the financial institutions. Financial institutions, in particular those that are required to observe higher required reserve ratios, will be forced to improve their performance under this arrangement. Meanwhile, the system will lay a foundation as well for improving the transmission mechanism of the monetary policy and for enhancing its effectiveness.

 

Despite some comments on the abolishment of required reserve ration as an international practice, reserve requirement and capital adequacy are prudential criteria which most central banks and financial supervisory authorities apply to financial institutions. The required reserve ratio is not only a tool for managing money supply, but also an effective means to promote stable operation of and to prevent payment risks in financial institutions. At present, most central banks including US Fed, Bank of Japan and European Central bank still apply very effective required reserve ratio system, while only a few countries such as UK and Canada do not apply compulsory required reserve ratios to financial institutions. In light of China's current macroeconomic and financial developments, required reserve ratio system still needs to be fully leveraged for some time in the future. So far, financial authorities of most economies all stipulate that depository financial institutions abide by the minimum capital adequacy ratio of 8 percent. For those financial institutions failing to meet the criteria, the financial authorities will take corrective actions and enforce recapitalization, merger or even liquidation. With such a mechanism of incentives in place, the financial institutions with sound assets liability structure can afford to expand in a faster pace while those with poor balance sheet will face restrictions in business expansion. Currently, a big portion of Chinese financial institutions has yet to resolve a too heavy historical burden to live up to the minimum capital adequacy ratio of 8 percent. With all financial institutions subject to a uniform required reserve ratio and given deficiencies in observing the required capital adequacy ratio, proper incentives like a differentiated required reserve ratio system need to be put into place to reward those with good performance and to punish those behaving badly.

IV . Establishing floating interest rates for central bank lending to improve the financing and interest rate relationship between the central bank and the borrowers

In order to improve the central bank interest rate formation mechanism, further strengthen central bank's capability in guiding market interest rate movement, harmonize the financing and interest rate relationship between the central bank and the borrowers, improve the scientific, efficient and transparent approach of central bank lending management, with the approval of the State Council, the PBC decided to float central bank lending rates, effective on March 25, 2004. According to the decision, with authorization of the State Council, the PBC could set and publish floating range for central bank lending rates based on the benchmark rate of central bank lending (rediscount) and the macro-economic and financial development.

 

The PBC decided to raise the rates of central bank lending maturing within one year that used for managing financial institutions' position and short-term liquidity support by 0.63 percentage points, and rediscount rate by 0.27 percentage points.

 

 

 

Box 3  The System of Floating Interest Rate for Central Bank Lending

 

The system of floating interest rate for central bank lending mainly refers to the arrangement under which, with the authorization of the State Council, and in line with the macroeconomic situation and on the basis of central bank lending (rediscount) benchmark rate, the PBC decides and published timely the increase range of interest rates for loans (discounts) issued by the Central Bank to financial institutions.

 

The system of floating interest rate for central bank lending is an important measure for advancing steadily the market-based interest rate reform. Generally speaking, the market-based interest rate framework comprises two aspects. The first is the implementation of market-based interest rates on deposits and loans of financial institutions. And the second is the changeover from direct control to indirect management of interest rate by the Central Bank. On January 1, 2004, with the consent of the State Council, the PBC expanded the floating range of loan interest rates, representing a marked development of market-based interest rate reform. However, the central bank interest rate policy still can not meet the needs called for by preemptive and fine tuning of monetary policy. For example, between August 28 and November 13, with the influences of required reserve ratio hike and issuance of large-cap stocks, 7-day-weighted average interest rates in money market are constantly higher than that of 20-day central bank lending, which invited commercial banks at the same period to increase short-term borrowing from the central bank. Such a release of base money caused by the lower than market rates of the central bank lending rate will lead to the distortion and failure of the intended monetary policy measures.

 

In order to improve the formation mechanism of interest rate, enhance the guidance of the central bank in steering the market interest rates, optimize the financing and interest rate relationship between the central bank and the borrowers, and manage central bank lending more scientifically, effectively and transparently, with the consent of the State Council, the PBC decided to establish floating interest rates for central bank lending to further strengthen the Central Banks' ability to adjust central bank lending (rediscount) interest rates in time. Considering the current economic and financial situations and the required support to small-and medium-sized enterprises, the PBC decided to raise the interest rates on central bank lending used for position adjustment and short-term liquidity support of financial institutions by 0.63 percentage points, rediscount interest rate by 0.27 percentage points. The increased interest rates should apply to all financial institutions applying for liquidity support and rediscount financing.

 

Figure 1: Excess Reserve Interest Rate, Central Bank Lending Rate

 and Market Interest Rate

 

Source: the PBC

Because of the small increase of central bank lending (rediscount) interest rate and the small proportion of central bank lending (rediscount) in external financing of financial institutions, market interest rate and the liquidity of financial institutions were not greatly affected. The aim of the policy is to set an institutional foundation for the exercise of indirect control, foster market expectation and encourage the financial institutions to actively adjust the gross volume and structure of assets through loan pricing while taking market as main source to finance liquidity demand. Besides, central bank lending and rediscount can function as valves to provide short-term liquidity to the market in face of sharp market fluctuations and keep short-term market interest rates move within a reasonable band.

At present, central bank lending (rediscount) interest rates in developed economies are mainly determined by increasing basis points to the target interest rate through open market operations. For example, the highest tranche of the US Fed rediscount rate (charged on secured loans) is formed by adding 150 basis points to the target US federal funds rates (the open market operation target interest rate regularly published by the US Fed). In the case of ECB, it's facility interest rate is formed by adding 100 basis points to the minimum bidding rate in open market operations, with the overnight rediscount interest rate constituting the upper limit of short-term interest rate in money market. Since the intermediate target of the monetary policy in China is money supply, central bank lending (rediscount) interest rate is formed by adding certain basis points to central bank lending (rediscount) benchmark interest rate.

 

V .  Strengthening window-guidance to the commercial banks to promote improvement of loan structures

In the first quarter of 2004, considering overinvestment in some regions and industries, the PBC held monthly meetings to review economic and financial development and strengthened warnings for the commercial banks to guard against potential risks. Commercial banks are urged to maintain sound operations and sustained business development with intensified capital constraints and reasonable loan growth. According to the instructions of the State Council, the PBC announced a notice on January18, requiring commercial banks to take positive measures to control loans to such overheated industries as steel, aluminum and cement, introducing and improving early warning system for credit risks in certain regions and industries. On March 23, the PBC summoned all commercial banks to carry out a specific analysis on current economic and financial situations, requiring a mechanism to be introduced to control loan expansion in line with their own risk-control capacities and capital adequacy status.

 

While controlling loans to over invested sectors and low-level duplicated constructions, the PBC encouraged and guided commercial banks to enhance credit support to small and medium-sized enterprises, consumption and employment. First, the construction of enterprise credit registration and personal credit reference system was strengthened and laws and regulations relevant to enhancing the development of consumer credit were improved. Second, measures have been taken to improve small credit support to laid-off workers by simplifying the procedures of loan guarantee, examination and approval, and encourage banks to support those small labor-intensive enterprises which employ laid-off workers to a certain proportion of their new employees. Third, compensation mechanism for student loan risks was further improved to facilitate the sustained development of education loans. Finally, paying high attention to the development of birds-flu epidemic and carrying out the guidance of the State Council, the PBC encouraged improved financial services to key vaccine producing enterprises and to the recovery of poultry production in the epidemic affected areas

VI .  Supporting economic development in the rural areas and speeding up reform of the rural credit cooperatives

In line with the spirit of the NO.1 document by the Central Committee of the Chinese Communist Party, the PBC enhanced financial support to help increase the farmers' income. At the beginning of 2004, the PBC increased central bank lending of RMB4 billion yuan to main crop growing areas to support spring farming activities. And in March, a central bank lending of RMB5 billon yuan was provided to rural credit cooperatives in 13 main grain producing areas to enhance credit support to farmers. At the end of March, the central bank lending to rural credit cooperatives totaled RMB128.8 billion yuan, 90 percent of which was provided to main grain producing areas and western regions. These measures intensified the role of rural credit cooperatives in serving rural areas by improving their funds and assets. On March 11, Notice of the General Administration Department of the PBC o Improving Financial Services for Spring Farming Activities was issued, requiring that financial institutions concerned take various measures to support farming activities in spring time.

 

The pilot reform of rural credit cooperatives with the financial support of the PBC was smoothly carried out. At the beginning of 2004, Guide on the Implementation and Evaluation of Financial Support to the Pilot Reform of Rural Credit Cooperatives was issued, specifying organizational, operational procedures as well as a detailed schedule to implement and evaluate the financial support scheme. For the moment, the PBC has agreed to bill issuance to the 8 provincial and municipal governments undertaking the pilot reform, which led rural credit cooperatives in 302 counties and municipalities to apply for the first issuance of special central bank bills. After quality review of the application jointly with the CBRC, the PBC has certified rural credit cooperatives in 272 counties and municipalities as having satisfied with the preconditions for special bill issuance. The first issuance has taken place as scheduled.

VII . Promoting development of money markets

First, development of money market funds was promoted and support was extended to fund management companies for product innovation. Second, information disclosure of inter-bank lending market was improved with 57 securities companies having disclosed their financial statements in the year 2003 while extending pilot financial information disclosure by 7 companies in 2003 to 10 companies. Third, management and services were well improved in inter-bank lending market. In Q1 of 2004, the PBC adjusted the inter-bank lending quota of 117 commercial banks and 3 finance companies, and licensed 4 branches of foreign banks and first-tier branches of 2 Chinese banks as members in the inter-bank lending market.

VIII . Renminbi exchange rate maintained stable at the adaptive and equilibrium level  to promote balance of international payments

The relationship between foreign exchanges supply and demand was further rationalized to improve the renminbi exchange rate formation mechanism through the following major steps. First, trade and investment approval procedures were streamlined to become more user-friendly; Second, the foreign exchange quota with forex bank account for current account transactions was adjusted to increase the proportion of foreign exchanges which can be kept at the forex bank account of domestic institutions for current account transactions. Third, the management on capital inflow and foreign exchange surrender was strengthened to keep short-term capital inflow under control. Forth, supervision on the foreign exchange operations of financial institutions was enhanced to standardize their foreign exchange operations. Last, foreign exchange market order was rectified to actively develop the inter-bank foreign exchange market.

Part Three  Financial Market Performance

I . Rapid growth of money market transactions

In the first quarter of 2004, the turnover of bond repurchases in inter-bank market totaled RMB2.48 trillion yuan, down by 0.9 percent on a year on year basis. The monthly-weighted average interest rate of inter-bank bond repurchase was first moved upward and then downward. The interest rate of inter-bank bond repurchase in January stood at 2.43 percent, representing an increase of 0.26 percentage points over December of last year, and that in February continued to drop till it reached 1.93 percent in March.

 

In Q1, the transactions in inter-bank borrowing market grew accumulatively by 19.4 percent to RMB433.7 billion yuan. The transactions with maturity of 7 days, as the most active ones in Q1, totaled RMB302.8 billion yuan, accounting for 69.8 percent of the whole turnover, representing a proportion of 6.7 percentage points higher over the same period of last year.

 

With regard to the funds outflow and inflow in the inter-bank borrowing market, the state-owned commercial banks remained the principal net providers of funds, the proportion of which rose significantly over the same period of last year. The principal net recipients of funds were securities firms and fund management companies.

Table 1 The Outflow and Inflow of Funds in Inter-bank Borrowing market in Q1 of 2004 (RMB100 million yuan)       

Note: 1. "-" stands for net outflow,"+" stands for net inflow.

2. Other commercial banks include joint-stock commercial banks and city commercial banks.

Source: China Financial Market Monthly Statistical Bulletin

Due to the growing demand for funds by financial institutions before the Spring Festival, the monthly-weighted average interest rate of inter-bank transactions increased by 0.21 percentage points from 2.17 percent in December 2003 to 2.38 percent in January 2004. The highest daily average interest rate of the 7-day breeds stood at 3.46 percent, representing the highest since 2000. Because of the large amount of inflow and the growing sources of funds for financial institutions, the interest rate in inter-bank borrowing market declined significantly to 2.24 percent in February and 2.07 percent in March.

II . Adjustment of bond market

1. Moderate increase of issuing interest rate in the primary market

 

In Q1 of 2004, the issuance of treasury bonds decreased by 12.5 percent on a year on year basis to a total of RMB83.2 billion yuan with bearer treasury bonds of RMB45 billion yuan, down by 25 percent; and book-entry treasury bonds of RMB38.2 billion yuan, up by 9.1 percent. At the same time, a total of RMB60 billion yuan of policy financial bonds and RMB5.5 billion yuan of corporate bonds were issued, up by 50 percent and down by 15.4 percent respectively over the same period of last year.

 

The issuing interest rates of treasury bonds and policy financial bonds both moved upward over the same period of last year. The interest rates of the 1^st issue of 3-year and 5-year bearer treasury bonds were 0.2 percentage points higher than that of the comparable issues of last year. The 2^nd issue of 10-year floating rate policy financial bonds by China Development Bank (CDB) stood at the rate of 3.51 percent, up by 0.12 percentage points over the comparable issue of last year.

 

Table 2 The Issuance of Treasury Bonds and Policy Financial Bonds in Q1, 2004

 

Source: China Financial Market Monthly Statistical Bulletin

 

 

 

Box 4  Innovations of Bond Issuance in Inter-bank Bond Market

Since the official launch of the inter-bank bond market in June, 1997, a series of measures have been taken to develop the inter-bank bond market, one of which is to introduce the market-based issuance of treasury bonds and financial bonds. At present, bonds are mainly issued by means of public bidding in inter-bank bond market with continued innovations in bidding ways and bond varieties. The ways for bidding include quantity bidding, price bidding, and interest rate bidding, yield bidding and interest rate spread bidding, etc. The bidding is accepted according to the proportional quantity, unified price or multiple prices. The bond includes discount bond and coupon bond, etc. In addition, with improved transparency of bond issuance, the issuers will declare issuance plans regularly to underwriters and market transacting entities. The market-oriented innovations have made the issuance of treasury bonds and financial bonds more open, fair, and just. What's more, these innovations have resulted in lower issuing cost, and better ensure the smooth issuance of treasury bonds and financial bonds, and pave the way for the transaction of the bonds.            .                                  

The main innovations of bond issuance in recent two years are:

Bond with options for investors——The investors have the option to cash the bonds ahead of the maturity date at a specified time. This measure may lower the risks on the one hand and increase the confidence of long-term bondholders. 

Bond with options for issuers (redeemable bonds ahead of the maturity date) —— Issuers can opt to redeem the bonds at a time before the maturity date (right to redeem). This is often used in the issuance of subordinate bonds because the effectiveness of the subordinate bond as supplementary capital decreased by 20 percent every year if its maturity is less than 5 years. The issuer usually chooses to redeem the bonds ahead of maturity date and re-issue new subordinate bonds so as not to increase the issuing cost while maintains sound capital adequacy ratio.

Strips bond——The issued bonds are striped into a number of zero-interest bonds according to the overall interests and final repayment of principals. The principal and interest have their own codes after the strip, so they can be held and traded separately. This kind of zero-interest bond becomes an important instrument in the market. Strip bonds with multiple maturity dates may facilitate the calculation of long-term and short-term rates of return and the pricing of products. At the same time, principals with same maturity dates can be transacted together, which can greatly enhance the liquidity of bonds and make the transactions in the subordinate bond market more active.

 

Forward bond——At present, the issuing date of forward transaction bond is far away from pay date (often over 1 month). The underwriters and buyers may price the bond through distribution and sale of their bonds. As to issuers, this kind of bond may set fixed coupon to reduce the impact of future interest rise and thus control the cost. At the same time, with its function of price discovery and more transactions on this kind of bonds, it will provide more complete yield curve, leading to more active transactions in the market.

 

Swap bond——It is now issued with floating interest rate (or fixed interest rate) and at the same time it can be swapped into fixed or floating interest rate at a specified date or dates. This type of bond provides instant returns on the one hand and avoids market risks on the other hand. It also lays the foundation for the derivation of Swap instruments.

 

Since 2002, new forms of bond issuance has been emerging in the inter-bank market, that is the re-bidding and re-issuance of the issued bonds with the same terms of issuance as the original ones in the form of price bidding. The increase of issuance may help enhance the liquidity of old ones. The Ministry of Finance also adopted cross-market issuance of treasury bonds. The central bond issuance system makes bidding and issues the bond through both inter-bank market and stock exchanges. After the bidding, underwriters may choose to registrar in either inter-bank bond market or stock exchanges, and they may entrust to others. In this way, the linkage of the two markets is strengthened.

                                                                                                           

 

2. Drop of bond market indices

 

In Q1 of 2004, the total of inter-bank bond market transactions reached RMB0.70 trillion yuan, 1.4 times that in the same period of last year. The total of treasury bond transactions in the stock exchange amounted to RMB697.8 billion yuan, down by 41.2 percent from the same period of last year. At the end of March, the closing index of treasury bonds in Shanghai Stock Exchange was 97.68 points, down by 1.71 points from the end of last year.

 

Since the beginning, especially April of this year, the bond prices in the stock exchange have dropped sharply, with that in Shanghai Stock Exchange closing at 92.17 points on April 30, down by 7.22 points from the end of last year, representing a decrease of 7.26 percent (the general index of inter-bank bond market during the same period decreased by 2.62 percent)

 

Figure2. Indices of Treasury Bonds at Shanghai Stock Exchange

from February to April, 2004

 

  

Source: Shanghai Stock Exchange

III . Stable development of bills market

In Q1 of 2004, the accumulated volume of bank acceptance (BA) issued by enterprises increased by 47.8 percent on a year on year basis to RMB736.61 billion yuan. The accumulated amount of bill discount and rediscount totaled RMB1.02 trillion yuan, up by 20.2 percent over the same period of last year. At end March, the outstanding balance of BA issued stood at RMB1.3 trillion yuan, indicating an increase of 57.2 percent over the same period of 2003. And the balance of bill discount and rediscount was RMB972.7 billion yuan, representing a growth of 50.1 percent over the same period of last year.

 

The development of bills operations was characterized by the following aspects: First, the continuous development of bill operations extended the bills market rapidly. Second, with the gradual discovery of the financing function of bills, bill financing became an important direct short-term financing means for small and medium-sized enterprises, and it alleviated their financing difficulties. Third, the development of bill operations was unbalanced among financial institutions, with small and medium-sized financial institutions and joint-stock commercial banks taking large market shares. Fourth, intensive bill operations were further developed with the rapid growth of cross-region transactions.  With the increase of cross-region transactions, the bill rediscount interest rates began to converge to a level slightly higher than that in inter-bank borrowing market, and fluctuated in the same direction as the latter.

 

The development of bills market should be consistent with the demands of extending enterprise financing channels, improving financial services, facilitating the change of operating mechanisms of the commercial banks, building a sound social credit system and improving the transmission mechanism of monetary policy. In this respect, the bills market should be developed in a regulated manner while the market regulation should aim at promoting market development. The development of bills with trade background should be an important policy measure to promote the development of money market in China. To this end, efforts will be made to improve the efficiency of bills transactions through accelerated development of market infrastructure. Meanwhile, risks of bills operations should be well kept away and irregular bills operations should be checked by improving bill laws and regulations and keeping bills transactions in good order. Besides, report system, market exit system and accountability system should be introduced to safeguard the healthy and sustained development of the bills market.

IV . Active stock market

In the first quarter of 2004, the stock market operated actively. The combined turnover of Shanghai and Shenzhen stock exchanges totaled RMB1,641.6 billion yuan, and the daily turnover averaged RMB29.31 billion yuan, both increasing by 1.5 times over those on a year-on-year basis. The accumulated turnover of A share market totaled 1,610.4 billion yuan, 1.5 times that of the same period of last year while the daily turnover increased by 1.3 times to RMB26.4 billion yuan.

 

During Q1, both the Shanghai and Shenzhen stock markets edged upwards in fluctuations. The Shanghai Composite Index reached 1760 points in March, the highest level since 2002, and the Shenzhen Composite Index hit 459 points, the highest since November 2002. At end March, the Shanghai Composite Index and the Shenzhen Composite Index closed at 1,742 and 458, up by 245 and 79 points, or with increases of 16.3 percent and 21.1 percent respectively over the end of last December.

 

During Q1, the fund raised by the issuance of A share and H share in stock market both increased significantly over the same periods of last year. The A share raised an aggregate of RMB13 billion yuan, increasing by 29.1 percent over the same period of last year, while the H share raised an aggregate of USD 833 million, an increase of 85.9 percent over the same period of last year. There were no convertible bonds issued in Q1 of this year while RMB6.8 billion yuan of convertible bonds were issued in the same period of last year. During this quarter, the accumulated financing of stock market was RMB19.9 billon yuan, down by 3.4 percent on a year-on-year basis.

 

In Q1, the new funds raised by domestic non-financial sectors (including the household, corporate and governmental institutions) in China through loans, stocks (marketable stocks only), treasury bonds and corporate bonds aggregated RMB973.3 billion yuan (total of both renminbi and foreign currencies), up by 8 percent over the same period of last year. The proportions of the financing by domestic non-financial sectors in the forms of loans treasury bonds, corporate bonds and stocks were 93.8 percent, 3.6 percent, 0.6 percent and 2 percent respectively.

 

Table 3．Financing of Domestic Non-financial Institutions

 

Source: Statistics Department of PBC

 

V . Significant growth of assets in insurance industry and increase of insurance fund in securities investment fund

In Q1 of 2004, the premium income of insurance industry stood at RMB120 billion yuan, up by 5.1 percent over the same period of the last year, but down by 27.7 percentage points compared with the growth in the same period of last year due to the decline of life-insurance premium by 3.9 percent. If calculated according to standard premium[1], the premiums in the first quarter were RMB50.82 billion yuan, representing a year-on-year growth of RMB10.09 billion yuan or 24.8 percent. In Q1 of 2004, lump sum payment of premium decreased significantly while the renewal premium and the new premium rose by 21.4 percent and 58.9 percent respectively. Structured changes led to lower premium in the short run, but laid the foundation for its growth in the future. Meanwhile, in Q1 of 2004, the accumulated amount of claim settlement totaled RMB22.5 billion yuan, indicating a growth of 27 percent and up by 6.2 percentage points over the same period of last year.

 

At end March, the aggregate assets of insurance companies totaled RMB998 billion yuan, increasing by 38.6 percent over the same period of last year, and up by 9.4 percent over the end of last year, indicating a rapid growth. Among the aggregate assets, the deposits by banks accounted fort the largest share of 48.5 percent, and security investment funds grew rapidly by 30.5 percent over the end of last year, accounting for 6.1 percent of the total, up by 1 percentage point over the end of last year. The reason for the growth is that steady stock market boosted the fund performance, from which insurance companies were benefited. Because of the heightened inflationary pressures, strong expectation for rising interest rate, and the downward bond market, the share of treasury bonds in the total assets of insurance companies decreased by 0.2 percentage points compared with the end of last year.

Table 4． Fund Use of Insurance Companies

 

 

Source: China Financial Market Monthly Statistical Bulletin

 

VI . Notable growth of Inter-bank foreign exchange transactions

In the first quarter, transactions of the inter-bank foreign exchange market maintained a growth momentum. The accumulated foreign exchange market turnover amounted to USD41.3 billion, an increase of USD11.8 billion on a year-on-year basis while the daily turnover averaged USD677 million, up by 37.9 percent over the same period of last year. In particular, the turnover of transactions in US dollars was USD40.4 billion, while the daily turnover averaged USD662 million, up by 37.9 percent over the equivalent period of last year.

Part FOUR  Analysis of Macroeconomic Situation

I. Global economic recovery remained strong with the support of accommodative monetary policies in major economies

 

1.  A good start for global economic growth in the first quarter of 2004

 

Since the beginning of 2004, the world's major economies have maintained strong demands featured by the rising price of energy and raw materials, strengthened business and consumers' confidence, dynamic investment and rapid rebounds of imports and exports. More and more countries joined in the economic recovery and growth. Among them, the United States and Asian economies grew even faster. According to the latest prediction by the IMF in April 2004, the world economy actually grew by 3.9 percent, 0.9 percentage points higher than that of 2002. Global trade in goods and services continued to grow by 4.5 percent in 2003 following the 3.1 percent growth in 2002. In addition, the world oil price increased by 15.8 percent on the average and the export-weight-average price of non-energy goods including grains and raw materials grew by 7.1 percent.

 

The US economy remained a steady growth with reduced deflation pressure. In Q1 of 2004, the US GDP grew by 4.2 percent on an annualized month-on-month basis and the unadjusted CPI was up by 1.7 percent. The unemployment rate, however, was still as high as 5.6 percent.

 

The economy in the euro zone continued its slow recovery with a 0.4 percent GDP growth rate in 2003 and 0.6 percent in Q1 of 2004. The CCI (Consumer Confidence Index) has maintained the rebound momentum since the second half of last year and the HCPI was up by 1.7 percent in Q1 over the same period of last year. The unemployment rate, however, remained as high as 8.8 percent and the fiscal situations in some EU members continued to deteriorate.

 

The Japanese economy recovered steadily with a GDP growth rate of 2.7 percent in 2003 continued steady recovery into Q1 of 2004. The capacity utilization rate picked up and equipment orders increased by 7.5 percent in Q1 over the same period of last year. The deflation, however, has yet to be overcome. The year-on-year CPI excluding fresh food price was around zero and the unemployment rate remained at 5 percent.

 

Emerging market economies and major developing countries continued to maintain strong growth momentum. Since 2004, Asian developing countries have witnessed rapid economic growth. In particular, the major four members of ASEAN enjoyed an overall growth rate of 5 percent in 2003 and continued growth momentum in Q1 of 2004 featured by over 4 percent growth rate in Indonesia and other economies. The economic growth in Asian emerging industrialized economies excluding Japan has picked up. Some regions like Taiwan experienced a growth rate of 5 percent in Q1 of this year. The overall growth rate in Latin America stood at 1.6 percent in 2003 and accelerated this year with over 2 percent growth rates in counties like Mexico in Q1 of 2004.

 

2. Stock markets continued to rebound

 

The world's major stock markets continued to rally in Q1 of 2004. The increased purchase of equity holding of commercial banks by the Bank of Japan, and improved performance of the technology stocks pushed the Nikkei 225 Index up by 10 percent in Q1 of 2004 over the end of 2003. Led by technology and telecom stocks, the STOXX50 in euro zone reached a peak level in Q1 of 2004, up 7.2 percent over the end of 2003. S&P500 rose by 4.1 percent and slowed down recently.

 

By the end of March 2004, the US dollar had fallen more than 7 percent against the euro over the average level in 2003. Since 2003, the Bank of Japan has stepped up its intervention in foreign exchange market to prevent further appreciation of the yen, which, however, continued to rise against US dollars in Q1 of 2004 against the US dollar. The exchange rate of yen to dollar has risen from 120 at the beginning of last April to 103.8 at the end of this March.

 

3.Eased monetary policy continued to prevail in major economies

The US Fed has maintained the federal funds rate at 1 percent and the European Central Bank has kept its refinancing rate at 2 percent since June 2003. Bank of Japan at the Monetary Policy Committee Meeting in March asserted that eased monetary policy would remain in place due to continued deflation, thus interest rate was still kept at zero in Q1 of 2004. Considering the rapid growth of output and heating up of the real estate market, the Bank of England raised its repo rate up by 0.25 percentage points to 4 percent.

 

II. China's economy continued to grow rapidly with overheated investment

China's economy continued to grow rapidly featured by substantial increase in rural and urban residents' income, corporate profits and fiscal revenues, healthy development of agricultural sector, strong growth of foreign trade and relatively high utilization of foreign investment. Nevertheless, problems such as overinvestment expansion, short supply in coal, electricity, oil and transportation, and heightened inflation pressure surfaced in the economy. China's GDP grew by 9.7 percent in Q1 of 2004. Fixed assets investments hit record high since 1994. The significant rise in import driven by the huge domestic demands led to a trade deficit.

 

1.      Over-investment in fixed assets must be constrained with aggregates control measures

 

Fixed assets investment has always been the major driving force for China's rapid economic growth. However, obvious signs of overheating appeared in Q1 of 2004. First, the investment increased too quickly. The real investment (price adjusted) approached the level of 1992-1993, when China's economy was over heated. In Q1 of 2004, the total investment in the fixed assets increased by 43 percent, 15.2 percentage points higher than that of Q1 of 2003. Among them, the investment in urban area was up by 48 percent, rural area 26 percent and urban real estate 41 percent. Second, there were too many new projects. There were more than 20,000 new projects with the investment of over RMB500, 000 yuan each, up 31 percent over the same period of last year. The total planned investment in new projects increased by 67 percent. Third, the projects under constructions were over scaled. The investment in projects under construction in 2003 topped RMB16 trillion yuan, three times the RMB5.4 trillion yuan of the completed fixed assets investments of that year. The planned investment in Q1 totaled RMB7.2 trillion yuan. Forth, the investment structure was not balanced. The problems of blind investment and redundant construction in certain sectors and regions were quite serious.

As for urban projects, the overinvestment in fixed assets focused on the following five aspects. The first is the investment in local projects, which increased by 60.2 percent, compared with 4.8 percent for state projects. The second is the investment in industrial and construction sectors with 66.1 percent rise in industry and 82.8 percent in construction. In particular, the manufacturing investment increased by 76 percent while agricultural investment only rose by 0.4 percent. The third is the investment made by private and foreign-funded enterprises. The investments by private sectors, foreign invested enterprises and enterprises from HK, Macao and Taiwan increased by 89 percent, 78.1 percent and 58.7 percent respectively. The fourth is the investment in mining of ferrous and non-ferrous metals, manufacturing of educational and sport facilities and furniture, waterway transportation, electrical and machinery equipments. The investments in those sectors grew by more than 120 percent. The fifth is the investment by some provinces and cities. The real fixed assets investment in Jiangsu, Guandong, Zhejiang, Shandong and Shanghai ranked the top 5 in the country and covered 48 percent of the state total. The 5 biggest increases in the fixed assets investment occurred in Inner Mongolia, Anhui, Henna, Hebei and Jiangsu, all up by over 65 percent.

The overinvestment had severely adverse impacts on the social and economic development. The first impact was on the supply of coal, electricity and oil. Overinvestment in fixed assets led to huge demand for such energy-consuming sectors as steel, aluminum and cement. The expansion of those sectors made the supply of coal, electricity and oil even more difficult and resulted in bottleneck. The second impact was on economic structure. The growth of investment was 33 percentage points higher than that of consumption, which was quite unbalanced. The third impact was the heightened pressure on inflation. The prices of investment products stood high driven by strong investment growth. The fourth one was increased potential risks in economy. The overinvestment in fixed assets and excessive money and credit expansion interact and reinforce each other. Without proper measures, it will lead to redundant production capacity, distress for enterprises, new bad loans and increased financial risks as well as higher unemployment rates, thus impeding overall economic and social stability.

 

Box 5.  Over-investment Must Be Resolutely Contained

 

In 2003, total investment in fixed assets grew at a nominal rate of 26.7 percent and a real rate of 24.5 percent, next to 29.1 percent and 35.2 percent in 1992 and1993 respectively, when China's economy was over heated. In 2003, China's capital formation was 42.7 percent of the GDP (also investment rate), next to 45.3 percent in 1993. This high ratio had hardly been seen in other countries in the world and rose very rapidly, which showed that more and more investment was needed in per GDP and economic growth relied more on the resource input rather than productivity increase based on technical development. In Q1 of 2004, the nominal increase of total investment in fixed assets reached 43 percent, up by 15.2 percentage points over the same period of last year and the real growth rate was 35.5 percent, up 8.5 percentage points, showing obvious signs of overheating.

 

Figure 3. Comparison of Nominal and Real Growth Rates of Investment in Fixed Assets

  

Source: China Statistics Yearbook

 

There are three indicators used to judge if overall investment is overheated. The first indicator is the prices in real estate and fixed asset investment. In Q1 of 2004, the land transactions rose by 7.5 percent on a year-on-year basis and the housing price by 7.7 percent. The price of investment-related fixed-assets increased by 7.5 percent, 6.7 percentage points higher than that of the same period of last year. The second indicator is the sustainability of resources. If existing resources could maintain and support current economic growth rate, the economy may not be over heated. On the contrary, if the economic growth is constrained by resources or more than what the resources could support, the economy might be over heated. In Q1 of 2004, the supply of energy, transportation and other important raw materials all could not meet the demand. A large number of enterprises witnessed an increase in consumption, a decrease in inventory and surge of costs of important raw materials including coal, steel, and processed oil. The third indicator is the ratio of investment against consumption. If the production capacity generated by investment (mainly fixed assets investment) could not match future consumption, there would be excessive production capacity, leading to great waste of resources. If most investments are financed by bank lending, there might be huge amount of new bad loans, or even financial crisis. Compared with other countries, China's economic growth depends more on investments. Therefore, consumption demand needs to be propelled.. According to IMF's International Finance Statistics, final consumption expenditure in developed countries accounts for around 80 percent of GDP but 74 percent in developing countries on the average and about 69 percent in Asian developing countries. This ratio in China, however, is only less than 60 percent.

 

There are many reasons for the current overinvestment problem. First, some local governments have not completely changed the philosophy of blind pursuit of economic growth rate, particularly when a new administration takes office. Many local governments are setting their development plans with the target of changing the landscape in one year and total altering in three years. Second, there are soft budget constraints in the investment of state owned enterprises. Third, local governments provide unreasonably preferential land and taxation policies to private and foreign enterprises, leading to the underestimation of investment costs. Due to deep-rooted causes for overinvestment, we must tackle the fundamental problems as to effectively rein in it. In the short run, the aggregate policy should be adopted to reduce overinvestment and release bottleneck constraints, while in dealing with fundamental problems, we need to accelerate the transformation of government functions and financial reforms.

 

With rapid expansion of fixed assets investment, consumption demand increased marginally. In Q1 of 2004, the total retail sales of consumer goods reached RMB1.3 trillions yuan, up 10.7 percent over the same period of last year. The real increase was 9.2 percent after the price adjustment, which remained almost at the same level of last year. The total retail sales of consumer goods in urban areas rose by 12.3 percent and 7.6 percent in rural areas. The wholesale and retail trades as well as the catering industry increased by 10.2 percent and 16.6 percent respectively.

 

Import and export increased greatly, but the deterioration of trade terms was a concern. In Q1 of 2004, the foreign trade volume totaled USD239.8 billion, up 38.2 percent over the same period of last year. Among them, the export and the import volume were USD115.7 billion and USD124.1 billion, up by 34.1 percent and 42.3 percent respectively. The accumulated trade deficit was USD8.4 billion. The major reasons for the trade deficit in Q1 are two-fold. First, the trade terms were deteriorating with the drop of export prices and rise of import prices. Second, with China's steady and rapid economic growth, raw materials and energy are in short supply, leading to sharp increase in demand for international commodities, especially primary goods, hence imports grew much faster than exports.

 

2.      The economic efficiency improved and further implementation of the scientific approach to economic development is needed

 

Business profits continued to grow substantially. In the first quarter of 2004, the total profits of the statistically large enterprises reached RMB234.8 billion yuan, increased by RMB71.9 billion yuan, a year-on-year growth rate of 44.2 percent. All enterprises witnessed rapid growth of profits. The profits of 36 out of 39 industrial sectors increased over the same period of last year. The top five sectors are: the refinery and processing of ferrous metals; processing of chemical raw materials and manufacturing of chemical products; oil processing, processing of coal and nuclear fuel; manufacturing of non-ferrous metals and the generation and supply of electricity and heating power. The newly added profits in those five sectors totaled RMB38.7 billion yuan, accounting for 53.8 percent of the total added profits in industrial sectors.

 

Incomes of urban and rural residents grew quickly. In Q1 of 2004, the per capita disposable income of urban residents was RMB2, 639 yuan, up by 12.1 percent over the same period of last year and the real growth rate was 9.8 percent after the price adjustment. The per capita cash income of rural residents was RMB834 yuan, up by 13.2 percent and the real growth was 9.2 percent. The growth rates of urban and rural residents income were 1.4 and 1.7 percentage points higher than those of the same period of last year.

 

The fiscal revenue grew to a large extent. In Q1 of 2004, the total fiscal revenue reached RMB694.4 billion yuan up by 33.4 percent over the same period of last year while the fiscal expenditure was RMB450.2 billion yuan, up by 15.7 percent, making a surplus of RMB244.2 billion yuan, an increase of RMB112.9 billion yuan over the same period of last year.

 

Box 6. Growth, Externality and Scientific Approach to Economic Development

 

Economic development needs a certain growth rate. China, as a big developing country, in particular, needs a sustainable high economic growth rate. However, we shouldn't pursue the single goal of speed. To take a scientific approach to economic development means growth should be coordinated with speed, structure, quality and benefits. At present, China's economic growth depends mainly on the increase of input and the expansion of investment at hefty cost of resources and environment. Therefore, economic growth itself does not mean comprehensive, coordinated and sustainable development. If the economic growth is achieved at the expense of depleting resources, reducing consummations and undermining environment, it is only a "growth" without real "development".

 

In February 2004, the top 10 sectors with the highest profit rates were as follow: tobacco (83 percent), oil and natural gas exploration (42 percent), mining of ferrous metals (24 percent), processing of oil, coking and nuclear fuel (23 percent), beverage (18 percent), refinery and processing of ferrous metals (17 percent), other mining (13 percent), mining of non-ferrous metals (13 percent), manufacture of transportation facilities (12 percent) and pharmaceuticals (12 percent). Some of the high profits in those sectors were the results of technical innovation and human resources development, but many of them were achieved through extensive operations, resource depletion, as well as environment damage. Driven by huge profits, the investments in 2003 in steel, cement and aluminum sectors increased by 96.6 percent, 121.9 percent and 92.9 percent respectively. In Q1 of this year, they were up by 107.2 percent, 101.4 percent and 39.3 percent respectively. The excessive growth of those energy-intensive sectors led to short supply of electricity and great environment pollution. Currently China's emission of SO₂ and CO₂ ranks the first and second in the world. Water pollution even threatens the safety of drinkable water.

 

In economics, externality refers to the situation that rewards or compensations need not be given to those who are influenced favorably or adversely by production activities. The externality with favorable influences is called external economy and the one with adverse influences is called external diseconomy. A typical example of the latter is environment pollution. The enterprises with the maximization of profits as their goals, often decide the degree of pollution control according to the comparison of marginal utility and marginal costs. In China, many enterprises don't take the external diseconomy into consideration, nor pay for the cost to control pollutions. Therefore, they underestimate the production cost and invest excessively. The most efficient way to deal with the external diseconomy is the counter pollution scheme made by the government, which could rectify the externality by means of direct control or financial incentives. The government should be responsible for the formulation of compulsory technical and environment standards as well as anti-pollution laws. It should also require enterprises to pay higher pollution fees, that is, equal to the external damages. Those measures could increase the environment protection cost for the enterprises, thus containing overinvestment.

 

On the whole, we should take a scientific approach to economic development and political achievements. We should have a broad perspective on economic growth by balancing its speed and structure with cost-efficiencies and environment protection. We should accelerate the fundamental transformation of economic growth patterns and economic restructuring. We should continue the reform in financial sectors and fight against industrial monopolies as well as regional blockage. The central bank will improve the pricing mechanism to build a level- grounded market without government interventions.

 

 

3.      Various price indices showed obvious rising trend and inflation needs to be prevented

 

CPI kept rising. In Q1 of 2004, the accumulated year-on-year growth rate of China's CPI reached 2.8 percent, 2.3 percentage points higher than that of Q1 of 2003 and 0.1 percentage points higher than that of the Q4 of 2003. In March, the CPI rose 3 percent, to which, food price related CPI contributed 2.6 percent and non-food price 0.4 percent. The month-on-month CPI grew 0.3 percent in March 2004, a growth rate higher than the –0.8 percent, average growth rate of CPI in March over the past 3 years. The core CPI rose steadily. In March, the CPI excluding foods prices grew by 0.5 percent, the same as that of the end of last year. CPI excluding green groceries of March was up by 3.8 percent (The prices of green groceries decreased), 1.1 percentage points higher than that of the end of last year. The purchasing price of raw materials and the price of agricultural production materials continued to grow at a rising speed up to 8 percent in March. According to PBC's monitor, Corporate Goods Price Indices (CGPI) has risen up to 8.3 percent in March on a year-on-year basis for 16 consecutive months. 

 

Figure 4.  Movement of Major Price Indices

 

  

Source: China economic Activities Monthly

The inflationary pressure continued to increase due to many factors. An important parameter to identify inflationary pressure is price transmission process, which is the transmission from PPI to CPI. The rise of PPI might be absorbed by enterprises because of the increase of productivity and market competition, but some part of it may be transmitted to CPI. Research shows that 50 percent of the PPI rise in the US may be transmitted into CPI. Therefore we should keep our eyes on the price transmission to ward off the risks of inflation.

 

In China, the price rise of primary goods is currently greater than that of intermediate goods, the latter, however, is higher than that of final goods. Therefore, the pressure on inflation is heightened. There are three characters.

 

First, in the process of price transmission from agricultural production materials to agricultural produces and then to CPI, the price rise of the first two is higher than that of CPI. In Q1 of 2004, the price of agricultural production materials grew by 6.2 percent, 4.9 percentage points higher over the same period of last year. And the Producer Price Index of agricultural produces was up by 12.8 percent and 20.7 percent up for the Producer Price Index of grains. At present, the price rise of agricultural production materials has not exceeded that of agricultural produce, but the rapid than expected growth of agricultural production materials will have adverse effects on the increase of grain supplies and the farmers' income.

 

Second, in the process of price transmission from industrial materials to industrial products and then to CPI, the rise of purchasing price is greater than the cost price and the rise of production materials is greater than that of the consumer price. In Q1 of 2004, the purchasing prices of raw materials, fuel and power were up by 8.3 percent, while the cost price rose only 3.7 percent with the difference of 4.6 percent, which was higher than that of the same period of last year. Therefore, the enterprise profit margin is narrowing while the competition pressure is increasing. In terms of the cost price, the price rise of production materials is greater than that of living materials. In this March, the cost price of production materials was up by 5.1 percent while that of the living materials was up only 0.9 percent over the same period of last year.

 

Third, in the process of price transmission from import price to CPI, the rise of import price is greater than that of CPI. The import price in 2003 was up by 6.4 percent, 1.5 percentage points higher than the previous year. It is particular the case in the trade of bulk goods, energy and intermediate goods. For example, the price was up by 18.3 percent for crude oil, 32 percent for iron ore sands, 28.2 percent for machine tools, 6.1 percent for steel and 15.2 percent for integrated circuits.

 

III. Major industries performed well, but structural reform is needed

 

In Q1 of 2004, the value added of primary industry grew by 4.5 percent, 1 percentage point higher than that of the same period of last year. The value added of secondary industry grew by 11.6 percent, 0.9 percentage points lower than the same period of last year. And the value added of tertiary industry was up by 7.7 percent, 0.1 percentage points higher than the same period of last year. The proportion of the value added of the primary and secondary industries in GDP were up by 0.6 and 0.7 percentage points over the same period of last year respectively. That of tertiary industry, however, was down by 1.3 percentage points. At present, China's economy is undergoing the rising phase of another growth cycle. Therefore, we should take this good opportunity to further promote the industrial structure reform.

 

1.      Good momentum in agricultural production

 

The agricultural production is developing well with the implementation of the state policies and measures of supporting grain production as well as the increasing enthusiasm of the farmer on the grain plantation. The sowing area of grains has recovered and that of other cash crops continues to expand. Animal husbandry and aquaculture sectors grow steadily. In Q1 of 2004, the output of animal husbandry and aquaculture increased by 3 percent and 3.2 percent respectively.

 

2.      Steady and rapid growth in industrial sectors

 

Since the beginning of the year, China's industrial production has maintained the high growth momentum in 2003. In Q1 of 2004, the accumulated value added of statistically large industrial enterprises reached RMB1.1 trillion yuan, up 17.7 percent on a y-o-y basis, including 19.4 percent growth in March. The proportion of industrial production in GDP was 41.8 percent compared with the 35.2 percent in 2003.

 

The industrial production in Q1 of 2004 has the following three features. The first one was the faster growth of heavy industry than that of the light industry. The value added of light industry and heavy industry grew by 14.9 percent and 20.1 percent respectively. The second feature was the rapid growth of the production of joint ventures and joint-stock enterprises. In Q1, the value added of enterprises with foreign, HK, Macao and Taiwan investment grew by 21.1 percent over the same period of last year; that of joint-stock enterprises was up by 18.1 percent; that of state owned and state-holding enterprises was up by 14.5 percent. These growth rates were all higher over those of the same period of last year. Third, electronics, metallurgy, transportation equipment, power, chemical industry and electrical machinery were the major force driving the rapid growth of primary industry. In Q1, the electronics sector contributed 2.2 percentage points and the metallurgy 1.9 percentage points to the industrial growth.

 

3.      The tertiary industry has a huge potential for development

 

In Q1 of 2004, the proportion of the tertiary sector in GDP was 35 percent, the lowest in recent years. The tertiary sector, which depends less on resources than the secondary industry, can provide a large number of job positions. The rapid development of tertiary sector will benefit employment, economic restructuring and overall economic efficiency. The tertiary sector in China is generally weak, but this also means the huge potential for further development. Tertiary sectors in most developed countries account for around 60 to 80 percent of GDP. Even India, which enjoys the similar development stage with China, has 51 percent of GDP in the tertiary sector, while China's tertiary sector only accounts for 32 percent of the GDP. The proportion of the tertiary sector could not be increased overnight. Rather, it needs a long growth process. If China's tertiary sector can grow at a speed much higher than that of GDP growth in the next 10 to 20 years, it may provide a large space for China's economic development and to some extent help resolve problems in the transition of economic growth pattern.

 

4.      Sectorial warnings: steel, cement and aluminum

 

In 2003, the growth rates of investment in steel, cement and aluminum sectors were 96.6 percent, 121.2 percent and 92.9 percent respectively, and 107.2 percent, 101.4 percent and 39.3 percent in Q1 of 2004. It can be predicted supply will be greatly exceed demand after the completion of those projects, leading to great waste and higher financial risks. In March 2004, the PBC carried out a quick survey on the investment and financing by steel, cement and aluminum sectors, which showed that since the end of February, 42 percent of the financing for the projects was from bank loans. Among them, 30 percent was direct bank loans and the other 12 percent was indirect bank loans managed by enterprises themselves. What's more, leverage ratios of enterprises in those sectors were all above 45 percent.

 

 

 

Table 5. Financing Channels of Investment Projects in February 2004

Unit: percent

	Steel	Cement	Aluminum
Total financing channels	100	100	100
State budget	1.7	4.1	0.0
Domestic loans	29.4	27.3	32.2
Bonds	0.0	0.2	0.0
Foreign investment	2.4	8.3	2.3
Enterprise funds	53.7	57.6	61.2
Other channels	12.9	2.5	4.2
Estimated proportion of bank loans	37.8	39.2	47.8
Leverage ratio	45.8	50.8	53.6

Source:Special survey on the investment financing of steel, cement and aluminum sectors in March 2004 by the PBC

 

Steel sector: by 2003, China had been the largest steel producer in the world for 7 years in a row. In 2003, China's steel output was 222 million tons, up by 21.2 percent; the output of steel products was 216 million tons, up by 21.5 percent; the import of steel reached 37.17 million tons, up by 51.8 percent. In the same year, the steel consumption was 271 million tons, up by 28.6 percent, of which, 13.7 percent of the steel demand needs to be met by imports. It is predicted that by the end of 2005, China will have a steel production capacity of 330 million tons, greatly exceeding the market demand in 2005. At present, leverage ratio of the steel sector is 46 percent and38 percent of the project financing is from bank loans.

 

Cement sector: In 2003, China's cement output was 813 million tons, up by 16.8 percent; the consumption of cement was 836 million tons, up by 15.3 percent. By 2005, the output of cement will be over 1 billion tons, much more than the market demand. At present, the leverage ratio of the cement sector is 51 percent and 39 percent of project financing is from bank loans.

 

Aluminum sector: Currently, China is the world's largest aluminum producer. By the end of 2003, the production capacity of aluminum exceeded 7 million tons, 28.2 percent higher than that of 2002. If it grows at the present speed, the production capacity of aluminum will exceed 9 million tons by the end of 2005, far more than the 6 million tons consumption demand at that time. The current leverage ratio of the aluminum sector is 54 percent and 48 percent of the project financing is from bank loans.

 

 

Part FIVE  Projections And Outlook

I. International economic and financial outlook in 2004

Based on the economic development in Q1 of 2004, global economic recovery will be spread from the US and Asia to Europe, South America and Africa and world economic growth rate will continue to rise. According to IMF's forecast in April, global economy will grow by 4.6 percent in 2004, 1.5 percentage points higher than that of 2003. The US economy will grow by 4.6 percent, up 1.5 percentage points; the euro zone will grow 1.7 percent, 1.3 percentage points higher; Japan will grow 3.4 percent, much higher than previous predictions; developing countries and emerging markets will keep growing at 6 percent with the strong rebound of global trade, the actual growth could be higher than predictions. In addition, both the IMF and the UN predicted that global trade in goods and services will greatly increase and prices will be higher as the world economic recovery prevails. Global trade volume will rise by 6.8 percent and 7.5 percent according to IMF and UN's forecasts respectively. Prices of oil, grains and raw materials will rise substantially due to the global economic growth and the expansion of demands.

 

International financial markets will remain stable, but the heightened global trade disequilibrium will threaten long-term financial stability. Huge current account and fiscal deficits of the US will continue to enlarge, which will have adverse impact on the exchange rates of US dollars. With the acceleration of economic recovery and changes in inflation expectations, some economies are likely to raise interest rates.

 

The overall external environment for China's economic development in 2004 is fairly good. The global economic recovery will help increase China's exports. And the rise of interest rates by some economies will narrow the interest rate differentials with China, which is conducive to coordinate the policies on renminbi and foreign currencies. Nevertheless, there do exist some uncertainties. First, China depends more on other countries for resources and energy. In 2003, the proportions of crude oil, iron ore sands, alumina, nickel and natural rubber imports were 35 percent, 36.2 percent, 47.6 percent, 55.4 percent and 68.2 percent respectively. In terms of China's resources and production capacity, China will import steel, aluminum, copper and oil to meet new demand, thus, international market fluctuations will make greater impact on the costs of Chinese enterprises and China's total imports. Second, no materials results were yielded in the Fifth WTO Ministerial Conference in Cancún in September 2003. Therefore, trade policies of WTO members will be more conservative under the pressure of interests groups. Trade protectionism against China will increase, having negative impact on China's exports.

II.    China's macro-economic outlook in 2004

China's macroeconomic targets of 2004 set the GDP growth rate at around 7 percent and CPI at about 3 percent. As for consumption demands, with the implementation of the state policies and measures of supporting grain productions, agricultural development as well as rapid economic growth, incomes of urban and rural household are expected to rise steadily in 2004, thus increasing consumption demands. According to the PBC's Q1 survey on household savings, the Index of Current Income Sentiment was up by 0.2, and Index of Future Income Confidence rose 2.1 over the same period of last year. As for the investment demands, new investment scale remains large. Newly launched project can not bring about any benefits until it is completed, and the undergoing projects have no flexibility of compression, therefore, it is predicted that the investment in fixed assets will continue to grow at a rapid speed. In terms of net exports, because China's economy continues to grow quickly depsite serious shortage of raw materials and energy, there is a huge demand for foreign goods, especially primary goods. In addition, the reduction of tariffs and the removal of non-tariff measures will lead to the surge of imports on the one hand and the international trade protectionism and the adjustment of export tax rebate will affect China's exports on the other hand. Therefore, China's net export demands will continue to slowdown.

 

The inflationary pressure still needs to be carefully monitored. Because many problems in the economic development have not been resolved effectively yet, the grains prices will probably rise further.  The housing, entertainment and education consumption will are likely to raise the core CPI excluding foods, while it may be driven down by the sectors such as clothing, home appliance and their maintenance as well as communications and transportation.  At present, the public expectation on inflation is rather stable. According to the PBC's survey on urban depositors in Q1 of 2004, 31.4 percent of the depositors said the prices would rise, 60.3 percent thought the prices would keep unchanged, and 8.3 percent of them believed the prices would drop.

 

The growth rate of GDP and CPI will remain high in the Q2 and slowdown in the second half of 2004. There are two major reasons. The first is the result of base period. Because the GDP growth rate in the Q2 of 2003 was only 6.7 percent due to the impact of SARS, the year-on-year GDP growth rate in the Q2 of 2004 will be relatively higher. Due to hangover effect and seasonality, the year-on-year CPI is predicted to rise in April and fall in the third quarter. The second reason is time lag of macro control measures. Some of the policy measures taken since 2003 will show obvious results in the second half of 2004.

Box 7. Further Strengthening Macro Control To Prevent Significant Economic Fluctuations

 

Over-investment is more often than not accompanied by credit boom, resulting in large amount of NPLs and economic downturn in the wake of the overheating. Overinvestment and credit boom, however, are not necessarily revealed by CPI. Take the Japan in the 1980's as an example. The over heated sectors, driven by the huge demand, witnessed soaring production prices and hence profits. With the improvement of enterprises' Balance Sheet and credibility, banks extended huge amount of loans to them. However, this process would be reversed when any part of the chain broke and economic situation began to change. With the deterioration of enterprises' balance sheet and credibility, banks tightened credits, leading to the further deteriorating of enterprises and large amount of NPLs in banks.

 

At present, the overall economy in China is good, but some sectors like steel, cement, and aluminum are over heated with the short supply of coal, oil and electricity. The over expansion of steel, cement, and aluminum sectors shows the overinvestment in overall economy rather than a structural problem. Any overheated economy does not mean simultaneous overheating in all sectors, rather it always starts from certain sectors and regions. The overheating in 1992 and 1993 focused on the real estate sector and some regions, while this time it is showed in steel, cement, and aluminum sectors. According to the "Bucket Law", the volume of the bucket is up to the shortest board and any part of higher than the shortest one is in vain. China has a large population and relatively fewer resources, therefore the rapid expansion of energy intensive sectors must lead to the short supply of key raw materials and unbalanced growth, thus undermining enhancement of overall economic efficiency.

 

Overinvestment must be curbed through aggregates policy and appropriate regulatory approaches. China's economic reform and opening up policy has been carried out for more than 20 years. With the preliminary establishment of socialist market economy and diversification of stakeholders, enterprises are more self-reliant and commercial banks have reformed their operational mechanism. Therefore, the macro control modes have been transformed from direct controls to indirect market-oriented adjustment. In 1993, the third plenary session of the 14^th Party Congress proposed to "establish the socialist market economy". In 2003, the third plenary session of the 16^th Party Congress called for more fundamental role of the market in resource allocation, stressed that we should improve state macro adjustment and regulation systems. Therefore, we should solve the present economic problems by improving macro adjustment and regulation mechanism and leveraging the market forces.

 

Since the year 2003, the PBC has strengthened the "pre-emptive tuning" and "fine tuning" and adopted some necessary measures such as the issuance of central bank bills and intensified sterilization in the open market. In addition, the central bank gave warnings to housing credits, raised the required reserve ratio from 6 percent to 7 percent, and lowered the excess reserve ratio. The new renminbi loans reached RMB1.8 trillion yuan in the first half of 2003 and then reduced to less than RMB1 trillion yuan in the second half of 2003, reflecting preliminary effects of the monetary policy. Due to the huge base number and hangover effect, the monetary and credit growth remained high in Q1 of 2004. The PBC stepped up open market operation and raised required reserve ratio again. It is expected that by the third quarter of 2004, those indirect adjustment measures will start to take effect. It is worth noticing that under the influence of large base number and hangover effect, the growth rates of GDP, CPI and money and credits will remain relatively high in the second quarter of 2004, which can be expected but does not mean the ineffectiveness of monetary policies. Preliminary forecast shows those indices after the third quarter of 2004 will slowdown and the monetary and credit control targets set at the beginning of this year will be met, i.e. broad money M₂ and narrow money M₁ will rise by around 17 percent and new renminbi loans of all financial institutions will total RMB2.6 trillion yuan, only next to record high level in 2003, RMB750 billion yuan more than the third highest level, thus implying a soft landing rather a hard one.

III. Sound monetary policy stance in near term: moderately tight

The current economic situation is generally good featuring rapid economic growth and improved economic efficiency. At the same time, however, we should be mindful of the prominent economic issues, which are characterized by overinvestment in fixed assets, low quality and redundant construction in certain sectors and regions, worsening resources bottleneck and increased inflationary pressure, which are all reflected in excessive money and credit growth. In Q1 of this year, total new loans of financial institutions reached RMB835.1 billion yuan, RMB24.7 billion yuan more than the same period of last year, accounting for 32 percent of the projected target of RMB2.6 trillion yuan for the whole year.

 

The PBC will develop and implement a scientific approach to economic development and the decisions made by the Central Party Committee, according to the requirements raised by the central Economic Work Conference as well as the Government Working Report. The central bank will take targeted measures subject to the economic and financial developments to appropriately control money and credit growth and improve monetary policy transmission mechanism. It's expected that money and credit targets set at the beginning of this year could be attained, that is, M₂ and M₁ will grow by around 17 percent and new loans total RMB2.6 trillion yuan. A moderately tight monetary policy will be adopted in coming period, but sudden brake or major fluctuations should be avoided so as to promote stable economic development.

 

1.            Appropriately tightening the liquidity in financial system and reining in excessive money and credit growth

 

By means of various monetary policies and instruments, the central bank will intensify preemptive and fine-tuning to guide the appropriate growth of money and credit. Given the rising trend of liquidity as a result of foreign exchange purchase, the central bank will continue to increase sterilization operation in the open market. Through strengthening management of central bank lending and rediscount, the central bank will coordinate various monetary policy instruments to keep excess reserves of commercial banks at a reasonable level, and thus appropriately check the money and credit growth.

 

2.            Closely watching price changes and steadily pushing forward market-based interest rates reform

 

The central bank will closely monitor the price changes in Q2 of 2004 so as to define the best preemptive and fine–tuning strategy with various monetary instruments including interest rates. The central bank will push forward market-based interest rates reform and extend more autonomy to financial institutions on loan pricing, which will guide financial institutions to set reasonable loan interest rates based on monetary policy stance and loan risks.

 

3.            Strengthening structural reform and preventing one-size-fits-all measures

 

The central bank will guide and supervise financial institutions to strengthen and upgrade their credit management and to improve lending structure. The central bank will provide more window guidance to the financial institutions and require them to rigorously control loans to over invested sectors, to pay much attention to the warnings issued by regulators on the industrial risks and strictly control the credit to the industries discouraged by the state, to refuse lendings to those projects not eligible for market access, and to appropriately utilize the floating interest rates band and increase the risk premium on the enterprises with low technology content and environment protection standards. The central bank will urge financial institutions to control their asset growth rates to maintain proper liquidity through adjusting their asset/liability structure, and continue to increase credit supports to key areas such as agriculture, consumption, small and medium-sized enterprises, employment and education.

 

4.            Promoting financial market development to expand direct financing

 

According to the State Council's opinion on promoting capital market reform and opening up as well as steady development, the central bank will strengthen coordination with relevant departments to promote and explore the ways of developing capital market through institutional and product innovations. The central bank will increase products in the bond market by promoting securitization of mortgage loans and credit assets to further facilitate the development of corporate bond market, develop qualified institutional investors, improve systems of the bond market maker and upgrade bond entrust and settlement system. The central bank will study ways to guide the qualified investment funds into the stock market and improve the efficiency of resources allocation so as to promote the steady and coordinated development of financial markets.

 

5.            Keeping the renminbi exchange rate stable at an adaptive and equilibrium level

 

The central bank will watch closely and analyze new developments in international financial markets and Balance of Payment in order to promote the balance of international payments by coordinating the renminbi and foreign currency policies. The central bank will improve the formation mechanism of renminbi exchange rate and promote the convertibility of renminbi steadily by gradually deregulating foreign exchange control, reforming current system of exchange surrender and purchase, cultivating foreign exchange market, and keeping the renminbi exchange rate at an adaptive and equilibrium level.

 

6.        Supporting the pilot reform of rural credit cooperatives to promote the transformation of their operational mechanism

 

The central bank will further work on the issuance and acceptance of special bills, and assess the issuance of earmarked loans. The financial support to eligible rural credit cooperatives for their pilot reform must be put in place. The central bank will also take effective measures to lift RCCs out of historic burdens and help them transform operational mechanisms and embark on the track of sustainable development. In this way, the financial services in rural areas can be upgraded to facilitate the development of the agriculture sector and the rural economy as well as the increase of farmers' income.

 

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