Next Steps for China

• Author: Eswar S. Prasad
• Position: Former head of the IMF's China Division, is a Division Chief in the IMF's Research Department

Why financial sector reform is a crucial element of a long-term growth strategy

China's emergence as an economic power and its sheer size have put it firmly at the center of the global economic stage. Its remarkable pace of growth has attracted a lot of attention, with some observers speculating that it could become the world's second-largest economy if this rate of growth were to be sustained for the next two or three decades. Furthermore, in light of China's trade expansion and rapidly rising stock of international reserves, discussions of global current account imbalances invariably put the spotlight on Beijing. At the same time, the possibilities of overheating and excessive investment in China are raising concerns, because a downturn in its growth could reverberate not just domestically but also in the Asian region and beyond.

Indeed, China's recent move to allow for more flexibility of the renminbi's exchange rate (by linking it to a basket of currencies rather than a fixed peg to the U.S. dollar) is seen as a response to both domestic and international pressures. Some observers have dismissed this initial step, which included a small revaluation of the renminbi, as being too modest to make much of a difference to domestic or international imbalances. What is more important, however, is the symbolic as well as economic significance of this step in terms of setting in motion the shift toward greater exchange rate flexibility and the authorities' stated goal of eventual capital account convertibility.

But the exchange rate regime is just one piece of the broader reform agenda. This article provides an assessment of what China needs to do to ensure the durability of its economic expansion by addressing the looming issues of financial sector reform and the need to bolster balanced domestic-led growth.

Trade patterns and the reserve buildup

To gain a better understanding of the implications of China's currency policy and growth strategy, it is helpful to examine the dynamics of China's international trade patterns and rapid reserve accumulation.

Let us begin with a regional perspective. China is becoming increasingly important in the Asian region in terms of both trade and financial flows. It now accounts for about 40 percent of all foreign direct investment (FDI) inflows into emerging market economies in Asia (including FDI flowing between Asian economies). On the flip side, Japan and the emerging market economies of Asia together now account for more than two-thirds of China's FDI inflows. This share remains well over half, even if one excludes a significant share of flows from Hong Kong SAR on the premise that these may represent round-tripping of capital originating from China to take advantage of preferential tax treatment afforded to FDI.

These patterns of intraregional capital flows are tied in to developments on the trade front, where China has become a major processing hub for goods manufactured in other Asian economies and destined for industrial country markets. Indeed, over the period 2000-04, the increase in China's combined bilateral surpluses with the United States and the European Union was offset to a significant extent by the increase in its trade deficit with other Asian economies (see table).

[ SEE THE GRAPHIC AT THE ATTACHED ]

But this is hardly the full picture. China's current account surplus rose to about $70 billion in 2004, with the overall trade surplus accounting for the major portion of this increase. During 2001-04, Chinese exports grew at a remarkable rate of about 30 percent on average each year (imports grew at a similar rate, but the level of imports has remained lower than that of exports). While this rapid export growth since 2001 can be attributed partly to China's low labor costs and...