China has been achieving impressive growth rates averaging 9.5% p.a. over the last 20 years. Since 2003 the Chinese economy has actually expanded by double-digit figures, and posted a result of 10.7% in 2006. First-quarter growth of 11.1% has just been announced, making it unlikely that the government aim of limiting growth to 8% this year will be fulfilled. We expect a figure of 10% for the year as a whole. Growth is concentrated in coastal regions, whereas inland and rural areas are far less dynamic.
There is concern about the economy overheating, as strong growth has been based largely on exports and investment. This has gone hand in hand with increasing global imbalances and gives rise to the threat of trading partners affected by China 's exports, especially the US , resorting to protectionist measures. The Chinese government is meanwhile set on reducing the country's large balance-of-trade surplus. Since the 2005 currency reform, the renminbi has appreciated by roughly 6.5% against the dollar. The government will no doubt allow a further strengthening, and the tax relief granted on export business is to be reduced. The balance-of-trade surplus shrank substantial in March, but the figure for the first quarter was still almost twice as high as a year ago.
The dangers of over-investment, with the possible consequence of loan defaults and in turn a threat to the financial system, have meanwhile been recognised. Interest rates and reserve requirements have been raised. In addition, environmental requirements and stricter rules covering real-estate transactions have been introduced. While first-quarter investment growth was four percentage points below that a year ago, it was still high with almost 24%. Consumption is meanwhile making a greater contribution to growth, which is in line with the government's targets of more balanced growth. Consumption could be further boosted by measures to reduce the high level of savings, and these would raise the standard of living and help to reduce external imbalances. One reason for the high propensity to save is the weakness of the country's social-security system. So far, only a minority are covered by any kind of health insurance, for example. However, with inflation passing 3% in March, the risk of the economy overheating remains.
According to UNCTAD, more direct investment has gone to China over the past 15 years than to any other developing country. In contrast with many other places, though, only a small proportion of this has taken the form of large shareholdings or take-overs. After some weakness in the second half of last year foreign direct investment rose again by 11% in the first quarter compared with the year-ago. More is now being invested in research and development activities and in production facilities higher up the value-added chain. One of the government's explicit objectives is to give the quality of investment – with regard to criteria such as sector, geographic region and environmental impact – priority over quantity. The hope, generally justified, is that incoming foreign capital in the form of direct investment will lead to an influx of technology, know-how, job creation and enhanced export capacities, in turn attracting more domestic investment. This also increases competition on the domestic market.
As in many countries, most direct foreign investment in China goes to the dynamic urban regions. So the main concern for less developed regions, especially in western and central China , remains how to attract capital, and not so much the potential dangers involved. Even with the government focus more on these regions foreign capital is needed especially for infrastructure development. To attract more direct investment administrative procedures will have to be overhauled to ensure transparency and regulations that can actually be enforced. Domestic companies will benefit when more of the incoming funds are channelled into existing businesses, and know-how is transferred by personnel moving from foreign to domestic companies. The harmonization in corporation tax rates (25%), which was previously lower for foreign firms, improves the competitive position of domestic firms. What is China 's role in global finance and what should its institutions look like?
China has taken steps in recent years to improve the banking system, such as upgrading the supervision of banks, opening up domestic banks to foreign capital, greater adherence to market criteria when loans are granted, and so on. Nevertheless, there is still more to be done: A wider range of financial and insurance services needs to be made available, the efficiency of the introduced measures needs to be improved, and basic rights such as property rights, a pre-requisite for financial transactions, need to be made transparent and enforceable. Some progress has been made here – the new property law, for example, which for the first time has placed private property on an equal footing with public property.
These measures are also essential for monetary policy to become more effective and establish stable macroeconomic conditions, which is in the interest of the global community as well. Only in a sufficiently developed capital market can monetary policy take effect without quantitative restrictions being needed. These have often negative side effects from an allocative point of view. When lending responds to interest-rate signals, bad investments become far less likely, as it is then fair to assume that the least profitable projects will not be supported.
Greater flexibility for the Renminbi could also have a stabilising effect, particularly since the strong influx of capital to China for some time now carries the threat of overheating and pressure on prices. And although the central bank's sterilisation policy has been quite successful so far, it will hardly be feasible to continue it for an unlimited period of time. The guiding principle for all new measures must be efficient regulations with no unnecessary complications, a consistent approach, and a minimum of red tape.