Central bank governor of the year 2011: Zhou stays firm amid China’s challenges

Tradition has it that the head of the Federal Reserve is the most influential central banker in the world. Ben Bernanke still is. But Zhou Xiaochuan, the governor of the People’s Bank of China, is beginning to run him close.

China’s role in the global economy is such that the world’s markets now hang on Zhou’s every word. Will he allow the renminbi to appreciate? Will he open up China’s currency to become a key global trading tool? What will he do with China’s more than $3 trillion of reserves? Will China continue to be the biggest owner of US treasuries, with latest estimates suggesting it holds a staggering $1.3 trillion of these securities?

And most important of all, can Zhou carry off the delicate balancing act of controlling China’s inflation rate and still maintain the kind of growth rates on which the economies of the developed world now so depend?

Zhou answered all of these questions and more in an exclusive interview with Clive Horwood:

What do you consider to be the most important decisions that you have made over the past 12 months? What impact did these decisions have?

Beginning from the second half of 2010, with the monetary policy stance shifting from "relatively easy" to "prudent" and with the introduction of macro-prudential policies, monetary conditions are returning to normal.

Since the outbreak of the global financial crisis, China has taken steps to further promote financial reform, based on lessons learned in the crisis. What makes China different from other countries is that we are in the transition from a planned to a market economy and need to undertake a large number of reform tasks. Therefore, our financial reform is necessitated by both the financial crisis and the transition.

In recent years, the People’s Bank of China has promoted financial reform in several key areas jointly with other agencies, such as the reform of state-owned commercial banks through recapitalization and the establishment of a modern corporate governance structure, the reform of the renminbi’s exchange rate regime, and the introduction of a macro-prudential policy framework. These are all very important reforms and have had a significant impact on development of the Chinese economy and financial system.

How are you balancing the need to maintain growth but contain inflationary pressures? Do you expect monetary tightening to continue?

After the outbreak of the financial crisis, a stimulus policy package had to be adopted promptly in China to mitigate the impact of the crisis, through the use of expansionary fiscal and monetary policies to restore market confidence, to stabilize economic growth, and to support recovery. Overly expansionary policies may be associated with inflationary pressure, but the priority at that time was to address the impact of the financial crisis.

The price hike that began in the second half of 2010 is related to the expansionary measures, and also to many other factors, such as excessive global liquidity, massive capital inflow, output fluctuation of domestic agricultural products, rising labour cost, and so on.

As the recovery was more and more solidly based, the PBC promptly shifted the focus of macroeconomic policies and took inflation control as our top priority. We will not adopt macroeconomic policies that might trigger a hard landing. Rather, PBC aims to achieve a soft landing by having the policies gradually produce their effect, and pays attention to preserving the stable and sustainable growth of the national economy. Having a medium-term inflation target of around 4% is aimed at achieving a balance between growth and inflation, and providing room for correcting price distortion and further marketization. Globalization and the continuing opening-up process have also made some sectors of the Chinese economy more susceptible to the international capital flow and commodity prices volatility.

Banks in China complained twice, around this Spring Festival and in July, of very tight liquidity conditions. How do you weight the need to preserve banking system liquidity against trying to control inflation?

Some people may feel that money is fairly tight, because they compare it with the crisis-response period in 2009 and 2010. In fact, money and credit growth are comparable to their normal pre-crisis levels. This, in my view, reflects the return of monetary policy from the unconventional, crisis response mode to its normal state.

Many economists see increasing the deposit rates up to above the inflation rate as the key to encouraging domestic consumption and curbing the speculative investments in commodities and real estate. Do you agree? What are the necessary conditions for a hike of the deposit rate in the near term?

The PBC has always valued the use of interest rate tools. Since October 2010, the benchmark interest rates have been raised five times. In an increasingly interconnected global economy, central banks need to evaluate international financial market and global economy when considering the use of price tools. With recovery in major advanced economies being tepid and global liquidity abundant, a large volume of capital is flowing into emerging market economies and making their macroeconomic management more difficult. As such, in order to make our monetary policy more effective, we need to carefully calibrate a combination of price tools, quantitative tools and macro-prudential policies.

You’ve said that it can be difficult to strike a balance between fighting inflation and meeting the financing needs of small and medium-sized enterprises. What measures can you take to remedy this? Many small and medium-sized enterprises complain that raising funds can be difficult. How justified are these concerns and what more can be done to help onshore fundraising?

The SMEs in China as a whole are getting improved access to financing. As of June 30 this year, outstanding SME loans grew 18.2%, about 1.3 percentage points higher than the general credit growth. In particular, the outstanding small enterprise loans grew 25.9%, about 9 percentage points faster than the general credit growth. As of June 30 this year, outstanding SME loans as a share of all corporate lending went up 3.7 percentage points from its 2008 level.

Admittedly, SMEs’ access to financing has always been a difficult issue, and this to a large extent is related to a shortage of small and medium-sized financial institutions and the underdevelopment of capital markets in China. At the current juncture when inflation is relatively high and monetary conditions are normalizing gradually, lending rates to small enterprises are likely to rise, and this will inevitably give rise to some complaints. A variety of measures are needed to address this issue, including speeding up financial reform and innovation, and allowing the market mechanism to better function.

Please assess the impact of the stimulus package. Did it achieve what you hoped it would?

In November 2008, the Chinese government adjusted the policy stance in a timely manner by implementing expansionary fiscal and monetary policies, and adopting an economic stimulus package. In general, these measures achieved the intended outcome, as they prevented confidence from plummeting, and promoted recovery of the economy. China’s economy began to show signs of recovery in March 2009, and it rebounded rather strongly in the second quarter of that year. The Chinese economy grew 9.2% and 10.3% respectively in 2009 and 2010, making China among the first to stage a recovery. Of course, expansionary policies also have costs. It is thus necessary to adjust policies in accordance with the changing economic condition, and bring money and credit growth back to normal. As a whole, benefits of the crisis-response package outweighed the costs, and the above-mentioned results are hard earned in an extremely volatile and complex global economic environment.

Many investors in China are concerned by the possibility of bad debts in local governments as a result of loans made during the stimulus package. How justified are they in these concerns and what can be done?

When seriously impacted by a global crisis, increasing public investments including infrastructure is an important measure to make up for the shortage of effective demand. Accelerated urbanization by local governments was part of the stimulus package, including increasing investments in infrastructure, utilities and public housing.

A majority of the projects of local government financing platforms generate returns and cashflows that are sufficient to pay off the debt, or are able to cover the costs through value added from the urbanization process. In some cases, repayment of public projects is guaranteed with local fiscal revenue.

In general, local government financing platforms were created by local governments [in order] to undertake urbanization projects under existing laws. The level of government debt in China is manageable. Admittedly, some individual projects might be risky, but they will not generate systemic problems.

You have said that China needs to move to a more prudential regulatory framework for the financial sector. Will this mean banks have to hold more capital? Will it be applied to all of the financial sector, or just to strategically important institutions? How do you counter the danger that such measures might lead to less credit being available to the private sector, as in the Western markets?

Enhancing the macro-prudential policy framework is at the core of global financial regulatory reform in the wake of the financial crisis, and an operational policy framework has been developed by the FSB, BIS and BCBS at the request of the G20. As an important G20 member, China supports post-crisis efforts to build a more prudential financial regulatory structure. China has been working with other countries to promote international financial reform and develop new financial standards, and is working to strengthen and improve macro-prudential policy framework at home.

[In order] to prevent systemic risks and ease pro-cyclical volatility in the financial system, it is necessary to improve financial institutions’ capital quality and capital adequacy. As China leads the post-crisis recovery, it is in a different phase of the business cycle from that in most western countries.

For the Chinese banking system, the challenge now is credit expansion rather than credit crunch. In this context, macro-prudential standards are needed to support healthy and stable economic development and to provide greater credit support to the private sector in the long run. PBC plans to develop, in a continuous way, a systemic-importance coefficient for each commercial bank, so that a majority of large and medium-sized Chinese banks will be required to, to varying degrees, increase their capital buffer in line with macro-prudential principles, thus avoiding the cliff effect.

You have admitted that China’s foreign exchange reserves have "exceeded reasonable levels". What are the dangers of this? How do you counteract it? How do you intend to diversify these reserve assets?

The Asian financial crisis and the recent global financial crisis led people to rethink the role of foreign exchange reserves. FX reserves provide for greater resilience against international payment risks, but this does not come without a cost.

Unreasonably high levels of excess FX reserves are not an optimal choice for resource allocation. There can be a better alternative that produces greater social welfare and more healthy economic growth. Achieving a better alternative, of course, would take some time, and this is especially true for a large economy.

This brings up the issue of dynamic optimization during this process. China endeavours to properly manage this process and achieve dynamic optimization under various constraints. One of the costs of excessive FX reserves is the difficulty it brings to inflation control. This is why PBC makes great efforts in sterilization operations to absorb the base money supplied through reserve build-up.

In reserve management, the PBC always follows the principles of safety, liquidity and reasonable earnings. We adopt a diversified investment strategy and, with good results, properly manage the currency, product, industry and geographic structure by following an optimal portfolio management model.

Technically, managing reserves of a certain size is not particularly difficult. The difficulty comes from excessive external volatility and uncertainty. Optimizing the allocation of FX reserves requires China to promptly implement the 12th Five-Year Plan, accelerate the transformation of the economic structure and economic growth model, and achieve a better macroeconomic balance.

How important was the opening up of the offshore renminbi debt market over the past 18 months?

Development of the offshore renminbi debt market is mainly a response to demand from the real economy, and it facilitates trade and investment. Facing turmoil in financial markets and large fluctuations in major currency exchange rates, it is the choice of many multinational companies to issue renminbi bonds in the offshore market [in order] to reduce currency mismatch.

What prompted you to take the steps to open the market at the time you did? How encouraged are you by the early demand for this product from both issuers and investors?

In terms of monetary cooperation, after the outbreak of the financial crisis, some central banks in Asia, such as Bank of Korea, requested currency swaps with the PBC. Considering the need for public support, we chose bilateral local-currency swaps. Since then, the PBC signed a series of local-currency swap agreements in response to requests from other central banks.

In terms of trade settlement, after the financial crisis broke out in 2008, companies expressed strong interest in using local currencies to settle international trade to lower exchange rate risks, and they applied to launch a pilot programme of renminbi trade settlement. In practice, ever since the 1990s, the renminbi had been frequently used in border trade with Vietnam, Myanmar and Mongolia, which laid a good foundation for renminbi trade settlement. In terms of direct investment, Xinjiang, among others, initiated a pilot programme of renminbi settlement for direct investments in 2010, which is a natural outcome of the renminbi’s gradual acceptance in foreign countries.

In the past two years, we observed a relatively strong demand by market participants in the offshore renminbi debt market. Development of this market should help trading partners and investors reduce currency mismatch, lower exchange rate risks, and thus better support trade and investment activities in the real economy.

How will you boost channels for overseas renminbi funds to be remitted to the mainland?

In theory, the restrictions on renminbi inflow can be abolished. However, the international financial market is not stable for the time being. To counter the impact of the financial crisis, major economies have adopted quantitative easing and zero or near-zero interest rate policies. With relatively high interest rates, emerging market economies become recipients of massive hot money inflow. We will continue to monitor and evaluate the effect of the policies supporting cross-border use of the renminbi, serve the needs of the real economy, and gradually expand channels for renminbi inflow.

How important is it to effectively manage the growth of volumes in this market? How do you envisage the development of the renminbi as a currency of choice for cross-border use?

The key policy consideration is to enable the cross-border use of renminbi by lifting unnecessary restrictions, and then to respect the voluntary choices of market participants, rather than having any quantitative goals for offshore market or transaction volume.

Generally speaking, we are optimistic about the use of the renminbi in trade and investment activities. China is a major trading economy. Nonresident renminbi holders are able to purchase all kinds of goods and services from China and do not need to worry about how to use the money. As such, the renminbi should have a good prospect in trade settlement.

Cross-border direct investments in renminbi are also expected to grow, since China’s inbound and outbound direct investments are both large and growing. In addition, renminbi trade financing and project financing has already started and will gradually grow.

What is your view of the current global financial situation?

Affected by the sovereign debt problem in Europe and the US, the international financial market has seen large fluctuations recently, and the momentum of global recovery is weakening. This reflects market concern about the political will and capacity of these countries to deliver fiscal consolidation and solve the sovereign debt problem, and shows investors’ worries about the recovery outlook of the global economy, in particular recovery in the US and Europe. This might imply that traditional policy measures are not sufficient to bring about stable global recovery, and thus more and bolder moves are needed.

Since the outbreak of the international financial crisis, G20 leaders have acted concertedly and promptly, producing a consensus for cooperation at their summits that helped stabilize market confidence. This initiative played a vital role for the world economy to weather its worst time.

The IMF and other international organizations also followed a conventional rescue approach, providing massive rescue money to crisis-hit countries. But the continuing crisis demonstrates that the traditional rescue approach might not be sufficient. Relevant countries should work together, and develop more decisive and resolute measures to respond to the crisis.

How did you react to the news of the US’s credit rating downgrade as the largest holder of the US Treasury bonds?

If a country has excessively high levels of public debt-to-GDP and current account deficit-to-GDP, and if it allows such ratios to keep rising for a long time, problems will come up sooner or later. As such, adjustments should be made in a timely fashion. The later the adjustments, the higher the costs will be. Policymakers should have the necessary determination to solve problems facing the country, and put in place the capacity and mechanism for self-correction.

The S&P downgrade has not changed the fundamentals of the US economy. The US remains the strongest economy in the world, and still enjoys advantages such as market flexibility and capacity for innovation. I am rather optimistic that the US will eventually overcome the financial crisis and solve its own problems.

Moreover, as required under the G20 framework and by the FSB, China has greatly reduced its reliance on external credit rating agencies. We will make investment decisions mainly on the basis of internal rating and analysis. Therefore, rating decisions by major international rating agencies, upgrading or downgrading, do not have a strong impact on China.

You recently urged the US to employ "concrete and responsible measures" to preserve the value of treasury bonds, Could you elaborate on what those measures might be?

Like many central bankers, I hope the US will handle its debt problem properly and make the treasury bonds market function normally. The US has the capacity and potential to solve the cyclical and long-term structural problems in its economy, and bring its fiscal condition back to a sustainable track. We are closely monitoring the process and have frequent communications with the US side.

Many in the west consider Asia, and particularly China, as the key to growth in the global economy. What pressures does this place on you?

We are willing to contribute to post-crisis global recovery. Securing China’s own economic recovery is in itself the most important contribution. During the crisis, China adopted expansionary fiscal and monetary policies to encourage investment and consumption. Such measures are in China’s own interest and have also helped recovery of the global economy. In this sense, there is no extra pressure.

The real pressure lies in how to strike a balance between the speed of growth and its structure, and between quantity and quality of growth. Overheating is likely to give rise to inflation and slow down structural reform. China is an emerging market and a transitional economy, and correcting distortion and achieving structural adjustment are very important in the transition process.

China has contributed its share in global economic growth. We will focus more on the quality and balance of growth through measures such as energy saving and emission reduction, expanding domestic consumption and accelerating the growth of service industries.

How important is it to open up China to international banks? And also, how important is it for China’s leading banks to build international operations?

At the end of July 2011, China had 39 solely foreign-owned banks and joint venture banks with parents from 14 countries and regions, and 76 foreign banks from 25 countries and regions have opened 92 branches in China. Foreign institutions hold equities of 12 securities companies and 38 fund management companies. There are 115 qualified foreign institutional investors (QFIIs) on China’s stock market. In addition, 52 insurance companies from 16 countries and regions have established joint ventures and solely foreign-owned insurance companies in China.

Opening up markets to international banks and allowing them to provide competitive services will help all banks, both domestic and foreign, to improve competitiveness. As an economy in reform and transition, financial institutions in China in the past lagged behind in their competitiveness, business skills and quality of service. Open competition has greatly accelerated the improvement of China’s financial institutions.

At the same time, it is equally important for Chinese banks to expand their international businesses, and participate in international competition and cooperation. First of all, China is a big trading economy and investor. It attracts foreign investments and also invests abroad. Chinese banks need to support and provide services for cross-border trade and investment activities.

Secondly, China has a relatively high savings rate. Although it has adopted a series of structural policies to reduce savings and expand consumption, it takes time for these measures to work. During this process, a large volume of capital is looking for international investment opportunities and seeking international businesses. Thirdly, Chinese financial institutions will improve and gain international competitiveness by developing international businesses.