Strategize, Adapt, Reform
Amid global economic uncertainty, People's Bank of China Governor Zhou Xiaochuan is one of the world's most talked-about central bankers.
Zhou attracts as much attention as U.S. Federal Reserve Chairman Ben Bernanke and European Central Bank President Mario Draghi because the world's financial markets are vitally interested in China's interest rate trends, bank deposit reserve ratio adjustments, and yuan-dollar exchange rates.
Zhou is a big-thinking strategist with firm ideas about financial reform. He's also a tactician who can find opportunities for promoting reform in any situation. His harmoniously pursues realism and idealism, seeking gradual progress while pushing for financial reform.
The year 2011 was difficult and complex for China' economy. The year 2012 will be no different. What does Zhou see ahead, and what lessons can be learned from the past year?
In an interview in December, shortly after the Chinese government set its 2012 policy goals at the annual Central Economic Work Conference in Beijing, Zhou sat down with Caixin to discuss his personal and the central bank's views toward inflation and monetary policy adjustments, interest rate control, exchange rate reform, capital account liberalization and the internationalization of the yuan. His comments follow:
Caixin: China's macro-economic policies were adapted to fit changing economic situations in 2011. How do you see the economic situation in 2012 and corresponding policy options?
Zhou Xiaochuan: The Central Economic Work Conference clearly articulated macro-economic policy, taking into account two considerations: Efforts to prevent an economic downturn, and efforts to restrain inflation.
First, we are encountering concurrent issues in the international arena, including an evolving European debt crisis, U.S. economic uncertainty, and slowing growth in emerging economies. More importantly, the international economy is changing rapidly, and its outlook remains uncertain. Thus, we must be prepared to respond to new situations.
On the other hand, looking at China's domestic economy, local governments will have leadership reshuffles in 2012 and the capacity for growth in the Chinese economy is still great. At the same time, the consumer price situation has changed for the better, and the need to control inflation is not as pressing as it was in early 2011. Of course, there are still uncertain factors, such as the impact that the real estate market will have on the national economy.
Overall, we need to plan for the worst external environment without relaxing efforts to keep prices from rising too quickly. We need to rationally manage inflationary expectations. Meanwhile, economic structural adjustment is still a difficult task. Macro-economic policymakers need to weigh all these issues.
China's consumer price index grew 4.2 percent in November, 1.3 percentage points below October's and below market expectations. How do you view this change?
The target of 4 percent inflation set for full-year 2011 may have been hard to achieve. Ultimately, it was likely to be around 5 percent. Technically speaking, year-on-year monthly comparisons sometimes give wrong impressions. Since the global economic crisis of 2008, economic data has fluctuated significantly, making for a large base-number effect for year-on-year comparisons. The effect of the base number must be considered in all monthly year-over-year numbers.
I have always advocated the use of seasonally adjusted sequential data, which reflects CPI trends quickly. In short, inflation control has achieved some results and is moving in the right direction, but we cannot be too optimistic.
From the perspective of the domestic driving force contributing to the growth of the Chinese economy, the quality of life for Chinese people needs further improvement. There is still plenty of potential in urbanization, and there is still room for expanding the nation's infrastructure on a large scale. These projects are all somewhat government-led.
Looking at national conditions and China's stage of development, the domestic economy is prone to overheating. Looking internationally, CPI growth in emerging markets is generally higher than in developed countries. This is not to say that there is currently a risk of overheating, but that inflation cannot be taken lightly.
How do you assess the effects of China's integrated use of quantitative tools and target-price-based instruments to achieve regulatory goals in 2011?
There are several aspects that require attention. First, the frequency and intensity of using quantitative tools and price controls are different. If you only look at the frequency of adjustments, it seems quantitative tools are used more often. But you need to look at the different strengths of the adjusted results that different tools accomplish.
Second, excess liquidity needs to be restrained. Only by estimating the existing liquidity situation can you judge whether a policy adjustment's strength is appropriate. Third is the judgment of neutrality. Because of the international imbalance, there should be quantitative hedging. Only when hedging reaches a certain point is it neutral. That is, you must distinguish tightening, neutrality and loosening based on quantity.
Of course, you have to consider the mutual impact of quantitative and price-based policies. In reality, they are connected. This can be seen clearly through a study of short-term borrowing rates on the interbank market. Quantitative adjustments bring price reactions. Conversely, interest rate adjustments bring quantitative changes in liquidity.
Since November, the Chinese financial institutions' yuan funds outstanding for foreign exchange have continued to decrease. Has this provided a certain amount of room for choice in monetary policy?
We've always had a relatively wide space for setting monetary policy. The policy tradeoff is mainly related to macro-control goals. For example, deciding whether to pursue higher unemployment or lower inflation requires repeated consideration of a balanced goal. Other future uncertainties will affect changes in policy objectives.
Of course, there will also have some constraints, and every policy choice brings some negative effects. Differing economic conditions in China's eastern, central and western regions, and a lack of domestic and international synchronization will generate arbitrage in opportunities. As long as the arbitrage is not on a massive scale, it is a question of balancing the positive and negative effects of policy, which requires making judgment calls.
You mentioned that now is a special time (for China's economic development). But is it also a time of reform?
Sometimes, reform's timing is complicated. Often, difficult reforms that require strong commitments are launched when pressures are relatively great. This is what we saw with the design of exchange rate reform in 1993 (which was implemented January 1, 1994). At the time, people said exchange rate reform required three conditions: very strong exports; adequate foreign exchange reserves; and experience in macro-economic regulation. The situation at the time was just the opposite, but reform was still pushed forward.
Calls for market-oriented interest rate reform have been heard frequently over the past year. How do you see the timing for further reform, and the risks?
Market-oriented reforms on interest rates are always being encouraged. Specific implementations should be introduced in an orderly fashion, and on the basis of overseas economic situations. From a sequencing perspective, the first step is, through reform, to put hard restraints on financial institutions. In this way, the competitive behavior of market players becomes more orderly, and price liberalization issues are not too great.
From past experience, soft restraints on financial institutions' competition behavior will always be ineffective, and there will be problems. It should be said that with joint-stock reforms and successful listings of 2010, the soft restraints and fair competition issues of financial institutions are gradually being resolved, and conditions are there for interest rate market reforms to advance.
When comparing international and domestic situations, domestic and foreign pressures have differed mainly since the financial crisis. China maintained a relatively high rate of growth, while some developed countries kept interest rates at zero. Advancing market reforms for interest rates at a time when there are wide gaps between interest rates will create some special problems.
The upcoming U.S. presidential election has created some pressure for yuan appreciation. On the other hand, from a market perspective, the yuan has showed a tendency to devalue. What is your opinion of this trend and any corresponding advancement for exchange rate reform?
A lot of results have been achieved in yuan exchange rate reform in recent years. In judging whether the exchange rate is at equilibrium, the current international comparison is mainly based on the current account balance. From the perspective of the current account balance, the yuan exchange rate has moved closer to the equilibrium point over the past few years.
There is a problem with lagging relations between the exchange rate and current account balance. Exchange rate adjustments will quickly affect decisions made by some manufacturers, such as whether to sell products internationally or domestically, or whether to procure domestically or abroad. But the deeper response involves adjusting capacity. A combination of adjustments to investing and factors of production are needed for them to adapt, and there will be a lag period, which is more obvious in China.
Changes in exchange rates cause readjustments in production capacity. For example, reallocating resources from the manufacturing industry to the service industry requires a process in order for changes to occur gradually.
China's current account surplus (mainly trade surplus) reached a peak in 2007 and 2008, and subsequently began to fall. The current account surplus at the end of 2011 may have ended up, being only around 3 percent of GDP. A current account balance inclining toward equilibrium is the result of structural and exchange rate adjustments.
Worrying too much about exchange rate adjustment and trade balance issues is inappropriate and useless because there is a process for resource allocation and adjustment. In reality, China has significantly developed toward equilibrium, although there will be fluctuations.
As for exchange rate reform, the closer the yuan is to the equilibrium level, the fewer difficulties will result from reform. At the same time, as the trading band expands and controls are further reduced, reform's difficulties will be smaller, and the conditions for yuan convertibility on the capital account will be increasingly present. In fact, exchange rate reform has, on the whole, developed for the better, with a number of international political implications.
Is the current two-way volatility of the yuan a temporary phenomenon, or does it fundamentally indicate that the yuan exchange rate has already been overshot?
In the past, people said expectations for the yuan were one-way appreciation. Until close to the equilibrium level, it would experience two-way expectations and two-way volatility. This sort of natural, bi-directional floating state is the goal that reform has pursued. But to truly reach this state may take more time. The movement in the current foreign exchange market is still mainly related to the external environment.
Speaking of foreign direct investment, many European and American investments in China did not bring the money back or even pay dividends in the past. Undistributed profits remained in a company's accounts. Now, if funds are tight in a parent company's host country, more profits (from Chinese operations) will be sent back (to the parent). Considering domestic factors recently, enthusiasm for overseas investment has rapidly increased.
In the past, many traders settled foreign trade payment in advance and made long-term purchases of foreign currency, resulting in a relatively high demand for yuan. Now, financing conditions for foreign trade are changing, and settlements are being postponed. This situation makes for periodic changes in foreign exchange supply and demand. Of course, there are individual cases of control evasion and using fake trading backgrounds for exchange arbitrage. For these and other reasons, the Hong Kong Non-Deliverable Forward contract has changed direction.
On the whole, these changes still have to be monitored. The most important thing is to look at economic fundamentals. Looking at the foreign exchange market, we still need to look at whether the current account is in surplus or deficit, (and) whether the net direct investment is flowing in or out; that is, whether direct investment from foreign businesses minus China's outgoing direct investment is positive or negative.
China's commodity trade surplus in 2011 may have been as high as US$ 150 billion yuan, and total FDI is still quite large.... Overall, the capital account and current account are still in surplus. The balance has improved significantly, but there have been no reversals for the fundamentals. Exchange rate movements need to be monitored further.
With the exchange rate approaching to the equilibrium point, can capital account convertibility be put on the agenda as well?
Some things still need clarification regarding capital account convertibility. In the past, there was an argument that full convertibility was understood as the highest standard. But in reality, international organizations have not clearly defined this. Most developed countries are not 100 percent freely convertible; maybe they only reach an 80 or 90 percent level.
Second, retaining necessary oversight is not an obstacle to the realization of convertibility. An internal International Monetary Fund opinion in 2010 said that to maintain macro-economic stability, it is rational for countries to implement a certain degree of management or employ temporary management measures for a capital account, especially for unusual, short-term capital flows.
In China's case, there are three principles to consider in the development of policy goals in the area of capital account convertibility. First, prudent macro-economic management of private and public debt must be implemented to prevent broad mismatches of currencies. Second, necessary oversight of cross-border financial transactions must be carried out. Currently, there are three oversight aspects that are internationally recognized and for which there is consensus: Money laundering, terrorist financing, and excessive use of tax havens must be prevented. Third, short-term, cross-border, speculative cash flows must be properly managed.
Discounting the above factors, comparing the 40 sub-items relating to capital account convertibility required by the IMF, one finds that, in fact, we are not far from the goal of capital account convertibility. There are two main difficulties. First, our concerns and worries about overseas investment by companies and residents are relatively high. This should be adjusted. The government's main responsibility is to educate investors, letting them accumulate their own knowledge and gradually undertake their own risks.
Another control is aimed at the problem of foreign companies coming to China to raise funds. Currently, foreign institutions are permitted to issue yuan debt in China, but equity financing is still prohibited. However, the China Securities Regulatory Commission is paying efforts to study the issues and the overall trend is to gradually liberalize. From this point of view, we are not far from capital account convertibility.
There is another prerequisite for capital account convertibility, which is for the yuan exchange rate to be close to the equilibrium exchange rate level. If the difference is too great, the hole for arbitrage will be relatively deep.
How do you view relations between yuan internationalization, market-oriented reform of the capital account, and maintaining the value of foreign reserves?
It should be said that this problem is a relatively weak link in research inside every circle. In theory, an optimal sequence should be designed in advance. Not every reform can be advanced following conventional procedures.
Some currently ask, How did the yuan become internationalized before convertibility? At the same time, they say other conditions are not yet in place. Will beginning to use yuan in place of foreign currency for import payments not cause China's foreign exchange reserves to grow faster?
Therein lie questions about understanding foreign exchange reserves. Some voices say higher reserves are purely bad. This idea is not comprehensive. It should be understood that the side effects of excessive reserves emerge when reserves increase too quickly, leading to a surge in funds outstanding for foreign exchange. If sterilization is inadequate, inflationary pressure will increase. Using yuan to pay for imports on the surface looks like replacing a portion of foreign reserve payment, but some foreign exchange reserves do not need to be sterilized.
Theoretically, reforms should first remove all unnecessary control policies and achieve capital account convertibility, and then push for overseas settlement of the yuan. But deregulation will not necessarily lead to an international currency.
Promoting cross-border use of the yuan stems from an opportunity seen at the beginning of the financial crisis. South Korea's capital outflows were quite conspicuous, and the country hoped to carry out a currency swap with China to increase liquidity and market confidence. But under those circumstances, if China had used U.S. dollars for the swap, it would have been unacceptable, because no one knew how the crisis would evolve. Thus, using local currency was proposed. Subsequently, more than 10 countries launched currency swaps with China, and wanted to go a step further by using yuan for trade and investment settlement.
At that time, the market confidence for dollar was declined due to the impact of the crisis. This was a little providential. This sequence of events certainly did not conform to general rules. But if neighboring countries welcome the yuan without it being convertible, why stop it? Of course, the basic logic is that we will have to streamline the procedure sooner or later. The sequence of what we do now may be contrary to common sense of the past, but this is not necessarily a bad thing, because it was created by opportunity. It can also force us to do things we had not done.
The internationalization of the yuan depends primarily on the degree of its acceptance by the market. First, this is affected by the progress of China's reform and opening. With slow reform, its popularity will fall. Second, related to the sustainability and stability of macro-economic growth. China's macro-economy now is relatively good, but in fact we have many difficulties and challenges.
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