Zhou Xiaochuan, governor of China's central bank, is an influential figure. But he is not as important as Alan Greenspan. His successors will be though. Global financial markets will hang on their words - once they’ve been translated. This is because monetary policy will soon work as effectively in China as it does in the United States, and that will give the people who influence rates enormous power.
Mr. Zhou's limited influence is easy to understand. China's monetary policy still does not work as it might- bank-interest rates are mostly administered and many state firms do not worry about the cost of funds when they borrow. That means the People's Bank of China does not have anywhere near as much leverage over its economy as the Federal Reserve does.
In addition, the PBoC is currently caught on the back foot trying to cope with China's large foreign-exchange inflows, rather than being allowed to set rates to suit the needs of the domestic economy. A stable currency is of course not without its merits, but it falls upon the PBoC to stop any unpleasant inflationary fallout. And lastly, unlike Mr. Greenspan, Mr. Zhou works within a central bank that lacks institutional independence.
However, this is all changing. Interest rates in China are rapidly becoming freer, the PBoC is busy putting the infrastructure of modern monetary policy into place, and wider structural changes in the economy mean that rates already have more of an impact than they once did. Once the peg to the dollar is relaxed, and structural reforms are completed, then monetary policy will, over the next decade, become the main means by which China’s economy is managed, as it is in the United States.
So, here are three questions: First, why does monetary policy not work that well in China at present? Second, is the pegged exchange rate really causing the authorities serious monetary problems, as standard macroeconomic theory predicts? And what will a China with "free" interest rates and a more flexible currency look like?
In mature market economies, the interest rate is the main means by which the authorities moderate aggregate demand, calm inflation and, depending on their mood, reassure or petrify financial markets.
In China, it doesn’t quite work like this - at least not yet. Take two examples. In the late 1990s, China’s economy was in a rough way - real growth was probably plumbing the lows of 4% to 5%, and by some estimates it actually stopped. Deflation was everywhere, and the government was worried. In response, the PBoC brought bank interest rates down sharply. (The PBoC controls the overnight borrowing rate, but at present this is ineffective, so its rate policy is mainly achieved through adjusting the rates at which banks lend and borrow.) The one-year loan rate, for instance, fell to 6% in June 1999 from 15% in July 1995.
Nothing happened. In fact, credit growth actually fell. In order to get the economy going again, the government had to resort to a big fiscal stimulus. Treasury-bond issuance rose, and in 2001 many analysts suspect the central bank simply asked the banks to lend more. That marked the beginning of the huge credit expansion and investment boom that we are only now nearing the end of. The lesson that many economists took from this debacle: Fiscal policy works; monetary policy does not.
Fast-forward three years to when the government needed to calm things down. Year-on-year annual M2 growth hit 21.6% in August 2003, overall bank credit grew at 23.9%, and annual fixed-asset investment was booming at 30% to 40%. Overinvestment, officials worried, was going to create overcapacity and saddle the banks with a new wave of nonperforming loans. Something had to be done.
But what? Since monetary policy was apparently ineffective, raising rates was not a realistic option. Instead, the government curbed its fiscal stimulus and opened up its planned-economy toolbox. In April 2004, a "macro-economic adjustment" program was rolled out. This was targeted at several heavy industries, including steel, cement and charcoal. The National Development Reform Commission was given power to authorize (or not) a large swathe of investment projects, control over land development rights was tightened, and banks were advised to curb their lending appropriately. Instead of making funds more expensive through raising rates, the government chose to make them harder to obtain.
By June 2004, M2 growth was back below 16% year on year, domestic credit growth had fallen back, and consumer price inflation was heading downward. The PBoC was allowed to raise bank rates just once, in October 2004, by 27 basis points, perhaps just enough to signal rates could rise - but apart from that it has played a subsidiary role in macro-policy over the past 18 months.
Given this experience, it would be easy to be pessimistic about the prospects for monetary policy in China. Will fiscal policy always win out?
The answer has to be no. Ongoing structural changes mean that China’s economy is more sensitive to interest rates than a decade ago. State companies now often have to repay their loans, and so care more about the cost of funds. As more state firms are sold off, they will lose their lobbying power to keep rates low. Private companies are increasingly accessing credit, and they are sensitive to rates. Banks now lend much more to consumers - they account for 11% of today’s outstanding loans - and these customers will be sensitive to rate changes.
Many economists believe that rates could, and should, be used now to moderate excess demand in China. Consumer inflation may have calmed, but only because utility prices have been controlled through administrative measures. Upstream raw materials' inflation is much more serious than CPI - these prices are increasing at 5% to 6% a year. This is a problem since real rates (calculated by taking expected inflation away from the nominal rate) are still very low, and this has kept up investment demand during the 2001-04 boom.
Put aside all the controversy over whether the yuan is hurting the U.S. economy. Instead, let us look at the domestic consequences of the peg, and assume that the yuan is undervalued (which the rapidly growing current account surplus indeed suggests is the case). Usually, undervalued currencies cause inflation. This is because a cheap currency means more exports than imports, and the resulting current account surplus causes net inflows of money from overseas. These inflows add to the monetary base, banks lend all this money out to new customers, and before too long prices are rising because there is too much money chasing too few workers and goods.
In China's case, these inflows have been coming thick and fast - $206 billion last year, $101 billion in the first half of 2005, a 50% year-on-year growth rate. The PBoC has relied on three tools - and some good luck - to cope with these inflows.
The first tool is open market operations, mainly using PBoC bills. These allow the PBoC to take money off the commercial banks' books, giving them bills instead. The banks cannot lend out these bills to customers, thus stopping the creation of new money by issuing loans.
Net bill issuance accelerated in late 2004 to cope with forex inflows of $20 billion to $30 billion a month, and remains at high levels. During 2004, the PBoC withdrew a total of 616 billion yuan ($74.5 billion) from the monetary base through bill issuance in the interbank market. This was the equivalent of 36.1% of forex inflows for the year. In addition, the PBoC appears to have secretly issued 196.6 billion yuan ($23.8 billion) in PBoC bills sometime in May-June 2004 to the four state banks. In total, the PBoC sterilized 812.6 billion yuan ($98.3 billion) during the year, equivalent to 47.5% of forex inflows during 2004. This year, bill issuance has been ramped up more. In the first half of 2005, Standard Chartered Bank estimates there was an increase in outstanding PBoC bills of 645 billion to 672 billion yuan, soaking up the equivalent of $78 billion to $81 billion worth of the forex inflows. In other words, the PBoC sterilized 68% to 71% of the inflows.
The second tactic to control forex reserve inflows has been higher required reserve ratios, which are prudential requirements on banks to place a certain proportion of their deposits with the central bank. On September 21, 2003, the RRR was raised to 7% from 6%, and to 7.5% on April 25, 2004. These moves had the effect of withdrawing 203 billion yuan ($24.5 billion) and 111.2 billion yuan ($13.4 billion) from the system.
Moral suasion has been the PBoC's third tool. Officially, this involves guidance on which sectors banks should lend to - less to cement and real estate, more to agriculture and small- and medium-sized enterprises, for example. However, in practice many suspect it also involves the PBoC guiding the banks on how much to lend. The fact that overall credit growth has so closely cleaved to the PBoC's target strongly suggests that the big banks are coordinated.
The degree to which this has taken place, however, is difficult to judge. That's because the PBoC had a stroke of good luck. At just the right time, China's commercial banks are trying to meet the new capital-adequacy ratios of 8% by January 2007 that the bank regulator has imposed. Investments in PBoC paper and most other forms of debt, which carry no capital requirement, are now preferable to loans to corporates, which demand a capital equivalent of 100% of the value of the loan. This is apparently causing the banks to draw back lending, helping the PBoC out.
All this has important consequences for the costs that China has to pay to defend the peg. With big forex inflows, fast growing bank deposits and few other investment options, commercial banks are keen buyers of PBoC paper. This has meant that there are large amounts of liquidity in China's money markets, which has driven yields low. The overnight borrowing rate in the market is now hovering around 1.2%, and one-year PBoC bills sold for 2% in late May, down from an average in 2004 of 3.2%. The second chart shows the overnight repo rate just above the floor provided by the excess reserve rate of 0.99%.
This means that sterilization is surprisingly cheap in financial terms - it only cost the PBoC an estimated $3.2 billion last year to pay for all its bills, compared to some $15 billion to $18 billion of returns it would have made from investing the country’s massive reserves overseas. Even on a marginal basis, the widening rate gap between China and the U.S. means that the PBoC is making money on the deal.
This has implications. The government has shown it can cope with the forex inflows, at least so far. The scale of PBoC bill issuance - outstanding bills are now equivalent to 12.5% of GDP - is cause for concern, but again it is being managed. This weakens the case for a big one-off revaluation - more than 6%, say. Certainly, more flexibility - an initial band widening of 3% to 5% - would be welcome (and a consensus appears to be emerging in favor of such a move). But the danger of undermining export growth with a big revaluation currently outweighs the danger of sparking more forex inflows with a small first move.
Now assume for a moment that the government reforms the currency regime successfully and over the next decade manages to complete its interest-rate liberalization program. By 2015, the renminbi trades against a basket of currencies, and capital flows in and out of China more or less freely. The PBoC sets the overnight borrowing rate at regular meetings, just like the Fed, and the commercial banks set their own lending and deposit rates. An active bond market, populated with decent private companies as well as government paper, means that a full yield curve can be calculated. What would all this mean for the economy?
Here are five things to expect:
The PBoC will quack like a modern central bank, but it won’t quite walk like one. Its team of in-house economists will be world-class, and its monetary-policy committee will enjoy much greater sway over economic policy than today. With state-owned industry marginalized, there will be less need to keep real rates low and stable. With monetary policy in play, the planned-economy tools - and their institutional sponsors - will wither away. Rate changes will be more regular. Firms and China’s 400 million-strong middle class will react when they rise. People will have to cope with higher mortgage costs.
One caveat: The PBoC will still be a government organ, with its governor appointed by the Communist Party leadership. Up till now, the PBoC has not suffered the usual problems associated with nonindependence - the government, for instance, has not told it to finance public debt, thus triggering inflation. This is likely to continue given the Party's strong preference for stability, both social and monetary. However, by 2015 the government will likely have built up more debt, which higher rates of inflation would erode, so the temptation for higher inflation will be there. Too low rates will also be a temptation.
A more flexible yuan will give more independence to monetary policy, but it won’t be total since exchange-rate considerations will still influence the rate decision. Over the next 10 years, interest rates will rise and fall more in relation to China's own economic cycle. However, it will not be all that easy since the PBoC will have to cope with structural pressure for yuan appreciation. China's rapid productivity growth - some 2.5% a year over the last 25 years - will be sustained if privatization, social security and financial sector reform are forced through over the next decade. Currencies tend to appreciate as productivity, particularly in the export sector, improves.
However, the importance of the tradable sector to China's GDP and job creation means that the currency will have to be managed much more, at least over the medium term, than in other continental-sized economies. This means that the yuan will appreciate against all of its trading partners over 2005-2010, but in order not to derail growth it will move only gradually. The yen's appreciation vis- a-vis the dollar from 1985, which led to an asset bubble and then the lost decade of the 1990s, is exactly what China wants to avoid. With an undervalued currency, the PBoC will likely continue to have to cope with net capital inflows. We expect the reserves to hit $1 trillion in June 2006. The central bank may well find that hiking rates at home exacerbates forex inflows, and this will constrain its monetary independence. The problem then will be that low rates will predispose the economy to asset bubbles.
Moving interest and exchange rates will drive the development of China's financial markets, as companies seek to hedge themselves against risks they've never had to face before. China's currency forwards market is currently small, with only a small number of local banks allowed to offer contracts, with price guidance from the PBoC. In May 2005, the PBoC released rules that expand the ambit of forwards, allowing interbank members the right to trade bills on a forward basis. Expect rapid development in these markets once there is exchange-rate flexibility.
Expect a few banks to experience some rate-related distress. A recent PBoC survey despaired of banks' inability to price and manage credit risk. This is holding back rate liberalization. As rates are relaxed, despite everyone's best efforts, a few of the smaller banks will likely experience problems as a result of mispricing loans or underestimating credit risks. Lower limits on bank loans and upper limits on bank deposits will remain in place for quite some time - perhaps until 2010.
Mr. Zhou's successors will not enjoy their new-found influence. China's PBoC will be the only developing country central bank with the power to move global markets like the Fed, the European Central Bank and Bank of Japan. That is all well and good. However, given the relative volatility of China’s economy, the lack of transparency of the decision-making process and the fact that the PBoC still has to learn how to manage the market's expectations, this will be a challenging job.
Monday, August 15, 2005
The Far Eastern Economic Review features an interesting piece about the future course of the People's Bank of China (PBoC). Author David Green, senior economist at Hongkong's Standard Chartered Bank outlines the gaining importance of China's central bank in financial markets.