Zhou: the man with China's bandaids

Central bank chief Zhou Xiaochuan has a progressive view on economic reform. Why, then, did the conservative politburo bend the rules to postpone his retirement?

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Reaffirming that authoritarian systems are far better at event logistics than their democratic counterparts, the 12th National People’s Congress concluded without any major hitches or hiccups. Carefully scripted and choreographed, the new Chinese cabinet was ‘elected’ and sworn in, with Xi Jinping taking his place as president and Li Keqiang appointed premier as expected.

One of the few unknowns was whether the Chinese Communist Party powerbrokers would bend the retirement rules to allow the 65-year-old Zhou Xiaochuan another term as central bank governor. A February report in the China Securities Journal seemingly let the cat out of the bag when it reported that Zhou would step down the following month during the National People’s Congress. The fact that Zhou retains this important role is encouraging indication that the hope for genuine economic reform lives on – even if reformers such as Zhou remain in the minority.

What’s the big deal about Zhou? Ranked fourth in the Foreign Policy Top 100 Global Thinkers report in 2010 and included in Bloomberg’s 50 Most Influential for 2011 and 2012, Zhou has an undergraduate degree in law and a doctorate in economics. But more important than accolades is Zhou’s standing and integrity as the country’s chief banker since 2002. He is a renowned straight-shooter on economic and reform matters which is rare in an opaque system staffed mainly by obsequious bureaucrats and officials. For example, Zhou has been one of the earlier and loudest voices calling for the winding back of capital and opportunity afforded to state-owned-enterprises as far back as the middle of the last decade.

The central banker also held little back when he became the highest ranking official warning about the systemic threat to the banking system resulting from hundreds of billions of dollars of loans to local government financial vehicles to invest in the property market from 2009 onwards. With still at least $US1.5 trillion of these loans still outstanding, Zhou’s urging did much to convince senior party officials to rein in the speculative excesses of local governments who became increasingly dependent on proceeds from the property for a significant proportion of its revenue. Although local government loans continue to pose a systemic threat to the country’s banking system, Zhou was one of the few technocrats not asleep at the wheel when the outstanding loan book of Chinese banks expanded by almost 60 per cent from 2009 to 2010.

Then there is Zhou’s external outreach and standing. He has consistently championed China playing a greater role in existing global institutions such as the International Monetary Fund and World Bank, often against the political wishes and instincts of many of his political masters. Zhou’s enlightened position is that the world’s second largest economy accepting a greater role and responsibility in these institutions is better for global and Chinese systemic stability and cooperation.

At the height of the GFC, Zhou was also the primary voice behind the suggestion that the US dollar be replaced as the international reserve currency by a new global regime controlled by the IMF. His suggestion was to use the IMF’s special drawing rights – whose value is based on a basket of currencies – as the new reserve currency. Although the proposal came to nothing, the point is that the instincts of China’s top banker is to find innovative responses within existing institutions – and for China to play a lead role as a responsible and innovative advocate of possible solutions. True, China is simply using existing institutions to push its interests. But this is what one should expect of any country. And as former American President Lyndon Johnson said about then FBI director J. Edgar Hoover, with whom the president had a troubled relationship, "It’s probably better to have him inside the tent pissing out, than outside the tent pissing in".

So why did Beijing’s powerbrokers bend the retirement rules for Zhou given that it is a fairly rare occurrence to do so? Although no one can doubt Zhou’s patriotism, he is hardly the mouthpiece for the faceless men of the CCP. His advocacy for the private sector to be given more capital and opportunity does not sit well with many CCP officials wanting to protect party and individual vested interest. Why give what some would see as a troublemaker and stirrer another five years in the top banker’s job?

It is not because there is an enthusiastic majority in the Standing Committee of the Politburo enthusiastically wanting to reform the country’s state-dominated economy. As I wrote on this site a fortnight ago, (China wavers between Party and progress, March 6) the country’s reform minded Premier Li Keqiang is surrounded by conservatives in the standing committee. Although moderately high economic growth remains a paramount priority, fundamentally reforming the economy is not on the cards.

More likely, it comes down to a majority view of economic reform as a technical fix rather than a transformative project. Let me explain.

Zhou’s command of the economy is highly regarded and widely recognised. Although few of China’s top leaders truly want to wind back the role of SOEs in the national economy, there is now universal recognition that the current political-economy has led to serious economic and social distortions throughout the country. That is the inevitable consequence when the least deserving receive a lion-share of the country’s wealth and opportunity.

Although Zhou has pushed for fundamental reforms over the past decade – such as overhauling the lending and risk policies of China’s banks, floating the yuan and opening up the country’s capital account – the People’s Bank of China is not an independent agency of the government but must follow the direction of the politburo and its various subcommittees. Over the past decade, Zhou’s full and frank advice has been sought after and received. But Zhou’s role has been to use his expertise and the policy tools and resources of the central bank to apply technical fixes to stabilise a rickety financial system and economy. Zhou (and the central bank) is used as a trouble-shooter, not as a reformer with a mandate to transform the political-economy.

A few examples will help to make the point.

Take the bouts of high inflation faced by China during Zhou’s decade long tenure: in 2004, 2008 and 2011. In each of these episodes, inflation was fuelled by the massive expansion of bank credit. Zhou was asked by his political masters to stabilise prices and rapidly bring down inflation. The obvious policy response would have been to raise interest rates significantly – a tool that was not made available to Zhou given the leadership’s higher priority of ensuring ongoing finance for SOEs. Indeed, Zhou has consistently urged Beijing to liberalise interest rates to prevent the ongoing systemic threat of asset bubbles and inflation. Instead, Zhou was forced to reach into a different kitbag of tools and resorted to more technical measures such as setting lower ceilings for bank credit expansion and imposing higher reserve requirements on banks.

The 2005 managed appreciation of the yuan – a Zhou initiative – is also revealing. Zhou had been asking Beijing to float the yuan for months, arguing that continuing the American peg forced China to replicate America’s low interest rates in order to halt the speculative inflows coming in through the back channels of a closed capital regime. The peg was also expensive and inefficient for the People’s Bank of China to maintain (due to the huge level of currency intervention required to maintain the peg) also made basic imported goods artificially expensive. Indeed, Zhou persuasively argued that one of the few real winners from the policy were foreign multinationals then dominating the domestic export manufacturing sectors.

In June 2005, Zhou got his wish of a managed de-pegging. The yuan immediately appreciated 2.5 per cent in July 2005 and rose another 19 per cent against the dollar up to mid-2008. Zhou had also asked for greater interest rate liberalisation and a reform of bank lending practices away from inefficient SOEs. All these moves were essential to reform the economy and ensure that any short-term pain produced longer term gains.

The problem was that yuan appreciation without other reforms would only cause pain to exporters with few overall gains for the economy. Premier Wen Jiabao’s failure to push through the other reforms meant that yuan appreciation received the lion-share of the blame for China’s economic woes leading into 2009. Since then, there has been no significant currency policy reform and Zhou has had to resort to more marginal measures such as a slight widening of the band within which the yuan can trade against the dollar. Meanwhile he continues to fight the good fight on currency reform.

The lessons from the past 10 years are clear: Zhou’s job is not to transform the economy but to apply technical fixes to some of the imbalances of the country’s state-led approach. Periodically, he is asked to stabilise the financial system without actually reforming and strengthening its foundations.

His reappointment is a highly welcome move. But he needs to be set free and not merely deployed as the party’s chief resident trouble-shooter.

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.