By Hu Rongping (胡蓉萍)
Issue 610, Mar 11, 2013
Market, cover
Translated by Zhu Na
Original article: [Chinese]

On Sept 15, 2008, Lehman Brothers investment bank collapsed and brought down the world's economy with it.

At that time, Zhou Xiaochuan (周小川) had just started his second term as governor of the People's Bank of China – China's central bank. The impending financial crisis was destined to make the next five years very difficult.

For the past decade, Zhou has taken a reformist approach to his position at the helm of the central bank. During his first term, monetary policy was focused on keeping inflation in check. But in 2008, battling a possible economic recession became the top priority. Since then, he's focused on pulling the Chinese economy back on the track of normal growth.

In the wake of the financial crisis, Zhou proposed a moderately loose monetary policy, the central feature of which was a four trillion yuan stimulus package. These measures have had long lasting effects. When Zhou became a member of the National Committee of the Chinese People's Political Consultative Conference (CPPCC) at this month's "Two Sessions," people were still wondering whether his injection into China’s economy had been an overdose.

Fixing on the Run

Some have said that if China's state-owned banks hadn't reformed in the way they had before the 2008 financial crisis, then the fallout could have been very different.

"China firmly pushed forward financial reform, replenished bank capital and dealt with bad assets," Zhou said in a speech at the World’s Best Central Bank Governor 2011 annual award ceremony in Washington. "This laid a good foundation for coping with the global financial crisis."

Zhou became governor of the central bank at the end of 2002 after a stint as chairman of the China Securities Regulatory Commission. At that time, some foreign scholars were saying China's banking system was already technically bankrupt. Reform of state-owned banks holding trillions of yuan in bad assets was considered a near impossible endeavor in international financial circles. 

The central bank led by Zhou Xiaochuan had to launch reforms to fix the financial system while at the same time maintaining financial stability. Zhou referred to this as "fixing things while on the run."

In 2003, China's state-owned banks began adjusting their management structures through shareholding reform. 

Then on Dec 16 of that year, the State Council approved the establishment of Central Huijin Investment Ltd, and made clear that this body would carry out restructuring at key financial institutions on behalf of the state. 

At the end of the year, foreign exchange reserves of $45 billion were quietly diverted into the Bank of China and China Construction Bank. The agenda then moved on to financial restructuring, dealing with bad assets and listing the banks. 

Bank of China, ICBC, China Construction Bank, Bank of Communications and Agricultural Bank of China all introduced modern corporate management structures and went on to list successfully. Zhou Xiaochuan said in 2004 that being listed was only the first half of the reform process though. The ultimate goal is to establish new market incentives, restraint mechanisms and completely break up the "quasi-bureaucratic system" in state-owned commercial banks, making them real market players.

This means that "fixing things while on the run" is far from finished.

In a transition economy, interest rates and exchange rates aren't usually market-oriented and the financial system isn’t very mature. Furthermore, fixing the whole financial system requires more than reforming a few state-owned banks. As governor of the central bank in the world's largest transition economy, Zhou Xiaochuan had to face complicated economic regulation.
 
Tiger in a Cage

On Apr 28, 2003, the China Banking Regulatory Commission (CBRC) was founded and was put in charge of supervising the financial sector. 

At that time, the central bank strengthened its ability to actively participate in macroeconomic control and regulation. It did so through adjusting interest rates and deposit-reserve ratios, as well as engaging in open market operations, which prevented economic overheating, and to a large extent, changed central bank practice to rely more on administrative means to regulate than in the past.

In 2003, the first target of regulation and control by the central bank was the real estate industry. The central bank's Document no. 121, which restricted the amount of bank finance that could be used on real estate, caused great controversy. At that time, people may not have realized that it kicked off a decade of real estate control. After that, fighting inflation became the main goal of monetary policy until the outbreak of the 2008 financial crisis.

Some in the financial industry believed the central bank increased the issuance of currency over several years during this time in line with the overall demand of government investments to drive economic growth. They believe this action resulted in the RMB appreciating against foreign currency and devaluing at home.

"When more RMB was put into circulation, people all complained about it," an official working in the central bank told the EO. "When foreign exchange reserves were used to purchase U.S. treasury bonds, people all criticized the decision. We were questioned for using very market-orientated means to regulate and control. We were also questioned for using not so market-orientated means to regulate and control. Governor Zhou didn't respond to these kinds of criticisms. He just let time prove [the policies] right."

After the outbreak of the financial crisis, Zhou started to believe that China's monetary policy should have multiple goals including maintaining low inflation, promoting reasonable economic growth, maintaining a relatively high rate of employment and maintaining the balance of international payments.

Later, the central bank backed away from using money supply as a monetary policy tool and turned toward interest rates to manage inflation expectations.

At a lecture to the Central Bank on Mar 18, 2011, Zhou Xiaochuan said, "A large number of currency deposits is a ‘tiger in the cage.’ Once it's released, it will lead to inflation. But the door of the cage is hard to shut properly. In order to stabilize inflation, the only thing to do is let the tiger stay in the cage on his own initiative so the currency that's issued that exceeds the real economy won't flood into the market and cause inflation."
 
However, Zhou still faces a financial system which is in the middle of being fixed and still doesn't fully rely on market prices. "When the government still has full control of economic regulation, the central bank as an institution can only take very limited initiatives in carrying out monetary policy," Chen Zhiwu (陈志武), an economist and professor at Yale University, told the EO.

Negative interest rates were a common fixture during Zhou's tenure because of the central bank's use of reserves and other tools. Zhou responded to criticism saying, "The existence of real negative interest rates was formed under a combination of many factors. It was not our intention."

Chen Zhiwu told the EO that he believes Zhou Xiaochuan tried his best to keep the currency stable. "Had anyone else been governor of the central bank, I believe it would have been less independent than it was under Zhou," Chen said. "This is related to his personal background and also his belief in the value of being market-oriented."

A Half Finished Game of Chess 

"Fixing a financial system on the run" has been compared to a chess game, where the move of any piece affects the whole game. The overall layout and coordination is key to financial reform. 

"Governor Zhou often stopped, went backwards a little bit, and then walked forward again," an official working in the central bank told the EO. "He was engaged in control theory and system theory, which he studied at Beijing University of Chemical Technology. Many of his reform plans were linked, systemic and paid particular attention to collaborative improvement."

While reforms of state-owned banks were still being implemented, the promotion of marketed-orientated interest rates began. In 2004, the central bank announced floating interest rates on lending that could be discounted to a maximum of 90 percent of the benchmark rate. Meanwhile bank deposit rates could float downwards without limit, but they couldn't exceed officially set levels. 

Eight years later, after being temporarily removed during the height of the financial crisis, market-orientated interest rates were once again promoted. Despite the heads of many commercial banks saying they weren't ready for the move, Zhou Xiaochuan believed the banks had gradually grown more mature over the eight years of restructuring and he pushed ahead with the reforms.

In June of 2012, the central bank announced a further expansion of the range which deposit and lending rates could vary. Commercial banks were given permission to set deposit rates as high as 110 percent of the benchmark rate and set rates on loans as low as 70 percent of the benchmark rate.

Under Pressure 

In 2003, less than one month after Zhou Xiaochuan took office, Japan and the U.S. piled pressure on China in relation to what they viewed as the serious undervaluation of China's currency. Zhou consistently had the same response internationally and domestically saying that a stable RMB exchange rate is important for the world's economy and that reform of the RMB exchange rate should proceed in an orderly step-by-step way. His greatest worry was that China's financial system, which was still in the process of "being fixed," still wasn't ready for a major appreciation of the currency.

On July 21, 2005, the central bank announced the introduction of a floating exchange rate system. European Central Bank Governor Jean-Claude Trichet said that China's RMB exchange rate no longer relied solely on the U.S. dollar, which would be better for the world economy and contribute to global financial stability.

Shen Jianguang (沈建光), chief economist with Mizuho Securities Greater China region who formerly worked at the European Central Bank, remembered that Zhou Xiaochuan had several confrontations with Trichet over China's exchange rate policy.

"In the exchange rate system, Zhou withstood pressure from the U.S. and Europe and also pressure from many ministries and enterprises domestically," Shen told the EO. "The former hoped appreciation would happen all at once and the latter didn't want it to change at all. Now it seems adopting a step-by-step appreciation is the most reasonable practice. This approach earned Trichet's respect."

In April 2012, the maximum daily band in which the value of the RMB was allowed to vary was raised from 0.5 to 1 percent.

Chen Zhiwu says that the most important thing Zhou Xiaochuan did in the past ten years was open up. But many professionals in China's financial industry hold a different view, questioning whether Zhou went too fast and created risks.

There are also some wondering why the internationalization of the RMB has come ahead of capital account convertibility. Shen Jianguang says the internationalization of the RMB is a window of opportunity brought about by the financial crisis. Although the country might not be fully prepared and may suffer in some areas, he says Zhou Xiaochuan believes it's a rare opportunity that must be seized. 

"Relaxing foreign exchange control, relaxing indirect and direct investment, relaxing RMB cross-border flows and liberalizing interest rates - the pace of these measures has been very fast," Shen said. "These policies need to continue."