W. Shuo, Z. Jiwei and H. Kan | Recently Governor Zhou Xiaochuan had an interview with Caixin and talked about the yuan exchange rate regime reform, macro-prudential policy framework, and other topics. The following is an edited transcript of the interview.
Caixin: The central bank convened its system-wide annual work conference in January. We learned that before the Spring Festival, the branch offices were studying the decisions adopted at the conference and discussing ways to implement them. Can you briefly describe the major agenda items of the annual work conference?
Zhou Xiaochuan: In the PBOC’s annual work meetings, we usually discuss and analyze the economic situation and financial market developments in China and beyond, and follow up on our tasks to implement the decisions of the Central Economic Work Conference and to advance financial sector reform. This year, we also discussed at length subjects including the foreign exchange market, the exchange rate, macro-prudential assessment, the central bank’s digital money and Internet banking, etc.
At present, market participants have different views on the outlook for China’s economic growth, which also affects their assessment of the yuan exchange rate. What is your view on this issue?
There are indeed differences in the views of the economic situation and financial market developments. It is necessary to analyze the current state of China’s economy in a comprehensive and objective way. Overall, the performance of the economy remains within a reasonably strong range. Against the backdrop of a slowing world economy and global trade, and heightened fluctuations in the international financial markets, China maintained a growth rate of 6.9 percent in 2015, still relatively high compared with other countries.
The change in China’s growth rate can be attributed in part to weak performance of the global economy. It also reflects the structural adjustment policies adopted by the Chinese government. Such a change is conducive to the ongoing efforts in China to pursue more sustainable and quality growth and is beneficial to the rebalancing of the global economy. Going forward, China will strengthen structural reform, especially supply-side reform, in order to strike a better balance among economic growth, structural adjustment and risk prevention, and to achieve sustainable and steady development.
There are widespread concerns about the fall of the GDP growth rate. After remaining in double digits for many years, the growth rate has declined consistently, and fell to 6.9 percent in 2015. This has given rise to pessimistic sentiments.
Among the views expressed on China’s growth, two factors are worth mentioning. First, China contributed enormously to the global GDP growth in 2009 and 2010. With a population that was 20 percent of the world total and GDP less than 10 percent of the world total, China’s contribution of the global GDP growth was over 50 percent. We must recognize the special circumstances and the sharp contrast between China and other economies at that time. While the advanced economies in Europe and North America were responding to the shocks of the financial crisis, China adopted a stimulus package. This situation is not to be regarded as a norm. For China, 50 percent is not a sustainable level of contribution to global growth. At present, China contributes around 25 percent to the world GDP growth, and this is relatively close to normal. This is not a hand landing at all.
Another factor is that in the past China put a lot of emphasis on GDP. In fact, looking at worldwide experience, there is not a direct correlation between GDP and the exchange rate, especially the growth of GDP and exchange rate movements. For example, overly rapid GDP growth sometimes causes overheating and high inflation, putting downward pressure on the currency. Some misguided views have been expressed in the debates around the world. In fact, the exchange rate of a currency is related to the international competitiveness and health of the economy of the issuing country.
When we take a closer look at economic theory and international experience, we see that the current account balance, among all the economic fundamentals, is the most related to exchange rate. In 2015, China’s current account surplus remains massive. In particular, the surplus in the trade of goods reached a historic high of US$ 598.1 billion. There is another fundamental, i.e. movements of real effective exchange rate, or the relative movements of inflation, that affects exchange rate. The inflation target of the United States, Japan and Europe is 2 percent. At the end of 2015, China’s CPI was 1.4 percent, a relatively low level for China. Low inflation is conducive to the stable value of a currency.
Global factors also have an important role to play in affecting the yuan exchange rate. In your opinion, which global factors deserve foremost attention?
Yes, indeed. I will not be exhaustive and will focus on four of them. First, following the protracted difficulties in the wake of the global financial crisis, the U.S. economy showed some positive signs of recovery, and the U.S. dollar started to appreciate while the euro and the Japanese yen depreciated significantly. Due to multiple reasons, the yuan exchange rate depreciated against the U.S. dollar by a relatively small margin, but appreciated against the euro and the yen markedly. Many market participants believe a makeup adjustment is thus needed. Second, the Federal Reserve has started to gradually exit from the quantitative easing policy. In December 2015, it raised its key policy interest rate for the first time in many years. Undoubtedly, the Fed’s policy actions have an important impact on asset allocation and capital movements worldwide. It is fair to say that although the policy evolution of the Fed in 2013 and 2014 had an impact on many economies, in particular emerging market economies, but the impact on China was not large. However, in 2015, the Fed’s policy evolution had a very notable impact on China, in particular the interest rate hike in December. This might be seen as sort of a makeup adjustment. Third, speculative forces have been targeting China. Speculative forces are always looking to bet on something. They saw the slowdown of economic growth and financial market volatility in China. The problem is that the previously weak speculative forces have gathered astonishingly large amount of liquidity after several rounds of QE by the major economies. How is the Chinese economy performing? We have confidence and patience to wait for further data releases to speak for the state of the Chinese economy. Of course, for those who have taken their bet, this is less relevant. What they want is immediate results, and they have tried hard to create hype. Fourth, in the conditions created by QE policies, financial assets worldwide have accumulated bubbles and adjustment pressures, though to varying degrees. Following accommodative monetary policies adopted in 2008 in response to the global financial crisis, the prices of many assets have increased for an extended period of time and accumulated internal pressures for adjustment. The question is what will trigger such an adjustment. Adjustment is always painful, so everyone wants to have someone to blame.
Some people are concerned that China will allow the yuan to depreciate in a bid to boost exports and GDP growth, which might intensify the so-called currency war. If one has a closer look at China’s current account balance, he will find that in 2015 goods trade surplus was close to US$ 600 billion and net exports’ contribution to GDP was fairly high. Therefore, there is not a motivation for depreciation to boost net exports. Premier Li Keqiang also reiterated this point on many occasions. Of course, a significant portion of the trade surplus in 2015 was due to the slump in commodity prices. China’s imports of many of the commodities in volume terms registered positive growth, especially crude oil, but the value of imports dropped. Therefore, China’s slowdown should not be the culprit for the decline in commodity prices. As such, in order to explain the depreciation pressures on the yuan against the U.S. dollar, one has to examine major factors such as the rapid appreciation of the U.S. dollar against other currencies, domestic and external events, and short-term market sentiment.
Does the central bank have an estimate of the magnitude of hot money?
Hot money does not have an explicit definition. Speculations are not the major forces influencing the balance of payments. Major speculative forces are in offshore markets, whereas cross-border flows under Qualified Domestic Institutional Investors and Qualified Foreign Institutional Investors schemes are limited in volume, and the size and pace of such flows are subject to management. Of course, shorting China in offshore markets can affect the sentiments of onshore markets.
We have observed that some export enterprises, affected by expectations, make decisions accordingly with regard to whether and where to convert foreign exchanges into the yuan and whether to delay such a conversion, conduct forwards transactions to mitigate forex risks, adjust the time of investment and bring forward the purchase of foreign exchange. These actions influence supply and demand in the foreign exchange market. A large number of domestic enterprises that have overseas subsidiaries can choose to put their money either at home or offshore more easily than before. But export enterprises need yuan funds to pay for wages, utilities, raw materials and spare parts. Such adjustment strategy thus has an ending. This also applies to import enterprises.
Another factor is that domestic enterprises (including foreign-invested enterprises), influenced by certain expectations, make adjustments in their liabilities, reducing or paying off U.S. dollar-denominated debts and borrowing in yuan instead in order to mitigate the impact of the U.S. dollar appreciation. China, as a major economy, has a fairly large amount of external debt, or over US$ 800 billion in 2014. To make adjustment, a massive purchase of foreign exchange from the central bank is needed. Shifting to yuan-denominated debt is made easier due to the availability and favorable prices of yuan loans. This means that if the expectations are right, adjustment of liabilities is rational, and enterprises have autonomy to make such decisions. As soon as external debt is paid off, such adjustment will come to an end. Many foreign-invested enterprises need their parent companies to use U.S. dollars for trade finance. This portion of demand is fairly large and unlikely to be reduced to zero.
As such, it is necessary to distinguish capital outflows from capital flight. It is normal for export-oriented enterprises to choose their foreign exchange conversion strategies and adjust their liability structures after weighing benefits and costs. Such an adjustment will not be endless. Such behaviors do influence capital flows and foreign exchange reserves, but they do not necessarily constitute capital flight.
As uncertainties have recently been abounded in the global financial market, some speculative forces are targeting China. Under normal circumstances, China is not the target of international speculators because it is not easy to make money due to the sheer size of the economy and abundant resources. As a matter of fact, China experienced mainly capital inflows for many years, some of which might be hot money. It is nothing strange that such money withdraws from China when opportunities are good.
You analyzed two of the major fundamental factors that affect the exchange rate, namely balance of payments and inflation. But, apart from these two, changes in the capital account also can have a large impact on the exchange rate.
Yes. Here is a summary of the capital account. First, direct investment items are basically stable, and foreign-direct investment, though experiencing some fluctuations, has remained basically stable. Second, Chinese enterprises make more outbound investments than before as they “go global.” This is a natural outcome of policy opening and a better understanding of the international market by Chinese entrepreneurs. Outbound investments have been growing rather rapidly, which is a good thing.
Of course, as we have noticed, some people are pursuing emigration and investing in overseas real estate due to concerns with confidence, property protection and original sins. Some businessmen are investing overseas through acquisitions, not due to comparative advantages or to expand into new markets, but to keep a way open for an exit in the context of incomplete bankruptcy law in China.
Given the size of the Chinese economy and the high degree of opening up, capital outflows do exist side by side with normal investments and there is room for improvement. However, the amount is not large compared to China’s trade volume of US$ 4 trillion per annum and several trillion dollars of foreign exchange reserves. It is necessary to differentiate the magnitude of various flows when making estimations. Furthermore, problems will be gradually addressed as the legal system in China continues to improve.
The direction of the reform of yuan exchange rate regime
What will be the direction and pace of the yuan exchange rate regime reform in the next stage?
The exchange rate regime reform will be carried out unwaveringly. We are patient. We hope to see substantial progress in the exchange rate regime reform during the 13th Five-year Plan period, moving toward greater reliance on market forces and a more flexible exchange rate.
The direction of yuan exchange rate regime reform remains unchanged, that is, a managed floating exchange rate regime based on market supply and demand and with reference to a basket of currencies. First, market supply and demand are emphasized. The market is to be respected despite the existence of short-term speculative forces. In the mind of the central bank, there is not an optimal, model-produced exchange rate level. The reference to a basket of currencies is a natural choice for China as a country with diversified trade partners and investment in multiple regions. The reference to a basket of currencies was not emphasized in the past with our focus on the U.S. dollar. In the next step, we will strengthen the reference to a basket of currencies. We have always held the view that the efficient market hypothesis cannot be relied upon 100 percent. A market deficiency may demonstrate itself from time to time when the market is dominated by speculative forces, short-term sentiments or herding behaviors, and therefore certain management is necessary for a floating exchange rate. Our aim is to have the exchange rate “broadly stable at an adaptive and equilibrium level,” and there are interactions between the two. Although the equilibrium level defies an accurate assessment, a broadly stable exchange rate level can only be achieved when it is around the equilibrium level. Stability is impossible when the exchange rate is at a wrong level or in disequilibrium. Meanwhile, the pursuit of an equilibrium level can only be facilitated by the presence of general stability. Few will heed fundamentals or equilibrium analysis in times of turbulence and turmoil.
For a country as big as China, to achieve the reform goal may require a considerable period of time. To press ahead with reform, one should take decisive actions when windows of opportunities open up, but refrain from reckless moves in the absence of such windows. We can wait a bit and create more favorable conditions for reform. We emphasize balancing reform, development and stability for the Chinese economy. The international economy is recovering from the crisis. This emphasis is still relevant. We are pragmatic, patient and determined with our goals, but do not target to move in a straight line toward reform goals. We will continue with reform efforts, and will also continue to be a responsible big economy.
The yuan exchange rate regime reform is making headway in the context of another round of global financial market adjustment. There has been much talk on the spillovers of China’s financial markets. Do you think this is fair?
A lot of volatility in the financial market is driven by events. Between the Fed’s announcement of QE tapering and its first rate hike, many trading opportunities were created. Meanwhile, event-driven transactions are amplifiers. Heightened volatilities may easily get on people’s nerves and induce finger-pointing. The launch of important policy measures should take these new factors into account.
In the past, the weight of China’s economy in the global economy was not big, and we were not accustomed to the possible spillover effects of our actions on the global economy and markets. Nowadays, the Chinese economy does have spillover effects. When the volatility of financial markets is intensified by market events amid heightened uncertainties worldwide, the international community pays greater attention to such spillovers. We will promote the yuan exchange rate regime reform prudently, choose appropriate opportunities and windows, and minimize negative spillovers, especially to avoid adverse interactions of various effects.
There have also been spillovers among the domestic stock market, the bond market, the foreign exchange market and the money market, which reflect by nature interactions among price distortion, soundness, bubble and resilience. As required by the Central Economic Work Conference, cross-contagion and adverse feedback among domestic financial markets should be avoided to prevent systemic risks. We’ve learned from the global financial crisis, which started from the 2008 subprime crisis in the U.S., that cross-contagion between the real estate market, the subprime market and shadow banking system in the United States produced disastrous impacts. There is also the soil for such contagion in China. Therefore, advancing reform should pick good windows of opportunities and requires art in timing, cooperation and skills of execution. Some reforms will lose momentum if suspended and the “once bitten, twice shy” mentality should be avoided. Certainly, another extreme should also be heeded, as international experiences have shown that caution should be exercised to avoid “transition trap” and “reform fatigue.”
Since the second half of 2014, the U.S. dollar strengthened significantly while the euro and yen depreciated by a large margin. The yuan basically followed the trend of the U.S. dollar, weakening against the dollar but not much. Therefore, the yuan has accumulated some depreciating pressure against other currencies. These are endogenous adjustment pressures. In the past few years, the yuan exchange rate was very stable compared with other currencies, with almost the smallest volatility globally. This has created unrealistic expectations in the domestic and international market that the yuan should remain very stable all the time. In this context, even a tiny move in the yuan exchange rate may trigger very strong external responses with regard to potential spillovers. In reality, in comparison with the yen and euro, the volatility of the yuan exchange rate is much smaller, not to mention the currencies of emerging markets such as Russia, Brazil and South Africa. However, people’s thinking is easily subject to inertia and needs time to adapt. Therefore, playing up the spillovers of China is unfair indeed in some way.
There’s a view in the market that the rules for the yuan exchange rate regime are not transparent enough, which gives rise to the need to guess the reasons behind central bank decisions. How could the central bank improve its communications with the market?First of all, the central bank definitely has a clear and strong willingness to improve communications with the public and the market. And we did have some very successful communications in the past. However, good communication is never an easy thing.
Currently, there are many uncertainties in the global financial market, which have led to the divergence of opinions and many debates. In these days of stress, everybody hopes for a person of foresight or an authoritative voice that could turn uncertainties into certainties. But uncertainties do exist in the market, which cannot be simply eliminated by some words of assurance. The central bank is neither God nor magician that could just wipe the uncertainties out. Therefore, sometimes the central bank has to say, “Excuse us, but we have to wait for new data inputs.”
With respect to forward guidance, there’re a few questions to consider. The first is about guiding the market. Could central banks outsmart the market in the quality of personnel or in terms of information collection? Are central banks’ theoretical basis or forecast models necessarily better than those of the market? The second is the relationship between forward guidance and traditional monetary policy tools. When there is no more space for tools like policy interest rates and open market operations, we have no other way but to discuss the future. Thirdly, we can learn from international experiences that debates are unavoidable at times, and even within central banks there is sometimes internal divergence of viewpoints. At these particular times, the signals sent by forward guidance cannot give the market much relief.
The yuan strengthened for many years in the past, and China’s foreign exchange reserves have kept building up. This cannot be an open-ended process. There must be a peak or turning point eventually. Before the turning point appears, overshooting in appreciation is unavoidable and requires adjustment. After the turning point, overshooting in depreciation is also possible. After that, there will be a trend of appreciation again, as the economic fundamentals point to a stronger yuan. The overall trend is for the yuan to gradually move toward stability through stages of adjustments and fluctuations, which is a dynamic feature of the system that objectively exists. China’s foreign exchange market is still not a fully competitive and sophisticated market. The central bank has different communication strategies for different market participants. To the general public, the central bank focuses on communications in knowledge and institutional frameworks. For institutions that use foreign exchange, such as importers and exporters, it is important for the central bank to guide and stabilize their expectations. For speculators, however, the central bank views them as rivals in a game, and it is unimaginable for the central bank to reveal its operational strategies to them. This is like a player who will never reveal his next moves to the opponent in a game of chess.
Managing Capital Flows
Many people are worried about the declines of foreign exchange reserves. How does the central bank view and manage speculation?
Speculation is not rare in the market, and it is sometimes hard to distinguish speculation from risk management operations. China has the largest volume of foreign exchange reserves in the world, and we will not let speculative forces dominate market sentiment. The scope of usage for foreign exchange reserves covers not only international payments, but also financial stability. China’s foreign exchange reserves are more than enough for international payments, and its role in safeguarding financial stability is a key function. China’s capability in this regard is beyond question. As capital flows in and out, the foreign exchange reserves may decline now and increase later. As long as there’s no problem in the economic fundamentals, rises and falls of reserves are perfectly normal.
Nevertheless, not letting speculative forces dominate market sentiment doesn’t mean we will engage in a head-on fight as long as there is a sign of speculation. We also need to consider effective use of ammunitions to minimize costs. Further reforming the exchange rate regime itself will give us more flexibility in responding to market speculation. If the fixed exchange rate in the past was considered an unmovable steel shield, the more flexible exchange rate could be considered a sponge shield, with which we could better manage excessive speculation.
Recently the central bank has tightened yuan supply in the offshore market, which has a relatively large impact on yuan internationalization. How do you strike a balance between the two targets?
We certainly hope to see smooth progress of yuan internationalization. It is impossible to wish that all the good things will happen in economic performance. The process of yuan internationalization will move forward like waves do. If speculation becomes the key problem in the foreign exchange market, we’ll emphasize dealing with speculation. However, when the market gradually goes back to a relatively normal state, yuan internationalization will keep on.
The proposals for the 13th Five-year Plan state that the building of a macro-prudential policy framework will be strengthened, and there will be reforms to improve the financial regulatory framework to adapt to the development of modern financial markets. Why is macro-prudential policy framework so important?
In fact, macro-prudential policy framework is not a new concept. It was discussed and proposed for development at the G-20 Summit in 2009, and was already in use in the late 1970s. Many economies have also adopted measures to the similar effects. However, more focus was on micro-financial regulation prior to the global financial crisis, while the importance of macro-prudential policy was neglected. Tremendous changes have taken place since the outbreak of global financial crisis in 2008. Central banks could not single-mindedly regard keeping inflation low as their only mandate, but instead should also be responsible for maintaining the health and stability of the financial system to prevent crisis. Improving the macro-prudential policy framework has already become a major trend and a key element in global financial sector reform.
After the crisis, it has been gradually recognized that the pro-cyclicality of financial system and cross-market risk contagion may cause shocks to macro economy and financial stability, and even trigger systemic risks. Adopting macro-prudential policy is mainly aimed at addressing this issue.
Currently, macro-prudential Policy is a widely used term around the world, which is a general term that covers policy objectives, assessments, tools, transmission mechanisms and governance structures for macro-prudential management and runs parallel to monetary policy.
The PBOC has been promoting and improving macro-prudential policy framework since 2009. How has been that undertaking going?
We have talked on several occasions about and adopted a macro-prudential policy framework since the outbreak of global financial crisis. Research was first conducted around July and August 2009 when different assessments about situations at that time gave rise to diverging views on who should lead the efforts in developing a macro-prudential policy framework. The term, macro-prudential policy framework, was officially introduced at the Central Economic Work Conference at the end of 2010. From early 2011, the PBOC began to calculate desirability loans in a countercyclical manner by largely relying on capital adequacy self-regulation and reasonable need of economic growth, and to build incentives and constraints via such tools as differentiated reserve requirement ratios. These are the major elements of the last round of macro-prudential policy framework.
In this process, some tried to equate a macro-prudential policy framework with old-fashioned, quantity-based management, regarding it as an administrative measure. In fact, this is not right. As an institution responsible for macro adjustment, the PBOC only put in place the differentiated reserve requirement ratios in 2004, with no other incentives or constraint mechanisms targeting the credit expansion by financial institutions. Calculation of the desirability of loans based on capital self-discipline was introduced later, which is still based on capital, but with a countercyclical factor. Therefore, it is consistent with a macro-prudential policy framework, but not exactly the same as the one used internationally, as it takes into consideration China’s circumstances.
The macro-prudential policy framework has played an important role. Otherwise, simultaneously dealing with the slowdown in economic growth, making difficult structural adjustments and absorbing the effects of previous economic stimulus policies might have exerted a more pronounced negative effect. As a result, it is natural to upgrade the framework now.
China has made a lot of innovations in theory and practice in macro-prudential policies and later the macro-prudential assessment framework. Why is China at the forefront of this issue?
After the global financial crisis, the PBOC voiced its viewpoints during different international events. In particular, we submitted a report on correcting pro-cyclicality at the annual meeting of Bank for International Settlements (BIS) in Sao Paulo in November 2008, noting that there are many pro-cyclical factors in the economy, namely, there are too many positive feedback loops while negative feedback is inadequate. The term macro-prudential was not used in an explicit manner at that time. After debate, the BIS said macro-prudential was used once and could be used again. At the same time, such concepts as positive feedback, negative feedback, oscillation, bubbles, pro-cyclicality and counter-cyclicality were all included in the macro-prudential policy framework, which was submitted to the G-20 London summit for deliberation in April 2009.
At that time, countries were divided on the judgment of economic situations. China was the first to recover from the crisis, and thus was in need of some countercyclical adjustment. So the PBOC developed the macro-prudential policy framework by taking into account China’s specific circumstances. Most of the macro-prudential policy measures adopted around the world were introduced afterwards. For instance, Basel III was introduced in 2010, including countercyclical capital buffer, which was then further developed by expanding to leverage ratio, liquidity coverage ratio and net stable funding ratio. As China was the first to recover, it may enter a period of excessive stimulus. Therefore, we need to act earlier.
There was another term at that time, which was macro-prudential regulatory framework, but it was changed into macro-prudential policy framework. Why was the change made?
During discussions in April 2009, it was proposed that central banks should be responsible for making judgments about macro-prudential policy and cyclical issues, as regulatory authorities were not good at making macroeconomic assessments. Policy design should be consistent with implementation. Problems would arise if policy design and implementation were separated. However, coordination should also be emphasized. After discussion, the term was finally changed into macro-prudential policy framework. Based on country-specific circumstances, the Basel Committee suggested that macro elements like capital buffer should be added to the Basel III to make adjustments in line with economic cycles. This has appropriately distinguished macro-prudential from micro-prudential policies.