Herbert Poenisch: Power to the Peoples' Bank of China-A New Paradigm for Central Banking?

2018-04-10 IMI
Herbert Poenisch, Member of IMI International Committee, Former Senior Economist of BIS Financial stability has been on the mind of Chinese leaders ever since episodes of instability have tarnished their image as custodians of stability.In Western countries the blame game after the GFC in 2008 led to similar recriminations. However, the policy reactions are very different reflecting the role of the financial sector, the relationship with government and governance in general[i].This article will focus on the comparative role of central banks. This contribution will briefly cover the reasons for financial crises in the West and in China, the reaction by Western governments, the paradigm given by the CPC to the financial sector, the recent measures to ensure financial stability adopted by the recent NPC and a conclusionfor China,where the role of central banking has been redesigned.
  1. Reasons for financial crises
The literature has ample analysis into their causes, the most important ones of which are: Domestically, an excessive credit expansion to prevent a downturn in economic growth. Ample credit was extended to the government (especially in the Euro Zone), the regional governments (in China through Local Government Financing Vehicles-LGFV), enterprises and households,leading to a rising debt service ratio. The monetary policy contributed to the credit bubble as historically low interest rates facilitated this credit boom. Consumer price inflation stayed benign, but asset prices escalated. These were property prices, share prices as well as bond prices. This reinforced the vicious spiral as credit was increasingly extended against inflated asset collateral. As a result, total credit to private non-financial entities spiralled to 260% of GDP in 2017 in China, compared with 160% of GDP in the US and 145% the EURO area. Looking at the credit gap, which is defined as the deviation of the private non-financial debt over its long term trendthe pictures is the same. At the beginning of 2017 China and the Hong Kong SAR were well above the trend whereas the US and Eurozone were below[ii]. There are a number of indicators of financial crises, as a recent BIS study shows[iii]. These are the three leading financial indicators, credit gap, debt service gap and asset price gap, which can be supplemented by others. The monetary indicator would be the expansion of broad money M2. At the end of 2017 China M2 reached 300% of GDP, whereas the US was at 75% of GDP and the EURO zone close to 100% of GDP, after years of quantitative easing. In China inadequate coordination of regulation of financial intermediationraised concerns of potential stability risks. Governor Zhou mentioned four areas in particular: shadow banking, asset management, internet finance and financial conglomerates[iv]. He also mentioned that once the confidence in apparent stability broke, the so called ‘Minsky moment’, the asset bubble deflated, with losses on the balance sheets of financial intermediaries, and debt servicing problems by local governments, corporates and households. The phase is called financial crisis, the accumulation of a many factors. Externally, the relevant asset price is foreign exchange. Domestic financial excesses lead to exchange rate pressures, both on the currentas well as the financial account, which can beaccommodated by exchange rate adjustments or preventingnecessary adjustments by tightening capital controls.
  1. Reaction by Western governments
The reaction to the major financial instability, the global financial crises (GFC) in 2008 was twofold. Banking regulation was tightened, such as through the Dodd-Frank Act, and central banks embarked on unconventional monetary policy through quantitative easing programmes (QE). This prevented a full blown recession but did not provide the stimulus to economic growth as expected. This expanded central banks’ balance sheets, increased the liquidity in the economy but the transmission to the real sector was still inadequate. Banks increased the quality of their balance sheets but not lending to the real sector, citing tighter regulation. Central banks willingly followed their monetary mandate, to ensure sufficient growth as inflation indicators were benign. As a result, historically low interest rates, touching the zero lower bound posed new challenges to central banks[v]. Their responsibilities for financial stability produced a different picture.Learning the lesson from the GFC, central banks paid more attention to financial stability. It was mostly emerging market central banks, such as China and Malaysia which extended the mandate of their central banks to cover financial stability. Advanced countries’ central banks were more reluctant to go down this way. There were two main arguments why they did not. Firstly, financial stability is far more difficult to define than monetary stability, and secondly, central banks should not be over burdened with responsibilities.SNB President Jordan even warned that such high expectations are exceedingly dangerous[vi]. Nevertheless, there are at least three compelling reasons for central banks to play a leading role in ensuring financial stability. They are: financial stability affects the macroeconomic environment in which they operate, they act as lender of last resort and need to assess the counterparty risk, and finally they have a better understanding of the functioning of financial markets[vii]. As a result Western central banks have accepted responsibility in the area of financial stability, mostly as contribution to financial stability rather than outright ensuring stability as is the case with monetary stability. This takes into account that there are various authorities in charge of financial market regulation and monitoring. Market participants practice self regulation or are subject to specialised supervisory bodies. Central banks are directly involved in the money market, the bond market and foreign exchange market. They deal with other financial markets at arm’s length. They usually do not write the rulebook for these. Central banks monitor developments in the various financial markets and use their levers if critical developments occur over an extended period of time. The money market is a case in point, where some central banks do not intervene to smooth interest spikes, others intervene regularly and others intervene daily. Similarly, in the foreign exchange markets, daily swings do not prompt some central banks to intervene, whereas other central banks actively manage their exchange rates. Western central banks consider a certain degree of volatility in financial markets as necessary tool for the reaction of market participants. Frequent intervention would blunt this instrument and add to the uncertainty in the market. They react to volatility only if it counters their mid-term growth and inflation targets. Transparency of their monetary target is of paramount importance, such as inflation targets. Financial stability in the minds of central banks is narrowly defined, the banking system. Most still pursue the microprudential approach by regulating and supervising individual institutions. Central banks are well placed to conduct macro-prudential policies because they have the capacity to analyse systemic risks[viii]. Macroprudential concerns, such as deflating asset bubbles, have not been broadly adopted as they lack the operational clarity. Opponents claim they don’t knowwhen to intervene and by how much. Using interest rates to deflate asset bubbles has not been commonly used.
  1. Chinese paradigm
The role of the financial sector is different in socialist economies. The CPC has restated it following the National Financial Work Conference on 15 July 2017. The financial sector should serve the people and as such is under the direct authority of the CPC. In order to achieve this, the Financial Stability and Development Committee has been set up in autumn 2017,presently under the chairmanship of Vice-Premier, Mr Ma Kai. Socialist countries never experienced financial instability as during the Soviet Union. Financial resources were allocated to the real sector and finance never took on a life of its own. The population was thus protected from any spill over from financial mismanagement until the end of the Soviet Union when hyperinflation, the reckoning from previous mistakes,wiped out the savings of the population. The Chinese leadership, bypaying attention to the historical lessons, in particular the collapse of the Soviet Union, is attempting to protect its population from financial instability. It is putting the emphasis on preventing financial instability by designing regulations for all participants in the financial sector. These are the banks which are heavily involved in shadow banking such as through asset management, the internet finance which provides financial services to a large part of the population through cyber currencies, e-payments, crowd financing, P-2-P lending and finally through insurance products.Non-bank holding companies provide financial services through one of their subsidiaries without proper supervision of the whole conglomerate. In addition, financial markets have dynamics of their own and create risks which cannot be regulated but need to be managed. The newly appointed PBOC Governor Yi Gang is well versed in managing the inherent risks as he has ample experience from living and teaching in the US as well as attending international meetings at the IMF, BIS and other forums where financial crises in the West were analysed thoroughly since he joined the PBOC in the mid1990s. Volatility in financial markets is viewed differently in China. It is a violation of supreme harmony which has guided Chinese authorities, dynasties before and CPC leadership now. As such, volatility needs to be prevented, rather than just managed[ix]. Trustingthe market participants to manage and hedge volatilityon a daily base is a foreign concept. How should a greater measure of market functioning, as promised by Chinese leaders without more volatility materialise, needs to be seen. In the same vein, allowing the powerful global financial markets more influence in China through less foreign exchange control needs to be seen. The Chinese reaction to volatility in the offshore RMB market in early 2016 sent a clear signal.
  1. Recent Chinese measures
The pre-eminence of the CPC in the economy and finance has been stipulated during the July 2017 Work Conference, during the 19th Party Conference in October 2017 and in the recent NPC meeting in March 2018[x]. What does this mean for the financial sector? It enshrines the authority of the real economy, the welfare of the majority of the population rather than the financial sector leading a life of its own, serving only the financial elite. In this way the Marxist stipulation G-M-G (growth-money-growth) has been restored where money is neutral and only facilitates real growth. In the West, this has been perverted into M-G-M’ where money creates profit (M’) through real growth. The CPC, notably Vice Premier Mr Liu He has expressed its disapproval of excessive credit growth to regional governments throughspecial financing vehicles (LGFV), to enterprises (the big private ones as well as theSOE) and most recently to households. The deleveraging process has already started. In all these cases the debt servicing capacity is a cause for concern. It has also expressed concern over asset bubbles, such as shares and property and prompted the PBOC to take measures to cool the asset markets. The PBOC istherefore authorised to apply macro-prudential measures. In addition, the PBOC has been given the supreme power to regulate the financial sector. The two supervisory agencies for banks and insurance have been merged into one to better control financial conglomerates. The Securities Commission is also under its authority, thus covering all finance sectors. Together, the PBOC has been made the main responsible authority under the guidance of the CPC to carry out more functions than most other central banks. The CPC oversees the work of the PBOC, notably by Vice Premier Liu He, the Committee for FinancialStability and Development and the CPC representatives inside the PBOC, notably Mr GuoShuqing. The PBOC is responsible for promoting growth, ensure price stability, managing the exchange rate, regulate the whole financial sector as well as ensure financial stability. An institution with so many tasks needs the tools, authority and safeguards. The PBOC has been given the authority, but complete tools and the safeguards rest with the political authorities. While it operates through reserve requirements, repo rates, medium term lending and manages the daily exchange rates, the key decision rests with political authorities. They have the power to change key interest rates, stipulate the exchange rate policy and provide safeguards for PBOC decisions. Having such a broad mandate will prove a challenge for the PBOC. Does it have the technical expertise in all aspects of the financial markets? Does it have a superior view of the risks emerging in different segments of finance? Does it monitor Black Swan and Grey Rhino risks? Does it understand how risks are transmitted through interlinkages? Does regulation providea clear picture of who holds the final risk after risk mitigation and do they have adequate provisions for these? Risks in a modern financial systemare generated through price fluctuations as well as counterparty ability to manage risks. The primary parties have risk sharing or risk transfer instruments at their disposal. The case study of the collapse of Lehmann Brothers in 2008 has given some idea of the complexity of risk sharing in digital times. It took months to reconstruct who was implicated to what extent in the losses incurred.
  1. Conclusion
Given the complexity and pervasiveness of finance in a modern economy, the recent additional powers of the PBOC take on a new dimension. While it is feasible, but demanding to close regulatory gaps in China, getting on top of financial instability altogether is a tall order, close to impossible. Financial volatility cannot be ruled out. It can be contained and managed, but it will certainly occur in a more market driven system. If market participants are allowed a greater role, they will make mistakes or game the system. Once instability appears, herding, a deficiency of market economies, will magnify the initial impulse. The CPC has not decided yet, whether losses are basically private or should be socialised? In countries where the authorities take on overarching responsibilities for the financial sector, such as China,there is a bias for socialising losses, called moral hazard. While the decisions of the recent meetings of the CPC and the NPC have been a great step forward, with a new paradigm for central banking, major issues are still up in the air. Is the PBOC or are market participants responsible for managing various financial risks? Are there ample instruments available for managing various risks? Are market participants, big and smallsufficiently educated to be able to manage their risks and bear the costs?How will ‘too big to fail’ be handled? The financial system needs more clarity on the red demarcation line between private and social responsibilities. In uncertain times, government bailout of loss makers, as after the stock market crash of 2015, will be the preferred rescue mechanism. [i] Sheng, Andrew and Xiao, Geng (2018): The Right Way to Judge Chinese Governance. In: Project-Syndicate, 26 March www.project-syndicate.org [ii] Credit-to-GDP-gap www.bis.org/statistics/c_gaps.htm [iii]Aldasoro, Inaki, Borio, Claudio and Drehmann,Mathias (2018): Early warning indicators of banking crises: expanding the family. In:  BIS Quarterly Review, Marchwww.bis.org/publications [iv]Zhou, Xiaochuan (2017): Prospects of the Chinese economy-broad based growth. Speech at the 32nd G30 International Banking Seminar, October www.bis.org/speeches [v]See 200th Anniversary Conference of the Austrian National Bank: www.oenb.at [vi] Jordan, Thomas J. (2014): A new role for central banks? Speech given at the Zurich Economic Society.www.snb.ch [vii]BIS (2011): Central bank governance and financial stability. A report by a Study Group (Chairman S Ingves) www.bis.org/publications [viii] IMF Factsheet (2018): Monetary Policy and Central Banking www.imf.org [ix]The Law on the PBOC states that the PBOC shall..guard against and eliminate financial risks, and maintain financial stability (article 2). [x]The CPC is playing a more transparent role since the 19th CPC Congress.