China's Fiscal Policy Dilemmas
Xiang Songzuo, chief economist at the Agricultural Bank of China, holds forth on China's fiscal predicament, government controls and the future of the yuan.
China's Fiscal Policy DilemmasBy Yi-shan Chen
From CommonWealth Magazine (vol. 568 )
Xiang Songzuo, chief economist with the Agricultural Bank of China, doubles as deputy director of the Center for International Monetary Research at China's Renmin University. Born in 1965, Xiang is one of only a handful of Chinese economists who have worked their way up from entry-level jobs at the People's Bank of China.
After obtaining his master's degree in economics from Renmin University in Beijing, Xiang worked at the central bank's Shenzhen Branch for five years. Xiang steadily moved up the ladder, serving first as deputy director with the Capital Planning Office and then the Currency & Credit Office before becoming director at the Financial Debt Management Office, witnessing dramatic changes along the way as China opened up its economy and implemented market reforms. Only after the Asian financial crisis hit in 1997 did Xiang realize the destructive impact of hot money on the economy.
Xiang studied under Nobel Prize-winning economist Robert A. Mundell while pursuing a master's degree in international affairs at Columbia University at the turn of the century. Mundell, who is hailed as the father of the Euro, inspired in Xiang a strong interest in international financial markets. Late last year, Xiang published his observations on the global financial markets and the real economy in his book New Capital in the 21st Century (二十一世紀新資本論).
Hong Kong-born American economist Steven Ng-Sheong Cheung, who is hugely popular in China, has praised Xiang as an extremely well-read person, saying Xiang must have read more than twice as much as he has. On top of that, Cheung says, Xiang has the ability to organize problems based on their importance, something Cheung says is a "rather rare trait" among economists.
Since last year, China has repeatedly lowered reserve requirement ratios for banks to increase liquidity. After interest rates were cut twice and the yuan's depreciation against the U.S. dollar, observers generally believed that the People's Bank of China would embark on a looser monetary policy. Yet Xiang, who is familiar with the mindset at the central bank, takes a different view. In this interview with CommonWealth, Xiang thoroughly analyzed China's monetary policy, predicting interest rate and Chinese yuan exchange rate trends.
The following are excerpts from the interview:
Regarding the future market trends for the Chinese yuan, I believe that the yuan's depreciation against the U.S. dollar will continue for some time to come, but the scope of depreciation will not exceed five percent. It will, however, appreciate against the currency basket. Globally, the yuan is still the strongest currency after the U.S. dollar.
Tough Decision No. 1:
Structural Adjustment vs. Stable Growth
The yuan will not depreciate massively because the monetary policy of the People's Bank of China now faces two difficult, fundamental decisions, so there will be no large interest rate cuts.
The first difficult decision is, "How to coordinate stable growth while adjusting the domestic economic structure." China's 15 manufacturing industry sectors continue to face deflation, the producer price index has been on a decline for 40 consecutive months, the purchasing managers index (PMI) keeps hovering around the expansion-contraction line, and the manufacturing industry is in a deflationary state.
From this perspective, it seems that the People's Bank of China should implement an across-the-board loose monetary policy, including a blanket reduction of reserve ratios and interest cuts. Some people even think it should learn how to carry out quantitative easing from Europe, Japan and the United States.
However, certain sectors such as educational, medical and tourism services are not suffering from deflation but rather from significant inflationary pressure, continually rising labor costs and stubbornly high real estate prices.
If we adopt monetary easing, inflation in the service industry will worsen and real estate prices might go up further. The manufacturing industry, which has a severe overproduction problem, might be able to take a breather, but at the same time, it may not have sufficient resolve to reduce inventory, throttle back production, deleverage and carry out structural adjustment. Should that be the case, the accumulated problems of the past will only become worse until they become irresolvable.
Tough Decision No. 2:
Stable Exports vs. Internationalized Currency
The second difficult decision is, "How to coordinate export stability with the promotion of an internationalized yuan, the liberalization of capital accounts and the internationalization of financial markets."
If we first look at the latter, the yuan exchange rate should become freer and exchange rate fluctuations should become wider, forcing investors to bear exchange rate risks themselves.
But from the perspective of stable exports, we also require a relatively stable yuan exchange rate. Exporters even hope that the yuan depreciates markedly.
As it looks now, however, structural adjustment has become more important than stable growth. That's the main tune of monetary policy. Therefore, the People's Bank of China has been extremely cautious all along about a blanket easing of monetary policy, instead insisting on directional controls and directional easing while pursuing stable growth. Chinese Premier Li Keqiang has repeatedly said that China cannot again rely on strong stimulus measures or "overflow the market with liquidity."
Since stable exchange rates are the main goal of currency policy, the exchange rate will be gradually allowed to fluctuate wider, while capital account liberalization will take a secondary role.
Of course, the People's Bank of China will find it difficult to withstand pressure from various industries, local governments and investors as they demand interest rate cuts across the board. The People's Bank of China is not an independent central bank but a division of the State Council of China. The bank's governor, Zhou Xiaochuan, does not have the right to make decisions as independently as Janet Yellen, chair of the Federal Reserve Board in the United States, or European Central Bank President Mario Draghi.
Chinese Currency and Stocks Still Going Strong
The main reason why the yuan remains comparably strong is because the Chinese economy can be expected to maintain mid- to high-speed growth. Annual growth rates of 5 percent to 7 percent should not be a problem within the next twenty years. Therefore, China will continue on its path to becoming one of the major countries attracting foreign investment.
Trading on most stock markets around the globe has become delinked from the underlying economic fundamentals. The stock markets in the Euro zone, Japan and the United States have soared to levels far above those seen before the financial tsunami of 2007-2008, whereas economic recovery still lags far behind pre-crisis levels, even in the United States.
Therefore, stock markets can no longer serve as an economic barometer, as they have been drastically delinked from economic fundamentals. The situation in Chinese stock markets is similar. During the latter half of last year, Chinese stock markets soared while the economy continued to slow down. This trend will continue.
Chinese stock markets will likely continue to still register higher increases this year, mainly because of an influx of a considerable amount of capital into the stock market. The sources of this capital are a looser monetary policy, a cooling real estate market, more market-determined interest rates, a regulatory change in the IPO procedure from an approval-based to a registration-based system, as well as the launch of the Shanghai-Hong Kong Stock Connect and the Shenzhen-Hong Kong Stock Connect schemes. In 2015, the Chinese stock market might become a capital-driven small bull market.
Overall risk in the Chinese bond market remains controllable. Although there will be isolated cases of default for individual corporate bonds, we won't see debt default on a large scale. Government bonds, local government bonds and corporate bonds will post somewhat higher growth. In comparison, bonds still constitute a safer investment opportunity.
Translated from the Chinese by Susanne Ganz