My lessons from life as a Chinese central banker
By David Daokui Li
When I became one of three academic members of the People’s Bank of China’s Monetary Policy Committee in April 2010, I knew I was unprepared, despite teaching economics for nearly 20 years in the US and Hong Kong before returning to China. In fact, few people could have been prepared: China has a large and mixed economy and its institutions are still young. The financial crisis made my task even harder, since it exposed the deficiencies in traditional macroeconomic theories.
Following my term on the committee, I think I have learnt three fundamental lessons, which may be useful for those trying to understand how monetary policy is made, not least in China.
First, central bank independence is an unhelpful superstition. In theory, independence is a good defence against pressures from politicians facing re-election. The PBoC is under the control of the state council, and not run under by autonomous bank staff. This may suggest that Chinese officials are subject to strong political whims. Perhaps, but Chinese leaders often stay in office for as long as 10 years and are as concerned about their legacy as long-serving central bankers such as Alan Greenspan.
In reality, China’s close co-operation with economic agencies is a stronger defence against local governments, equity investors and property developers – all of whom push for easy money policies – than a pure independence model. The MPC consists of officials not only from the central bank, but also from the finance ministry, and the banking, securities and insurance regulatory agencies.
Knowing this, I was nevertheless shocked when the Chinese premier recently said that only two factors had the potential to undermine his government: corruption and inflation. He does, of course, have some influence over these factors.
My second lesson: do not be overconfident in the power of price instruments. Textbooks preach that prices are the most fundamental signals in a market economy. However, in reality, price signals in the monetary system may not work quickly enough. We should be modest in our expectations for interest and exchange rate policies.
Take the trade balance, which does not respond quickly to exchange rates. It depends upon existing contracts between importers and exporters, which cannot quickly respond to exchange rate changes. It might be a policy objective to reduce the trade surplus but a fast appreciation of the renminbi against the dollar is likely to cause speculation of further appreciation, creating bubble-like exchange rate dynamics.
My third lesson: respect investor sentiments but work steadily and patiently against them. These are actually the most important drivers of economic fluctuations.
Unfortunately for central bankers, I estimate that monetary policies can influence, at most, 50 per cent of investments. In China, this figure was about 70 per cent before the financial crisis. A central banker must respect investor sentiments, not because they are correct but because they have an overwhelming momentum, like a huge oil tanker. How do you change the direction of such a huge tanker? Steer early and steadily, while staying patient and not expecting instant response.
Since the financial crisis, China’s central bank has been carefully steering against investor sentiments. Between August 2008 and June 2009, Chinese investors were largely pessimistic. Monetary policies were then aimed at delicately changing investors’ minds through cuts in interest rates and deposit reserve ratios. By mid-2010, however, investor sentiments had swung in the other direction – annual output growth was running at 10 per cent. Tighter policies were then pursued, together with stronger banking and property market regulations. By mid-2011 sentiments finally stabilised.
Looking to the future, what is the most important question for China’s central bankers? In my opinion, it has to be how to lower China’s huge stock of broad based-money in renminbi – equivalent to $14tn or 190 per cent of gross domestic product. Thirty per cent is locked up at the PBoC, giving it the largest central bank balance sheet in the world. An amount this large is a perennial destabilising force for the entire economy, which is at the mercy of the mood of the depositors.
China needs reform. It must enhance the size of its securities markets, especially the bond markets, in order to lure bank deposits. China must also implement bank loan securitisation, ie convert some of the good quality bank loans into bonds so that banks can raise capital and become more robust. Until these steps are taken the capital account cannot be fully convertible, the exchange rate cannot be fully liberalised and the renminbi cannot be a genuinely international currency.
The writer is a professor of economics at Tsinghua University and a former member of the People’s Bank of China Monetary Policy Committee