Clear messages from PBOC Governor Zhou Xiaochuan

Global economic leaders have been urging China to do a better job of communicating its policies to markets.  A positive response to this was PBOC Governor Zhou Xiaochuan’s interview in Caixin. This was a comprehensive and rich discussion.  Three comments struck me as particularly revealing about China’s economic policies in 2016.

Concerning sources of growth:

China’s savings rate remains quite high and will continue to be translated into high investment. Though part of this investment will be outward investment, its proportion will be very small compared with domestic investment. This will not lead to a moderation of investment gains and a reduction of investment opportunities in China. There is a good basis to keep domestic investment at reasonably high levels.

The growth of investment has slowed in China in response to over-capacity in real estate and manufacturing. The government is trying to walk a fine line, accepting that some slowdown is necessary, but trying to maintain investment at sufficient levels to ensure growth above 6%.  The January credit data showed bank lending reaching new highs, confirming this intention to keep investment at ‘reasonably high levels.’  It was interesting that after the release of the January credit data, PBOC quickly came in with higher required reserve ratios for some banks, especially smaller ones whose lending grew especially rapidly in January. This illustrates the dilemma that the authorities face, that they want enough lending to prevent a hard landing but are also aware of longer-term risks in the continued build-up of leverage.

Concerning the exchange rate:

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, one 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.

Governor Zhou and other officials continue to point out that the large and rising trade surplus indicates that there is no foundation for a large devaluation of the currency.  In the medium to long run one should expect further appreciation.  But China has been trying to de-link from the US dollar as the Fed normalises interest rates and the dollar rises against the Euro and the Yen.

Each small move of the yuan down vis-à-vis the dollar, however, has been met by accelerating capital outflows.  Governor Zhou would like to shape expectations such that small movements of the yuan are not taken to presage further devaluation.  One of the key questions for 2016 is whether China can stabilise expectations around the current level of the exchange rate or whether accelerating outflows force an unruly devaluation.

There is so much nervousness in markets about the direction of the yuan that talk has bubbled up about the possibility of this week’s G20 meeting leading to an agreement between governments to stabilise currency values.  The obvious precedent is the Plaza Accord, signed in New York’s Plaza Hotel in September 1985, when France, West Germany, Japan, the United States and the United Kingdom agreed to depreciate the US dollar in relation to the Japanese yen and the German Deutschmark. A Plaza-type accord seems extremely unlikely, however, because the two biggest players, China and the US,  have, at best, mixed views about such coordination.  China worries about tying its hands and has a negative view of what the Plaza Accord did to Japan’s economy.  The US has led the charge on the notion that domestic monetary operations are legitimate whereas direct intervention in currency markets is ‘manipulative’.

Governor Zhou did not address this issue directly but did touch on it indirectly by commenting on whether we could expect better international coordination mechanisms:

I would say that such an international coordination mechanism is yet to be established, but efforts related to the SDR are aiming at building one. At present, there are discussions with the hope of sharing burdens and safeguarding stability through coordination. Those discussions are helpful, but years of hard work are still ahead of us.

This opinion originally appeared in The Interpreter by the Lowy Institute in Australia