We are sharing with our overseas readers the exclusive interview by Caixin Weekly selectively translated by us in English on PBOC Governor Mr. Zhou Xiaochuan. We believe this is an extremely important interview at such crucial juncture of global market weakness and uncertainty, and it surely can clarify some questions raised by investors, if not all. Our purpose here, is to help our readers understand the policy objectives of PBOC and investment implications going forward. We are presenting this truthfully, unbiased, but with considerable omissions on some non-sequiturs and some content on macro prudence framework and digital currencies.
Q- Caixin Reporters A- Zhou Xiaochuan
Q: Could you brief us on the main agenda of January’s comprehensive annual review conference of the PBOC?
A: Annual review conference was historically designed to discuss the current international and domestic economic and financial matters, as well as to implement the objectives set by Central Economic Work Conference (Editor commentary: held in December last year) and to promote financial reforms. This year, in particular, our discussions have been focused on forex market and currencies, evaluation of macro-prudence, digital currencies and Internet finance, etc.
Q: There have been some divergent views on China’s economic growth outlook, which have an impact on the evaluation of the RMB exchange rate. What is your take on this?
A: So far there has been quite some divergent views on (China’s) economic outlook and the financial market, but it is also crucial to have a comprehensive and objective understanding on the current economy of China. Overall, China’s economy is still growing at a reasonable speed; under the backdrop of overall global economic and trade slowdown, as well as increasing volatility of the global financial market, China still maintains a GDP growth rate of 6.9 percent, a relatively high growth rate compared to global counterparts.
The change (slowdown) in China’s economic growth, can be partially attributed to slower growth globally, but it is also a result of policy adjustments by the Chinese government, which necessitates a more sustainable, high-quality growth in the future, and is helpful for the global re-balancing. In the future, China will continue to work on enhancing structural reforms, especially supply-side reforms, to balance economic growth, structural adjustments, as well as risk management.
Q: In your view, what is China’s main driving force for economic growth?
A: China still has a high household savings rate, which will lead to high investments, as this causation remains intact. Although a fraction of high investment now has shifted to “Go Global”overseas investments, it is still comparatively meager compared to domestic investments and does not necessarily mean there are less opportunities and room for growth in terms of domestic investments. Thus there is reasonable basis for high domestic investment growth.
On the other hand, there has been some shift of comparative advantages (Editor commentary: referring to high labour-intensive low-end manufacturing). But the transition towards middle to high-end products means Chinese manufacturing is still enjoying huge comparative advantage. The short-term adjustments is partially due to higher environmental requirements, which restricts high pollution, high energy-intensive industries’ excessive expansion. Moreover, the expansion of service industry as of GDP has been witnessed from 43% in 2014 to 50% in 2015, which still has huge room to grow.
Apart from what I said just now, entry barriers to private capital was still too tightened in the past, and we have conducted considerable administrative measures to alleviate this situation. There is also huge room to grow for “mass start-up” scheme.
Q: China’s economic growth slowdown has been a concern globally, which leads to considerable amount of pessimism.
A:There are two key factors that determine how people view China, which is important to evaluate: Back in 2009-2010, China has accounted for more than 50% of global GDP growth, while we only account for 20% of the global population and less than 10% of global GDP. This is a special time period – as the EU and US faces economic crises, China rolled out the economic stimulus package, and led to dramatically different results of growth. But this situation should not be considered as norm – 50% is neither a standard, nor sustainable in the long run.China’s current economic growth contribution to the world is 25%, which is much closer to the norm, and shouldn’t be considered as “hard landing”.
Another key issue is that China overemphasized GDP in the past. Globally speaking, GDP, especially nominal growth, has little to do with exchange rates. For instance, high GDP growth might correspond with economic overheating and high inflation rate, which leads to more depreciation pressure of the domestic currency. Now people are referring to the GDP slowdown of China with regards to its exchange rate, which is a misleading argument. In fact, domestic exchange rate has more to do with competitiveness and economic health.
Based on economic theories and global experience, the factor that is most highly correlated with exchange rate is the current account balance. In 2015, China still has a high current account surplus, of which trade surpluses was 598.1 billion USD, a historical high. Another factor that may impact exchange rate is the real effective exchange rate (REER), which incorporates domestic inflation rate. US, EU and Japan’s inflation target is 2%; China’s CPI growth in 2015 is 1.4%, this is a relatively low inflation rate for China, a source of stability for exchange rate as well.
In sum, China still has a fine balance of payments, strong competitiveness, relatively normal cross-border capital flows, and RMB has maintained stable against a basket of currencies – in fact it has appreciated a bit. There is no ground for consistent depreciation.
Q: But global market factors are also important for RMB exchange rate, what do you think are the global factors that you will pay attention to?
A: Of course, this is very important. I cannot be too comprehensive here, but will only talk about four main points: primarily, the global economy has suffered a bit from 2008 financial crises. US has shown some good signs afterwards, which leads to appreciation of the USD and a depreciation of the JPY and EUR. Because of multiple reasons, RMB has depreciated relatively mildly (against USD), and has appreciated significantly against the EUR and JPY. The market has an expectation of a “long-term due” to be paid.
Second, the Fed has transitioned from less amount of QE to a halt of QE, and eventually hiked the interest rate last December. In 2013-2014, the change of Fed monetary easing has a huge impact on some emerging economies, but has relatively limited impact on China. 2015’s rate hike, however, has a significant impact on China, which can be referred to as “paying long-term dues”.
Third, speculative forces have been focused on shorting China for a while. In fact, these speculative forces always need to find hot spots to place bets, and they spotted China’s economic slowdown in 2015 and financial market volatility. The problem is, these forces were quite weak in the past, but they have increased their dry powder significantly after multiple rounds of quantitative easing by various central banks. Is China economy going to be fine? We have patience and confidence, and are waiting data to prove our point. But we also understand this has nothing to do with their bets or their voices, as they are trying to create waves in the media, and attempt to force a result out of the current market.
Fourth, global financial assets have demonstrated various degrees of “bubble”or is bound for correction. Asset prices have been growing quite a lot since 2008 and the subsequent monetary easing globally. There is a certain degree of distortion, and an inherent pressure for correction. Now we are curious what will trigger the correction – correction is always painful, so it is natural to find a third party to blame.
There are global concerns that China will depreciate the RMB for the sake of exports and GDP growth, and even participate the so-called “currency war”. But if you look closely at China’s current account balance, China’s trade surplus was as high as 600 billion USD; net exports have contributed rather significantly to the GDP growth. Thus there is no incentive for us to depreciate the currency to expand net exports, which is re-emphasized by Premier Li. However, there is an issue worth mentioning regarding the high trade surplus in 2015, which is the falling commodities prices. China actually increased imports of commodities volume wise, but fell on an amount basis. It is unfair to blame the fall of oil prices solely on China’s economic slowdown. Therefore to explain the depreciation pressure on the RMB against the USD since late last year, it is necessary to look at USD’s sharp appreciation against major currencies, several global and domestic event, as well as short-term market sentiment.
Q: Is there an estimate of “hot money”by the PBOC?
A: There is no clear definition on that. But speculators were not the main forces of influencing balance of payments. Main speculators were in the overseas market, but there is little cross-border capital flows on QDII and QFII schemes, which limited the size and growth. Of course, shorting China externally may have an impact on the domestic market in terms of market sentiment.
From what we gathered so far, some export enterprises have changed their decision of settling currencies (forex) and timing of settlement, delayed settlement, hedged currency risks using currency forwards, as well as adjusted investment timing and purchased foreign currencies in advance. These all have an impact on the supply and demand dynamics on the currency market. A large number of domestic enterprises have overseas subsidiaries – to put their money domestically or abroad, it is more convenient now than ever and follow the right window opportunity. But export enterprises still need to pay wages, utilities, and raw material costs using RMB. We can see a limit to that strategy , which can also be applied for importers.
Another issue is that domestic enterprises will adjust their balance sheet accordingly under certain currency expectations, mainly to prevent USD appreciation’s impact on their USD liabilities. They will change their USD liabilities into liabilities denominated in domestic currencies. China is a huge economy and has relatively high amount of external debt. In 2014 we have external debt of 800 billion USD. As long as there is room for adjustment, there will be demand for foreign currencies on the central bank. Comparatively, RMB debt financing has certain standards – RMB loans are quite accessible now and is not excessively burdensome ( in terms of rates). That is to say if the expectation is correct, there is little to argue against the adjustment of companies’liabilities’ structure. The good news is that this type of adjustment has a ceiling, i.e. When the external debt is fully paid. Also a number of foreign enterprises in China needs USD debt financing, which cannot be downsized to zero due to their headquarter’s location.
It is necessary to distinguish between capital outflow and capital flight. It is normal to change FX strategies and liability structures for external-facing corporations. It is a matter of judgment. It does have an impact on capital flows and China’s foreign exchange reserves, but it cannot be simply understood as capital flight.
Recently there have also been a number of uncertainties in global financial markets. Different from the normality, a number of speculative forces have aimed China as target recently. Normally speaking, global speculators found it hard to aim China due to high economic volume and powerful resources of the central government. It is not easy to earn profits from shorting China as a whole. Also, China has enjoyed capital inflow for years, of which partially can be attributed to “hot money”. It is thus no news for them to exit from their current positions.
Q: You have talked about balance of payments and REER, but capital account also have an impact on exchange rate, could you elaborate on that?
A: Yes. As for capital account, the basic information we gathered are as follows: first, FDI has been relatively stable despite some volatility; second, a number of Chinese enterprises have aggressively pursued “go global” strategy, a result of policy loosening and more Chinese entrepreneurs gradually began to understand global market. There has been considerable increase in ODI, which is a good news.
Of course, we have also observed that some people have been pursuing immigration and overseas property investments, due to confidence, protection of intellectual properties and original sins (原罪 referring to some criminal activities or embezzlement, a first time ever for central government high ranked officials to mention this word); some entrepreneurs also invested in companies overseas, which cannot be misconstrued as loss of comparative advantage or business development move, but rather a “flight”protection due to lack of bankruptcy legislation in China.
China has such a huge economic volume and a such a high degree of economic openness. It is natural that there were certain capital outflows accompanying normal outbound investments, which requires room for improvement. But this is still limited compared to 4 trillion USD trade volume and several trillions of foreign exchange reserves. We need to look at relative volume when doing our calculations. Also, the improvement of rule of law in China will ameliorate these issues going forward.
Q: What do you see as the direction and pace for RMB currency reform?
A: There is no change in our overall course of reform. But we have patience as well – we hope that China will achieve great progress in the realm of currency reform during the 13th Five Year Plan. The direction is to rely more on market forces, which leads to a more flexible currency rate.
The RMB exchange rate reform’s overall direction is to achieve a managed float currency mechanism, under the basis of market supply and demand, together with reference to a basket of currencies. The primary focus is still on market supply and demand – though there might be short-term speculative forces, we should still respect the market. There is no optimal currency rate predicted by a single model in PBOC. Referencing a basket of currencies is a natural choice for us due to our multilateral, diversified trade and investment partners. We haven’t done that well enough in the past, as we tend to focus on the USD. We will continue to reference a basket of currencies. We always tend to think that it is unwise to rely fully on effective market hypothesis, as there might be deficiencies in a free market, dominated by speculative forces, short-term sentiments and flock effects. Thus our floating exchange rate mechanism needs to be “managed”. We hope and will strive to achieve “basic stability under a reasonable equilibrium level”. Although it is hard to estimate equilibrium level, basic stability can be only achieved under reasonable equilibrium level; erroneous, unbalanced currency level cannot be stable. On the other hand, it is necessary to aim for basic stability, in order to find the “reasonable equilibrium level”. There isn’t much room for fundamentals and equilibrium analysis during huge volatility and market havoc.
For such a huge country like China, it may take longer time to achieve reform targets. The art of reform is to progress without reservations during fine window opportunity; but take a break when there is no window opportunity. We can afford a wait and create good conditions for the future. China’s economy always emphasizes on equilibrium among three factors- reform, development and stability. The global economy is still recovering from crisis, which also needs to juggle among the three factors mentioned just now. We are practical, patient, well-aimed but are not single-minded and look just for direct results. We desire reform, but we are also a responsible economic power.
Q: RMB exchange rate reforms coincides with a new round of correction in the global financial market. Is it fair to say there is a considerable degree of spillovers caused by Chinese financial market?
A: A lot of volatility in the financial market is event-driven, such as Fed’s decision to halt QE and to hike rates eventually, creating a bunch of trading opportunities. Event-driven trades tend to overextend themselves. With higher market volatility, market participants become nervous and tend to blame each other. We also need to take these factors into account when rolling out important policies.
In the past, China has limited impact on the global economy and we are not used to any spillover effects of our policies. As for now, we do see some spillovers (on policy making of China). When the global market uncertainty deepens, event-driven trades aggravate market volatility, and there is considerably more focus on China’s spillover on the global market. We will continue to prudently promote RMB exchange rate reform, and pay attention to reasonable timeframe and window opportunity. We will try our best to reduce negative spillover of our policy making, especially avoid grouping events with other global incidents.
Moreover, domestic stock market, bond market, currency market, and money market tend to also have spillovers against each other. In essence, it is an interaction of price distortions, financial health, bubble and resilience. Just as what central economic work conference has stipulated, it is necessary to avoid contingent infection, mutual impact and systematic risks. What we learned from the 2008 US subprime mortgage-led global financial crisis, is that US real estate market, subprime mortgage markets and shadow banking infect each other, which leads to disastrous results. China also contains potential soil for mutual infection. Thus, we need to find right window opportunity and aim for right timing, coordination and techniques. Some reform items does not fear slow pace but fear sudden halt, and we cannot just focus on risks but disregard the benefits of reform. Of course, we need to also avoid another extreme, which is “trap of transition economies”and “reform fatigue”.
I would like to also stress that USD has appreciated quite a lot against EUR and JPY since late 2014. RMB has basically followed USD with some mild depreciation. RMB also has accumulated some pressure for depreciation against other major currencies, an inherent risk of correction. For the past few years, RMB has been too stable compared to other global currencies, and has little volatility. It gives an unreasonable expectation of no volatility for RMB in the global market. Now as the RMB exchange rate moves, it causes strong spillover effects. However, if we use JPY and EUR as reference, RMB exchange rate volatility is much smaller, not to mention Russia, Brazil, South Africa and other emerging economies’ currencies. However, people do tend to have path dependence on their thinking patterns. Thus it is unfair to overemphasize negative spillovers by China.
Q: Since China announced RMB exchange rate index since December 11th, 2015, does that mean the PBOC will focus more on “a basket of currencies”?
A: China’s currency rate formation has deviated from a hard peg with the USD, but it is not a complete floating currency as well. In the future, it is still the main task to increase the referencing against a basket of currencies and maintain basic stability. A more mature referencing mechanism will incorporate a series of structural arrangements, including guiding the market to estimate the exchange rate level necessary to maintain basic stability against the basket, requiring market maker to consider the importance of the basket when providing pricing for the “fixing”, as well as considering more weights on the basket when implementing currency rate adjustments. The result of such move, will be more stability against a basket of currencies, while there might be some more volatility on against the USD going either way.
We will significantly enhance the referencing of a basket of currencies, but this does not mean we will fix against the basket. There are more factors that might influence the exchange rate. Fixing against a basket of currencies might have the benefit of increasing transparency of expectations and guiding the market to understand the rate formation better. However, there are a number of difficulties stemmed from this move- first is how to implement the impact of new macro figures; second is how to demonstrate the basis of market supply and demand; third is how to determine the weight of the basket. There is no authoritative weighting mechanism, it could be trade-weighted, referenced by SDR baskets and may be other baskets. Different baskets form different indices and is still debatable on which one is better. Thus we have announced the currency indices against three different baskets, the future mechanism design may continue to adjust based on macro economic trends and market supply and demand dynamics.
It is also customary to have a process of search in order to achieve a mature, transparent mechanism. So far there has been more consensus on referencing a basket of currencies, and the fixing mechanism has been focused on introducing elements of the baskets. In practice, the aim is to stabilise against the basket, but also introduce other mechanism when macro economic data has an impact on exchange rates. PBOC will continue to communicate with the market and increase the application of RMB index going forward, so as to let the market determine the effectiveness of referencing against baskets of currencies.
Q: What do you think of global coordination’s role in dealing with spillovers of policy making by various countries?
A:There is no such coordination mechanism so far. SDR’s attempt was to establish such mechanism. Now there have been discussions so that we can all share the burden and maintain stability. These discussions were helpful but still required years of efforts.
Q: What do you think of the market’s view that the exchange rate formation mechanism of the RMB was quite opaque and required market participants to guess?
A: First of all, PBOC definitely has the strong and clear intent to continuously ameliorate our communications efforts with the public and the market . In the past we have implemented some successful attempts of communications. But we also clearly understand that it is hard to make good communications consistently.
The global market has quite a lot of uncertainties now, which will lead to divergent views and disputes. At this moment, we all hope that there is a prophetic or authoritative view, which can convert uncertainty into certainty. But uncertainty objectively exists in the market, and is impossible to eradicate via mere verbal statements. Central banks were neither God, nor magicians. We cannot eradicate all uncertainties, that’s why we often say “sorry, we need more data inputs”.
In terms of forward guidance, there are several questions to be researched. Primarily, is central bank’s human resources and intelligence better than the market? Do we have a better theory or estimation model than the market? Second is the relationship between forward guidance and traditional monetary tools- when there is no room for interest rate and open market operations, we can only talk about forward guidance. Third is that judging from global experience, it is sometimes hard to avoid disputes, even within the central bank. At that point, forward guidance’s policy signal can neither help the market nor alleviate the concerns.
We have to observe that for the past several years the RMB has been on a constant trend of appreciation and the foreign exchange reserves have also been accumulated constantly. This is definitely not an infinite journey – it is bound for a ceiling and a turning point. When the turning point arrives, appreciation might be overextended and is bound for a correction. There might also be appreciation expectations going forward, because the fundamentals support that. Overall, the trend is stabilisation after a period of volatile adjustments, which is customary dynamics of the system. China’s forex market is still not a completely competitive market – facing various market participants, the PBOC has different communication strategies. For the public, we tend to focus on communications of knowledge and systematic framework; for exporter and importers, we tend to guide and stabilize their expectations; for speculators, we are competitive counter parties and opponents, how are we supposed to inform all of our strategies to them? It is like playing chess, you won’t tell your opponent what your moves are going to be next.
Q: Some people were worried about the falling forex exchange reserve, what is the PBOC’s take on this and their moves against speculative forces?
A: It is not strange to have speculative forces on the market, and is hard to tell them from normal risk management moves. China has the largest forex reserves in the world, and we will not let speculative forces dominate market sentiment. Forex reserves’usage include cross-border payments as well as financial stability. China’s forex exchange reserves guarantees adequate funds for cross-border payments as well as financial stability. Following capital flows, forex exchange reserves is reducing now, but might grow in the future as well. As long as the fundamentals stay intact, it is perfectly normal to have some fluctuations.
Of course, it does not mean we will definitely intervene whenever speculative forces dominate the market sentiment. We also consider the issue of using our ammunition effectively and minimize our cost. A further reform of our exchange rate formation mechanism is helpful to react against market speculative forces. If we say the fixed exchange rate regime is an static iron-made shield, flexible exchange rate is a “sponge shield”, which can help us be flexible against excessive speculative powers.
Q: PBOC has tightened liquidity in the offshore RMB market, which has an impact on RMB internationalisation. How to balance between the two ?
A: We obviously want RMB internationalisation to progress without obstacles, but there is no free lunch in economic development. RMB internationalisation will progress in the pattern of waves – when we find the primary focus to be speculative attacks, we will focus our energy on it; until the market stabilises, the RMB internationalisation will continue to progress.
Q: Will China have stricter capital control, facing speculative forces and cross-border arbitrage?
A: When we think about convenient usage and risk management, we tend to stress on stricter risk management , anti-money-laundering, anti-tax-evasion, anti-tax-base-erosion and profit transfer. We will protect all normal forex usage to be guaranteed and free.
Some people have argued that China needs to implement this or that capital control measures- some of which are obviously rumors to stir panic among residents and traders, so as to coordinate with their bets.There are even rumors on current account limits, rather than capital account, saying that SAFE will limit FDI enterprises’ profit expatriation back offshore. We need to understand that this is current account item and is always allowed. SAFE has never set any quotas. In terms of capital account, normal cross-border M&As, subsidiaries set-up can also purchase forex following normal procedures. Financial market differs from the real economy in that confidence is the key issue here.
Global experience shows that capital account limits have some impacts on those relatively closed economies, but is less effective for open economies. Capital account limits is also more effective for capital inflows than outflows. China is a huge and open economy, and relies on trade much more than other countries. We have 4 trillion trade volume, concerning hundreds of trade enterprises; we have 100 million residents going abroad each year, with 50 million overseas Chinese; we also have capital pool of FDI enterprises over trillions of USD. THese were all interest parties of RMB exchange rate and exchange mechanisms. Any unreasonable capital control will cause trouble for the real economy and trade, which will have further impact on confidence and balance of payments. Moreover, because of high degree of openness, by-passing restrictions is quite common and well-expected. We will continue to maintain the delicate balance between legal enforcement of current regulations as well as maintaining the degree of openness.
Our overall comment: we believe Governor Zhou’s statements provide a guide to what PBOC will manage its exchange rate policies and capital account going forward. We believe the overall message is quite positive, as the policy reforms are still important for PBOC going forward. The speculative attacks were acknowledged by Zhou, but he also believe right techniques and better communications are needed going forward. However, a “Plaza Accord 2.0″or a global coordination on exchange rates seem like a remote option and is not even to be on the discussion item going forward. The interesting part of this interview is, Zhou’s frankness on central bank’s so-called “omnipotence”, which he thinks is not possible. This is also a fine guide for their central bank counterparts, Dr. Yellen, Kuroda and Draghi.