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Can China’s Central Bank Ever Be Independent?
Why Beijing's interest rate cut is a red flag for economists.
Eventually, it seems, the pressure was just too much. The governor of the People’s Bank of China (PBOC), Zhou Xiaochuan, and his colleagues didn’t want to cut interest rates, but the risk that China’s economy might continue to cool was too great for their bosses in Beijing. After holding firm for two years, the PBOC lowered the one-year lending rate by 0.4 percentage points to 5.6 percent and the one-year deposit rate by 0.25 percentage points to 2.75 percent, giving banks more latitude to extend credit. In economic terms, it’s short-run stimulus with a potential long-run cost. But there’s a cost for the PBOC as well.
Though the economic situation in China is hardly dire — the economy is still expanding by at least 7 percent annually — things haven’t exactly been going to plan. With its growth rate at a five-year low in the third quarter, China may miss its economic target for this year. Of course, the calculation of national statistics in China is notoriously opaque, so a missed target might not show up in the official figures. Yet whether it’s on the books or not, China’s leaders still have reason to worry.
Slowing growth in China raises the potential for instability and discontent. China’s working-age population of 920 million may already be declining as its population ages, but there are still about 15 million Chinese youths reaching working age every year. Of these, perhaps 7 million will become college graduates, who currently face a job market that doesn’t necessarily value their education and skills.
If China maintains its rapid economic growth while the working-age population declines, then these young people should eventually be able to find some sort of suitable employment. But the economic cycle can cause temporary disruptions in the labor market — the political consequences of which have spooked China’s leaders before. Moreover, an overqualified workforce will not just be restive but will also try to leave.
After all, they can’t just vote the bums out. In democracies, governments with lousy economic records are usually replaced. Under China’s system, wholesale change can only come from within the government, and there’s rarely an unscheduled change at the top — especially when a leader has consolidated his power the way Xi Jinping has. So emigration and protests provide the main outlet for discontent; the former doesn’t present an existential threat to the government, but the latter just might. For this reason, the politicians in Beijing are especially sensitive to any hint of a sudden slowdown in the economy — hence the pressure to cut interest rates.
But for the PBOC, cutting rates was equivalent to throwing gasoline on a fire that it was already struggling to control. China’s credit markets are experiencing a ballooning of wasteful and speculative investment. Lower rates may help businesses to borrow and hire, but they’ll add more air to the balloon and make it easier for banks to keep bad loans on their balance sheets as well. Loose credit will also continue to fuel construction, and bringing more supply to the real estate market will only cause falling real estate prices — another headache for Beijing — to fall further.
Most likely, this is not what Zhou had in mind. The PBOC had been trying to enforce discipline, in preparation for lifting restrictions on credit markets, which was a crucial part of China’s big economic reform package. Cutting rates now just damages its credibility, emphasizes its lack of independence, and further delays those reforms. If the PBOC must respond to every whim of China’s political leaders, it becomes only an executor and not also an originator of monetary policy.
This is a red flag (pardon the expression) for economists. In fact, the politicization of monetary policy could cost Beijing the realization of one of its dearest ambitions: making the renminbi a global reserve currency. China wants the renminbi to compete with the dollar as a currency for trade, finance, and commodity prices. Needing fewer dollars among its own reserves, China’s economy would be less affected by monetary policy made in Washington. And nothing says "important advanced economy" like having securities denominated in your money stacked up in the vaults of the world’s great central banks.
The first step for major economies looking to establish a global reserve currency is liberalizing financial markets, so securities can be easily bought and sold (a change that may now be on hold for a little while longer). The next step is to make the currency convertible, by allowing investors to buy and sell it as often as they like at whatever price they mutually decide. Having an independent central bank isn’t essential — the Bank of England wasn’t independent until 1997, yet the pound was the pre-eminent global reserve currency long before that — but it helps.
The reason has to do with time horizons. In democracies, politicians typically have short time horizons; they live and die from one election to the next. As a result, they may want to cut rates and boost the economy before an election, even if it will lead to inflation and a weaker currency in the future. They may also want to keep rates from falling in a downturn, as a more austere policy can generate problems for the party in power. For them, the long-term health of the economy means less than their short-term political fortunes.
But a global reserve currency works best when its value depends more on long-term economic trends than short-term political expediencies. Central banks, sovereign wealth funds, and other institutions that build up reserves need to plan for the future; they don’t want to worry about the monetary policy favored by every new crop of politicians. A politicized central bank just causes more hassle, and hassle lead to shifts away from assets denominated in that bank’s currency.
So when it comes to having a reserve currency, is the independence of the central bank equally important in China? The first question to ask is how long the time horizons are for China’s leaders. Each one can be expected to serve for 10 years, but his actual time horizon may become much shorter if his regime is under threat. If that happens, then it’s hard to imagine that anything — certainly not any notion of the central bank’s independence — would stop him from trying to defend his mandate and, if necessary, the Communist Party’s control of the government. The PBOC may be independent in good times but not in a crisis, or indeed not even in a slowdown like the one China is undergoing right now. And that’s the same as not being independent at all.
By contrast, leaders come and go in many democratic countries, while central banks stand apart. The idea that one might seize control of monetary policy in order to save his or her mandate would seem outrageous and retrograde to voters. That confidence in the central bank’s independence, like its own credibility in making monetary policy, is both self-reinforcing and essential for a global reserve currency.
Ironically, that independence may now be in danger in Washington. Among the pet projects of the Republican Party in Congress is a plan to limit the Federal Reserve’s flexibility in conducting monetary policy. Constraining the Fed would eliminate an important advantage of American economic institutions over their Chinese equivalents. Given the consequences of a politicized central bank for China, is that really such a good idea?