The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  “They had a red rubber stamp, stamping on every project that they came across,” said Northwestern University professor and veteran China watcher Victor Shih, at a conference. “Once you have this paper from the [National Development and Reform Commission], you’d take it to the bank and say give me money.”

  Compare that to the crisis response in the United States. In both countries, monetary policy was loosened to try to combat the economic downturn. Both countries enacted fiscal stimulus, though with the messy realities of democracy, the American Recovery and Reinvestment Act became a contentious partisan issue. And because banks are under direct government control in China, the nation’s leaders were able to force them to lend, whereas the privately owned banks of the United States, reeling from crisis, were pulling back at the time the economy needed them most. Another difference: In late 2008, when experts and scholars began criticizing the U.S. stimulus package for funding wasteful projects, Chinese media were ordered to stop publishing negative coverage. The U.S. effort was vociferously and repeatedly attacked in the American media.

  It all worked. The Chinese economy bottomed out in the fourth quarter of 2008, six months earlier than the U.S. economy did, and it returned to its precrisis growth path of nearly 10 percent almost immediately. Democracy and free speech are among the greatest achievements of Western civilization, but in moments of financial panic, authoritarianism has its advantages.

  Zhou and the PBOC were good soldiers in this initial phase of responding to the crisis, even at the risk of the banking system becoming overextended and inflation rearing its head. “From other countries we’ve already learned this lesson: We’d rather act quickly and decisively,” Zhou said in an interview with a Chinese publication in March 2009. But later that year, with the Chinese economy having decisively rebounded, the opposite problem was starting to afflict the nation: There was too much bank lending, with a great potential that many of those loans were going to unworthy projects that would leave the banks with big losses in the future. Banks were doing as they were told, making loans to local governments on a mass scale, comfortable that the national government would cover any losses, but in the process they were creating longer-term risks for the Chinese economy, very likely starting to inflate the next bubble.

  Wu Xiaoling, a former vice governor of the PBOC who left the bank in 2007 and has thus been able to speak more freely on recent events than Zhou, said that in July and August of 2009, “astronomical lending” levels were “masking catastrophe.” The PBOC started quietly tightening its regulatory policies over the second half of 2009. On January 18, 2010, the central bank was sufficiently alarmed by the latest numbers on lending that it reportedly gathered senior bank executives together for an hour and a half to issue a “stop order” demanding that they cease making loans. The PBOC backed up the words with penalties: Banks that failed to comply would face higher reserve requirements, essentially making them less profitable and choking off the flow of money into the economy.

  The Chinese government, including the PBOC, had accomplished something remarkable. First, it had shielded its nation from the ripple effects of the Western financial crisis, to the extent that the global downturn caused only temporary damage domestically. And then, as its excesses of stimulus started to threaten new bubbles and inflation, it had immediately turned off the spigot.

  Harmoniousness had been preserved.

  • • •

  Zhou Xiaochuan was born in 1948, as Mao Zedong’s armies were starting to overwhelm Chiang Kai-shek to conquer what would soon become known as the People’s Republic of China. Zhou’s father, Zhou Jiannan, was a top official in the Ministry of Machine Building and elsewhere in the Chinese government, and, crucially for his son’s political career, was a mentor of Jiang Zemin, the nation’s leader from 1993 to 2003. The younger Zhou is a “princeling,” the vaguely derogatory term for the sons of top Communist Party officials under Mao who have emerged as members of China’s new ruling class.

  Being a child of privilege of his generation came with costs as well as benefits. During Mao’s Cultural Revolution of the 1960s and ’70s, Zhou and many other young, educated urbanites were dispatched to the countryside to do hard labor. Zhou, who spent four years at a construction-materials factory in northeastern China, has given no hints that it was as brutal an experience for him as it was for many others. “Besides laboring,” he once told an interviewer, “I was exposed to other things, like telephone technology, and I got to improve upon carrier-wave broadcast technology, and also updated some machine tools.” Zhou’s interest in engineering persisted, and he studied at Beijing Chemical Institute in the early 1970s as a “worker-farmer-soldier-student,” then earned a PhD in economic systems engineering from Tsinghua University’s Machine Building Research Institute. His dissertation was on how the engineering concept of “control theory” could apply to price reforms in migrating a centrally planned economy to a market-based one.

  In 1986, Zhou joined a government economic think tank, where his engineering studies proved surprisingly relevant to analyzing economies—particularly those in crisis. Control theory deals with how to keep a system stable through sensors that constantly adjust themselves based on conditions. Its uses can be mundane—allowing a car to drive using cruise control or a washing machine to adjust its cycle depending on the load it contains—but it is also a crucial technology behind communications satellites and advanced weapons systems. Borrowing from control theory, Zhou said in a 2009 speech, “In a complicated system, there are usually many feedback loops. . . . A positive feedback loop enlarges amplification, tends to create oscillation like boom and bust pro-cyclicality. . . . while a negative feedback loop can reduce amplification. . . . In economic and financial systems of recent years, we have too many positive feedback loops. Thus the system shows a strong pro-cyclicality. What we need to do is not to totally rebuild the system, but to add a few negative feedback loops.”

  As a young economic researcher in the 1980s, Zhou worked with some of China’s reformers, people committed to building a system with less corruption and more reliant on markets. One of them, the prominent economist Wu Jinglian, to this day speaks out against “old-style Maoists”; another, onetime premier of the People’s Republic of China Zhao Ziyang, was purged for opposing the 1989 massacre of demonstrators in Tiananmen Square. In the aftermath of Tiananmen, Zhou lost his job as an assistant minister of foreign trade and was forced to leave China, maybe because of his ties to Zhao. He went to the United States, where he spent two years on a fellowship at the University of California at Santa Cruz, publishing papers and writing a book. He seems not to have made a great impression on his U.S. colleagues during his time in Santa Cruz: A quarter century later their recollections of him were faint to nonexistent.

  Zhou’s political career in China had seemed finished after Tiananmen Square. But as his father’s old protégé Jiang Zemin rose to the top ranks of the Chinese government and those of a reformist bent ascended more generally in the 1990s, opportunities in his homeland reopened. Whatever one thinks of the revolving door between the financial sector and economic policymaking in the West (Exhibit A: Hank Paulson serving as chief executive of Goldman Sachs, then as U.S. treasury secretary), it’s nothing compared to the interconnection of the major Chinese banks and the government agencies that shape China’s policy. Steps toward privatization notwithstanding, the big banks remain tools of the state, responsive to directives on what companies to lend money to and on what terms. Their executives have deep political connections, and the career paths of senior economic policymakers inevitably wind through the worlds of both banking and public service.

  Zhou is a prime example. In the early 1990s, he was a vice president of the Bank of China (not to be confused with the People’s Bank of China). Next, he spent two years as deputy governor of the PBOC, then two years at the China Construction Bank, then two years at the China Securities Regulatory Commission, the nation’s e
quivalent of the U.S. Securities and Exchange Commission. He was appointed to the governorship of the PBOC in 2002, where he would serve for a decade. Throughout, his economic sensibility was different from that of most Chinese government officials. On taking the job as China’s chief securities regulator in 2000, he said, “Whatever the market can solve, let it solve it. As regulators, we should only be referees, not athletes, not coaches.”

  • • •

  The People’s Bank of China is a curious mix of old-school Chinese bureaucracy and Western-style economic thought. It is headquartered just over two miles west of Tiananmen Square in central Beijing, in a semicircular building meant to evoke a Chinese ingot, the currency of the imperial era. As at many government agencies, workers gather for communal meals according to a strict schedule, at 8 a.m. for breakfast, noon for lunch, and 6 p.m. for dinner; many take a break after lunch for a walk or a nap. Low- and midlevel employees gather at long tables, eating rice and bony fish unappealing to the typical Western palate; higher-level officials and visitors eat in an executive dining room that serves food that could be found in any business hotel in the world.

  The organization Zhou inherited didn’t have high-performing economic research departments. “Most of their researchers are not trained as proper economists,” said a former PBOC official. “They don’t do academic research. The reports are more like case studies or policy papers. They are not as technically trained.” There are few of the vigorous internal debates on economic theory that one finds at the Western central banks. Instead, researchers carry out projects assigned by Zhou and other higher-ups.

  Zhou has aimed to change that culture and make the PBOC a more typical central bank. He has disproportionally hired haigui, or “sea turtles”—Chinese nationals who left for the West and then returned. (The term is a pun: Gui, the word for “return,” sounds like the word for “turtle.”) Zhou himself, despite having spent only a brief time overseas, is deeply connected to Western culture: He drinks good French wine, enjoys European classical music and opera, and in his office at the PBOC sometimes listened to Voice of America radio broadcasts in English. Like Tim Geithner, Mervyn King, and many other economic policymakers in the West, he plays tennis. In a doubles match against then White House economic adviser Larry Summers in 2009, Zhou and Summers jokingly bet that the winner could set the renminbi-to-dollar exchange rate. Zhou’s partner was so good that the Americans suspected he was a ringer, perhaps an accomplished college player picked from the PBOC staff. The Chinese won.

  In Zhou’s decade as governor of the Chinese central bank, there was remarkable progress made toward creating a more liberal, market-oriented national financial system. In the early 2000s, China was at a crossroads. It didn’t want to get stuck being merely the factory for the rest of the world and providing only middling wages for its citizens (a situation known as the middle-income trap). A modern financial system would be required to fund the industries of the future and allow China to assert its influence across Asia and the world. The nation’s old system, however, had worked marvelously to bring hundreds of millions of people out of dire poverty since the 1980s. It’s difficult to turn away from a system that’s working, whatever its limitations.

  In the debate over China’s economic future, Zhou and the PBOC pushed for a freer flow of capital across borders, interest rates set by markets rather than by the government, and less intervention in global currency markets to lower the value of the renminbi and hence advantage Chinese exporters. The Chinese government set as a goal making Shanghai a global financial center by 2020, and work by Zhou and the PBOC would be essential if that were to come true.

  Part of being a great financial power is having a deep and liquid bond market—a place where savers can put large amounts of money and channel it to companies or governments that have useful things to do with it. Bond markets, when fully developed, grease the wheels of commerce and support a wide range of other transactions, setting market interest rates across the economy. And a vibrant bond market ensures that companies have access to capital outside the channels of state-controlled banks; it funnels money to the businesses that the market decides have the best prospects, not just those favored by politicians. China’s bond market is breathtakingly underdeveloped, with total corporate bonds outstanding of about 9 percent of its GDP in 2012, compared with more than 50 percent in the United States. Zhou and the PBOC long advocated for developing a more vibrant bond market, and in recent years had some success.

  In 2005, the PBOC created a loophole allowing Chinese companies to start issuing short-term commercial paper on financial markets after completing a streamlined registration process, in contrast to the lengthy, politicized process that securities regulators had in place for companies to issue longer-term corporate bonds. In 2008, seizing on the need for Chinese municipalities to borrow money amid stimulus spending to combat the financial crisis, the PBOC prevailed in creating a market for medium-term local government debt. The central bank successfully argued, as part of the campaign to make the renminbi a more international currency, for loosening capital control rules to allow “dim sum bonds”—that is, bonds traded in Hong Kong but denominated in the Chinese currency—starting in 2010. And in 2012, the PBOC and securities regulators relaxed rules to make it easier for corporations and municipalities to issue debt for even longer periods of time.

  Zhou and the PBOC, in other words, were persistent and opportunistic in pushing for the development of the Chinese bond market, using loopholes, the need for stimulus spending amid the crisis, and Chinese financial nationalism to get his way. The PBOC has also been one of the most consistent promoters of renminbi internationalization, the idea that China’s currency should one day stand alongside the dollar, the euro, and the yen as an important currency of global trade. In an essay published in early 2009, Zhou openly pondered what “kind of international reserve currency we need to secure global financial stability and facilitate world economic growth,” suggesting that the supremacy of the dollar was a major factor in the world financial crisis.

  The statement reflected a general angst among Chinese leaders—evident after the Fed’s QE2 announcement—that their massive holdings of U.S. debt had left them uncomfortably exposed to the vicissitudes of the American economy. Unspoken but unmistakable was the conviction that a greater role for the renminbi would be an inevitable part of some new global currency regime. In October 2009, the PBOC created a new department, the “Monetary Policy 2” division, to study renminbi internationalization. It is headed by a consummate sea turtle, a Stanford PhD and Harvard Law graduate named Li Bo.

  In recent years, the PBOC has created swap arrangements with many other central banks of the Pacific Rim, including those in South Korea, Indonesia, Thailand, and Australia. “The main purposes of the swap agreement are to support trade and investment between Australia and China, particularly in local-currency terms, and to strengthen bilateral financial co-operation,” the Reserve Bank of Australia said in its announcement. There was talk in 2012 that other advanced nations’ central banks, such as the Bank of Japan and even the Bank of England, might soon enter similar arrangements. That should allow banks in those countries access to Chinese currency should they need it, part of a deliberate effort to smooth the process by which more global trade happens in the renminbi rather than the dollar.

  In public communications, Zhou and the PBOC soft-pedal the idea that they’re trying to make the renminbi a major global currency. In official documents, the phrase used for the phenomenon is not “RMB internationalization,” but rather what would be translated as “the RMB going out”—which is to say going out into the world beyond China. Zhou in a 2012 interview said that renminbi internationalization was “the will of the market rather than a government-backed move.”

  But there is clearly a deliberate effort under way, even if it’s a reversal of the usual sequence by which nations ascend to great financial power. Typically, as prominent Chi
nese economist Gang Fan put it, internationalization of a currency begins with a flexible exchange rate system, followed by a liberalization of capital flows that makes the nation an attractive place for international investment, which leads to widespread use of the currency. China is supporting the use of the renminbi in international transactions before fully liberalizing other aspects of its economic policy. Zhou, in one interview, was blunt about why. “If some areas need to be reformed, but it is impossible to do, we can first reform other aspects, and then push forward reform of those aspects which are difficult to advance.”

  There’s a more cynical way to cast the same idea, a theory of what Zhou and other Chinese reformers are up to that’s widely accepted among Western China watchers and policymakers—even if Chinese officials dismiss it, as one central banker put it, as a “conspiracy theory.” Zhou and the PBOC face steep political resistance to liberalizing Chinese finance and wresting more power for the technocrats at the central bank for its own sake. But when they cast their arguments in terms of China’s national greatness, when the question isn’t about the petty battles of this bureaucracy versus that one but making Shanghai to the twenty-first century what New York was to the twentieth and London was to the nineteenth, their political masters are more likely to listen.