Analysis: China central bank takes lead in economic reform push

China's readiness to bend retirement rules to keep arch-reformer Zhou Xiaochuan at the helm of the central bank signals clearly that new Communist Party chiefs want to speed economic reform in the country's most critical development phase in three decades.

Central bank insiders interviewed by Reuters say the People's Bank of China (PBOC) is the country's most potent force for reform in the face of powerful vested interests, echoing sources with leadership ties who last week said Zhou would keep his job despite reaching the mandatory retirement age of 65.

Keeping Zhou ensures that the PBOC will remain a trusted instrument through which China's leaders can enact financial reforms designed to boost free markets and private enterprise, rebalance the economy, reinvigorate growth and ultimately heal a socially divisive rift between the country's rich and poor.

"Governor Zhou has been rather bold in spearheading market reforms and sometimes does not care about the possible repercussions," said a PBOC official who requested anonymity due to the sensitivity of the matter. "They really need someone who can sustain the reform momentum."

The reform agenda espoused by Party leaders Xi Jinping and Li Keqiang is not always popular with the local government officials, state-backed business and cosseted national lenders who would find their power bases fundamentally weakened.

Liberalizing interest rates, for example, would hit fat lending margins at state banks.

Expanding capital markets would end subsidized access to funds for state-owned enterprises and cut private sector finance costs while creating investment options beyond real estate -- cooling the property speculation that lays at the heart of local government corruption and debt risks.

The PBOC has a track record of getting the job done in the face of entrenched opposition.

It has modernized domestic bond and money markets, laid the groundwork for short-term market instruments to manage bank liquidity and credit, while simultaneously creating mechanisms that allow the PBOC to resist pressure from growth-obsessed local officials to constantly tweak interest rates.

Indeed, the last 12 months have produced the most important package of interest rate, currency and capital market reforms since the landmark July 2005 break of the yuan's peg to the dollar -- and all in a year when political change at the top of the Party was supposed to stall change elsewhere.

That's despite a clear clash with the China Banking Regulatory Commission on the liberalization of interest rates.

"Big banks were definitely against interest rate reform, but they could not openly oppose it," Zhao Qingming, senior economist at China Construction Bank, one of the so-called "Big Four" state banks.

When the PBOC proposed doubling the yuan's trading band to 1 percent last year, it worked hard to soothe fears of the Commerce Ministry that it would not harm the export sector, according to sources familiar with the situation.

"We were persuaded that further sharp appreciation was very unlikely," said a senior researcher with the Ministry.

Arguably it was Zhou's 2005 success in engineering a break of the yuan's dollar peg in the face of staunch opposition from the Commerce Ministry that most clearly states his credentials.


Yu Yongding, a respected economist and leading advocate of major currency reform, recalls the wrangling required to make the decision on a PBOC monetary policy committee stacked with senior officials from a variety of government departments.

Yu, an economist at the top government think-tank, Chinese Academy of Social Sciences (CASS), sat on the policy panel from 2004 to 2006, as the PBOC went head-to-head with critics of revaluation who complained that exporters could not withstand any rise in the value of the yuan.

"Their views had to reflect the stance of their respective departments," Yu told Reuters, recalling the logjam as pro-export officials railed against the suggestion of some other committee members of a revaluation of as much as 10 percent.

Yu says Zhou's pragmatic approach defused the row, agreeing to a small initial rise of 2.1 percent in the yuan's value against the dollar, while forging a top-level consensus on the incremental annual pace of currency strengthening that has seen it gain around 33 percent in nominal terms since.

Despite the stronger yuan, China has become the world's single biggest exporting economy while its companies have been forced to make productivity and quality improvements to stay competitive.

Xi and Li, due to take over in March as President and Premier, respectively, need to engineer an even more widespread move up the value chain to deliver enough growth to support China's next stage of economic development -- and the transfer of about 400 million people into cities from the countryside.

That's no mean feat given the general conclusion that China's export-oriented, state-driven economic model that delivered three decades of breakneck double-digit expansion, has reached the outer limits of its effectiveness.

Growth in the world's second-biggest economy slowed in 2012 to a 13-year low, albeit at a 7.8 percent rate that is the envy of other major economies.

Many analysts believe China's growth will be nearer 5 percent than 10 by the end of this decade without far-reaching economic reform -- a worry for a government that has pledged to double household income over the coming decade in a bid to close a wealth gap so wide it threatens social stability.

About 13 percent of China's 1.3 billion people still live on less than $1.25 per day according to the United Nations Development Programme and average urban disposable income is just 21,810 yuan ($3,500) a year.

Meanwhile China has 2.7 million dollar millionaires and 251 billionaires, according to the Hurun Report.


Using the PBOC as a catalyst for reforms is a smart move, provided the anticipated domino-effect works as expected and relatively straightforward liberalization efforts trigger more fundamental evolution in China's economic structure.

The PBOC must make bank borrowing costs more market-driven to improve resource allocation and wean the economy off its reliance on state-led investment, analysts say.

But the financial system is dominated by big state-owned banks that channel the bulk of loans to state projects and state-owned enterprises, starving private enterprise of cash.

All of which conspires against the creation of additional investment options for Chinese households, lumbered mainly with low-yielding bank deposits that constrain consumption.

Optimists say that even if it doesn't deliver entirely as anticipated, the PBOC is likely to be more effective in the short-term than trying more politically-charged reforms, such as China's strict system of household registration, or Hukou.

A further advantage of using the PBOC as the instrument for change is that the most important decisions it disseminates are essentially edicts approved by the State Council - China's cabinet - or by the Communist Party's ruling Politburo.

Keeping a reform-oriented Zhou in the top PBOC job ensures the leadership is dealing with a like-mind.

"If we get someone who is tepid and does everything on an even keel, the reform process could be slowed," said Xu Hongcai, a former PBOC staffer and now a senior economist at China Centre for International Economic Exchanges (CCIEE), a Beijing-based think-tank. "We must ensure policy continuity while injecting a new air into reforms."

(Editing by Nick Edwards and)