The “Meta” Gray Rhinos Facing the Next Central Bank Governor:
A Global Perspective
By Michele Wucker
Author of THE GRAY RHINO
During his 15 years as governor of the People’s Bank of China, Zhou Xiaochuan has gained international respect for the important part he has played in steering China through the depths of the global financial crisis that erupted in 2008 and its aftermath, and today in promoting understanding of the next set of challenges among the public and other policy makers.
The eve of his retirement offers an opportunity to reflect on the obvious but unresolved “gray rhino” risks that lie ahead, and what they mean in particular for his successor at the central bank.
Since the 2008-09 global market crash and its aftermath, central banks have experienced an era of breaking new ground, policy experimentation, and the frequent use of the word unprecedented. Also during this period, central bankers have continued a shift from the old style of maintaining an air of mystery and leaving the markets to guesswork, to a new and much welcomed, more open practice of signaling intentions as far in advance as possible.
In this context, Zhou has been forthright about the challenges facing the financial system –China’s financial risk “gray rhinos” particularly as he detailed in his November 4th article on the PBoC website. This openness benefits China because it helps to create the sense of urgency needed to make changes, and to raise public understanding of policies that are taken to lessen the danger. Some financial gray rhinos perhaps did not get as much attention in the past because other issues seemed more urgent, but they are now looming large in the economy.
As a result, it is no surprise to anyone that China is seeking to reduce financial leverage and increase liquidity, to lower credit risk from non performing loans and rising bond defaults, and to address the risks posed by cross-border shadow banking and financial crime.
Zhou, along with China’s dedicated economic policy actors, has done a good job in diagnosing the issues, communicating shared resolve to address a group of related financial gray rhinos in a systemic way, and creating a real sense of urgency.
There is no space for detail here on the debates, well documented elsewhere, over how to resolve them and the tradeoffs involved in macro-prudential policy, regulation, supervision, capital flows, development policies and so on.
But I do want to look more closely at some challenges that face the PBoC in particular in its specific role in dealing with the gray rhinos in China’s financial landscape –and across the globe. In particular, I mean what I call “meta” gray rhinos: that is, challenges in processes and systems that create particular obstacles and opportunities given the policy tools available to a central bank.
“Meta” Gray Rhinos I: The Nature of the Toolbox
Meta gray rhinos are systemic factors that can affect our ability to manage gray rhinos involving specific situations. For example, they might be distortions in decision making processes, resource or capacity limitations, or structural constraints.
The biggest “meta” gray rhino for central banks is that their tools are very broad. This makes them very powerful –essential- in shaping the economic and financial landscape. But it also limits their ability to address some of the specific factors that affect the central bank’s success as well as the overall financial and economic outlook.
Thinking of a painting, you could describe the central bank as the canvas, and the brushes and pigments as the tools of regulators, supervisors, tax authorities, investors, traders, and micro-economic actors.
This division of labor means that central banks often must respond to financial conditions over which they rarely have precise control. It also creates a feedback loop that includes unintended consequences that may undermine its actions.
“Meta” Gray Rhinos II: Independence and Coordination
The more independence central banks enjoy, the more effective most market players perceive them to be. But, paradoxically, they also are most effective when working in cooperation with other arms of economic policy.
In this sense, central bankers also must be strong advocates for effective policies that often involve economic actors. Some of the most important of these are fiscal policy, data collection, and macro-prudential policies.
Fiscal policy: During the financial crisis, governments in many Western nations chose pro-cyclical fiscal austerity policies that threatened to prolong and deepen recession. The European Central Bank and the U.S. Federal Reserve countered with historically low interest rates to fight off deflation. Most Western governments reduced their budgets and did not take full advantage of historically low interest rates to implement fiscal stimulus. If they had done so, the recovery likely would have been stronger and central banks would have been able to normalize policy sooner.
The latest development offers a particular challenge to the global economy: the United States has enacted a fiscal stimulus through a tax cut at a time when the economy is already relatively strong. At the same time, the Federal Reserve is seeking to normalize monetary policy. One point of view is that the fiscal stimulus makes it easier to raise interest rates and reduce the balance sheet. But the resulting double hit to the budget –from lower revenue and higher interest rates- will create a vicious cycle of rising deficits and falling credit quality. Few economists expect this to end well.
Information gathering: Central banks need accurate information to make the best decisions. China’s new emphasis on the importance of improving government data reporting –not a small task- will make the PBoC’s job easier once achieved. Improving confidence in economic data also is one of the strongest signals that China’s policy makers can send to international investors. I can say this confidently from my experience in Latin America in the 1990s.
At the same time, there is a vigorous debate over which indicators are the most important. For example, many experts rightly question whether gross domestic product (GDP) accurately reflects economic health –and what measures might be more effective.
Another example: in general, central banks around the world have look for wage inflation as a sign of danger, but have paid far too little attention to asset inflation and bubbles. (This is particularly important in the U.S. right now, because corporations have indicated that their priority is to increase share buybacks, further overheating the market, and not to increase wages.)
Central banks are in a strong position to shape these fruitful debates by encouraging robust improvement in data practices and through the selection of data they use and publicize in their decision making.
Macro-prudential policy: In an economy where policy makers have prioritized de-leveraging, like China’s, the central bank can offset the negative economic impact of debt restructurings and writedowns, and the resulting ripple effect.
Bringing shadow banking and new financial products under the macro prudential umbrella is an important goal for China. As regulation and reporting of assets in newly developed wealth management, off balance sheet financing structures, and online finance, improve, there will be an adjustment process. Tracking changes in money supply will become more complicated in the short run, but with greater benefits as time passes.
“Meta” Gray Rhinos III: Unintended Side Effects
Because monetary policy is such a blunt tool, central banks create many unintended consequences.
An expansive monetary policy, for example, hurts savers, benefits debtors, and feeds financial market speculation. Conversely, monetary contraction –like Paul Volcker’s interest rates to smother inflation in the 1980s- can drive debtors into insolvency, and without backstopping, brings down their creditors too, as the Latin American debt crisis threatened to do.
Inequality: One of the biggest issues today is the side effect of the past decade’s quantitative easing on economic inequality. It hurts pensioners and savers and the middle class, and encourages financial speculation over real economic growth. This rising inequality has led to the populist waves and xenophobia in the United States and Europe, and will lead to increasingly dangerous social and political instability if policies do not change. There has been talk since the crisis of the possibility of central banks using “helicopter money” –essentially printing money and distributing it to the wider public. Originally proposed by the American economist Milton Friedman in 1969, the idea was revived in 2002 in a speech by Ben Bernanke, who of course later would go on to lead the Fed. It remains a hypothetical idea, but it is one of few areas in which central banks could directly offset inequality.
Asset bubbles. Too many countries have relied far too heavily on central banks to try to stimulate economies, when monetary policy is not proving itself to be efficient in helping the real economy grow. By one estimate, over 90 percent of the U.S. stock market’s rise is the direct result of quantitative easing. By another, only one fourth of quantitative easing went into the real economy in the U.S.
Financial liberalization: Extending the financial liberalization that is one of the hallmarks for which Zhou’s tenure is known brings both benefits and new risks. A priority for his successor will be to continue to balance risks and benefits, and to managing the timing of additional reforms to minimize the potential for shocks.
The benefits of financial liberalization includean increase in the ability to use market signals to guide investment, thus reducing distortions and efficiently allocating capital; but it requires close monitoring for gaps created by market failures.
Similarly, financial internationalization increases the danger of swings in currency values and capital flows, and must be managed extremely carefully. But it also can deepen and add liquidity to capital markets. And the infusion of new equity into the banking system can strengthen capital structures. Increasing the ratio of equity to debt financing across the economy also can align incentives in new ways, as shareholders and creditors behave very differently in shaping the future of a company, and in turn the broader economy.
Internationalization of the renminbi, over the long term, also will bring challenges like those that face the U.S. Federal Reserve. Because the dollar is a reserve currency and is used for so many financial transactions outside of the United States’ borders, the effects of Fed policies are not as easy to control as in a more closed system.
The Fed’s quantitative easing policies after the 2008 crisis, for example, provoked protests from Brazil and other emerging markets protesting “hot money” that distorted their financial markets and constrained their monetary policies . That reality also muted the effect of quantitative easing within the U.S. real economy, as funds went outside its borders.
This brings us to a final important point: the global role of central banks and the challenge a new era of central banking poses to the PBoC.
Central Banks and China’s Global Role
For many years, the global economy has relied heavily –too heavily, some argue- on China to drive global growth. Its announced shift to a “quality growth model” has perhaps alarmed some investors; but to those concerned about financial risk, this new model is encouraging.
Post-crisis, China’s policy combined a proactive fiscal stimulus via infrastructure and other state investments and, as with other central banks around the world, a dramatic expansion in monetary supply. This effective approach stood in contrast to the West, which failed to take advantage of low interest rates to make needed public investments and now is struggling to find its path forward.
As a result of China’s growing financial power, its global leadership responsibilities also are rising. With that, global considerations are becoming an increasing part of challenges for the PBoC, whose decisions will result in bigger and bigger financial ripples around the world.
These new developments come at a crossroads for the world’s central banks, which continue to chart new paths following a decade of bold policy experiments in face of the biggest financial crisis in most people’s living memory.
Because there is no reliable historical comparison to the scope of the global quantitative easing of recent years, by definition all efforts by the world’s central banks to normalize it are experiments as well.
The financial gray rhinos the PBoC faces in coming months and years are the same as those facing China’s broader financial and economic landscapes. But to optimize its ability to addressing them, it will need to pay close attention to the “meta” gray rhinos that affect its ability to be as effective as it can in reducing financial risk, maintaining price stability, and supporting quality economic growth.