China’s Central Banker Analyzes U.S. Trade Deficit

The reform and opening-up of China’s financial sector to global competition and foreign investment should and will continue regardless of trade tensions with the U.S., central bank Governor Yi Gang told a group of American policy advisers and scholars at a recent meeting in Washington.

“Reform and opening-up is the basic strategy (for China) to deal with uncertainties and difficulties,” Yi said at the Caixin Roundtable, jointly sponsored by Caixin Media and the Washington-based think tank Peterson Institute for International Economics.

It was the first time a senior Chinese official publicly addressed the country’s strategy for managing trade friction with the U.S. following a series of tit-for-tat tariff threats thrown out by both countries over the past month. Officials from both sides should adopt rational approaches to resolving trade issues through long-term, joint efforts, the central banker said.

“It is a wise strategy” for China to accelerate the financial opening-up at this moment, former U.S. Treasury Secretary Lawrence Summers said at the event.

Yi, 60, became governor of the People’s Bank of China in March, succeeding Zhou Xiaochuan, who retired after more than 15 years in the post. Shortly after his appointment, Yi spoke at the Boao Forum for Asia Annual Conference in early April. There he announced a series of policies to further open up China’s financial sector to foreign investors.

Some of the measures he cited have since taken effect, including relaxing restrictions on foreign ownership stakes in domestic securities firms and allowing foreign banks to underwrite government bonds.

“Further opening-up is an inevitable trend and meets China’s needs for economic development and transformation,” Yi told Caixin.

Yi is known as an advocate of financial reform and opening-up for China. He has an extensive academic background in macroeconomics and built his career as a scholar and economic researcher.

After studying economics at Peking University for two years, Yi earned a degree in business administration from Hamline University in the U.S. state of Minnesota. He took his Ph.D. in economics at the University of Illinois with a dissertation on statistical model selection methods. From 1986 to 1994, he taught at Indiana University before returning to China to join the faculty of Peking University as a professor.

Yi co-founded the China Center for Economic Research, the predecessor of Peking University’s National School of Development, one of the country’s top think tanks on economic affairs. His research included explaining China’s economic boom from the perspective of changes in money supply, predicting and offering advice for policy responses to China’s deflation in 1998 following the Asian financial crisis, and explaining how to improve the allocation of China’s financial assets.

Yi joined the People’s Bank of China in 1997 and was appointed deputy governor of the central bank in December 2007.

In an interview with Caixin following the Washington event, Yi explained a pragmatic way to analyze China-U.S. trade disputes, the logic of China’s financial opening-up, and the prospects for the monetary policy. Excerpts from the interview follow.

Caixin: How do you see China’s current economic and financial situation and what will be the next step for monetary policy?

Yi Gang: China’s economy is improving. We recently released first-quarter data with the GDP growth rate at 6.8%, compared with 6.9% the previous quarter. It is pretty good. The unemployment rate is at 5%. What’s worth mentioning is that the unemployment statistics were shifted from the previous method by taking into account the rural labor force. So it pretty much follows the international statistical standard and reflects the actual picture. Market prices are stable, and the yuan has slightly appreciated.

The structure of the Chinese economy continues improving, as it increasingly relies on consumption rather than investment and exports. The service industry’s contribution to GDP growth has reached 58.8%. The balance of payments and cross-border capital flows have remained stable, supporting market expectations of a stable value of the yuan. China’s economy is transforming into a consumption-driven economy.

Moving forward, we will maintain a prudent and neutral monetary policy, focusing on eliminating financial risks and controlling the level of leverage. I expect stable growth of money and credit supply and a smooth deleveraging progress.

As the growth of broader money supply slows, how will the central bank manage to control the financing costs for companies to meet the capital demands of the real economy?

China’s broad money supply, known as M2, has grown more slowly since 2017, mainly because of financial deleveraging. Efforts to cut financial leverage were aimed at squeezing out excessive liquidity without affecting real economy financing. Meanwhile, the driving force of China’s economic growth is shifting from capital-intensive industries such as infrastructure and real estate to consumption, services and technology. More importantly, the reduction of financial leverage will actually benefit companies with cheaper and easier access to capital.

Financial market development and innovation have made money supply more complicated. The measurement of M2 is becoming less relevant and adequate to reflect the exact relationship between finance and the real economy. Regulators should also adjust their macro-control measures accordingly to better respond to economic and financial development.

China’s economy has transformed from high-speed growth to high-quality development. Monetary policy also needs to shift its focus from quantity to quality to better serve economic transformation and structural adjustment. Regulators should adopt measures to direct more credit support to areas with greater importance or capital needs, encourage financial institutions to improve their asset structure through asset securitization mechanisms, and improve the efficiency of capital by cutting corporate leverage and revitalizing state assets. Regulators also need to enhance coordination led by the state council’s Financial Stability and Development Committee to maintain the stability of the financial system.

The reserve requirement ratio (RRR) cut on April 17 has drawn attention as the central bank previously relied mainly on open market operations and liquidity tools such as medium-term lending facility (MLF) to adjust liquidity. Why did the central bank make the RRR cut at this time rather than using MLF?

The RRR cut applies to major commercial banks whose reserve ratios were relatively high. The RRR cut is more suitable for current market conditions because it creates a more stable and longer-term capital supply than MLF that will reduce companies’ financing costs. Meanwhile, capital released by the RRR cut is required to mainly support small and micro businesses. This will be included as a requirement in the macro-prudential assessment for banks.

What will be the next step in yuan exchange rate reform?

Between 2014 and 2016, the yuan faced great depreciation pressure, which led to the use of $1 trillion of the foreign exchange reserve to defend the yuan. Since 2017, market expectation (for the yuan) and capital flows have stabilized, and the yuan’s rate has remained stable. As the U.S. dollar weakens, the yuan has appreciated against the dollar. China’s foreign exchange reserve has also increased.

An exchange rate regime that allows flexible and two-way fluctuation is the effective stabilizer of the international balance of payments and cross-border capital flows. The best scenario is letting the market decide without official intervention. The People’s Bank of China hasn’t intervened in the foreign exchange market over the past 12 months. Its next step is to push forward further exchange rate reforms to make the yuan’s exchange rate regime a flexible mechanism based on market supply and demand.

At this year’s Boao Forum for Asia, you mentioned measures to further open up the financial industry. What prompted the measures?

Over the past 40 years of China’s opening-up and reform, we made many achievements in financial industry opening. Many foreign institutions have started doing business in China, prompting China’s financial market to improve and diversify. But there is still great room for China’s financial sector to open further and improve its competitiveness to catch up with international standards. In recent years, foreign financial institutions’ share in China has eroded. Many scholars have argued that China lacks concrete measures to open its financial market.

China is now facing both external and internal challenges. Many pending reform measures are key factors for the country’s economic transformation. As the economy is increasingly driven by innovation, an open, diverse and inclusive financial market offers the most important backing to innovation.

Opening-up will invigorate the financial market and enhance the competitiveness of China’s financial industry. Meanwhile, the financial industry is the most prepared part of China’s services sector for opening-up. It will also lead to further opening of other service sectors.

Will the opening-up hit domestic financial institutions?

Chinese financial institutions have grown stronger in recent decades, and some of them have become global players. China’s financial market is big enough to accommodate domestic and foreign institutions to compete and achieve a win-win situation.

Chinese and foreign financial institutions have different strengths. For instance, Chinese banks are strong in asset size and network while foreign banks are more sophisticated in management, risk control, business compliance, and research and development. Greater openness of the financial market will allow all institutions to play to their strengths to boost the growth of the entire industry.

What’s different between recent financial opening-up measures and previous efforts?

The latest financial opening-up is distinct from previous efforts because of fundamental changes in principles. Firstly, the financial industry is a competitive industry, so we should grant fair treatment to all players and manage the industry with a negative-list approach (or publishing a clear list of prohibited activities, rather than an ambiguous list of permitted activities). Financial opening-up should not only follow the commitments made for the World Trade Organization accession, but also look at the needs of China’s economic development and transformation.

Secondly, the pace of market opening should coordinate with exchange rate regime reform and progress toward capital account convertibility. While opening-up will improve resource allocation and competitiveness of the financial market, exchange rate reform and capital account liberalization will enhance the economy’s resilience and offer greater convenience for foreign investors.

Will financial opening-up bring more risks?

The problem of China’s financial industry is not opening too much but not enough. Further opening-up is an inevitable trend and meets China’s needs for economic development and transformation. The direction is definite.

We have noticed concerns over potential risks along with the financial market opening-up. But the experiences from the past 40 years proved that opening-up has pushed forward financial industry growth rather than bringing systemic risks.

Opening-up doesn’t mean deregulation. The capability to prevent financial risk is decided by the supervisory system, institutions’ risk control ability and the effectiveness of the market. China has over the years strengthened its financial supervisory system to guard the country’s financial security. Chinese regulators will also enhance cooperation with foreign counterparts to enhance oversight of cross-border capital flow, prevent regulatory arbitrage and risk contagion.

In fact, an isolated financial market that lacks competitiveness is more prone to risks.

What’s your take on the current trade imbalance between China and the U.S.?

We should look at the trade situation from a multilateral perspective instead of a bilateral angle. From a multilateral perspective, China’s current account surplus has declined from 9.9% of GDP in 2007 to 1.4% in 2017, falling into a reasonable range by international standards. The imbalance between the U.S. and China in terms of trade is a structural problem, which is decided by the countries’ different positions on the production and value chain. China’s surplus to the U.S. represents Asia’s surplus to the U.S. While China holds a surplus with the U.S., it has substantial deficits with Japan, South Korea and Taiwan. China imports lots of components from other parts of Asia and assembles them into final products to export to the U.S.

Meanwhile, trade imbalance is a macro economy problem. We need to look at the budget deficit, investment initiative and private savings rates when analyzing the trade deficit. The fundamental problem of the U.S. trade deficit is America’s low national savings rate and the imbalance between the country's savings and investment rates.

We should consider trade in services when we talk about the trade imbalance between China and the U.S. According to U.S. data, the U.S service trade surplus to China was more than $38 billion last year. The surplus has grown at an annual rate of nearly 20% since 2000. With further opening-up of China’s financial industry, the U.S. has a more comparative advantage in terms of service trade.

We should also take into account the role of U.S. companies’ subsidiaries in China. In 2015, U.S. exports to China were about $165 billion. In the same year, sales of U.S. companies’ subsidiaries in China totaled $222 billion. If we put them together, we will see a dramatic decline of the overall imbalance.

China and the U.S. must acknowledge that the trade imbalance is a structure issue that requires rational analysis and long-term joint efforts to solve.

What’s the idea behind the recently released rules for the asset management industry that were jointly drafted by the central bank and other financial regulatory bodies?

Asset management businesses have grown rapidly in recent years. On one hand, they offered more investment options and promoted the development of direct financing. But on the other hand, the loosely-regulated market has accumulated potential risks.

The new regulations have several purposes. Firstly, they will prevent capital flows away from the real economy to pursue higher returns from speculative investments. Secondly, the rules will set unified requirements on the business to prevent regulatory arbitrage and ensure fair competition. Thirdly, they will rein in financial risks and guide the market to a healthy development path.

How will the central bank push forward the deleveraging campaign?

Lowering the overall leverage ratio is the top priority. China’s debt-to-GDP ratio stood at 249% by the end of last year, with an annual increase of 2 percentage points. This indicates a stabilizing of the leverage ratio’s growth. The average annual increase in the ratio was 13 percentage points over the last five years. I hope this year it will continue to stabilize.

In terms of state-owned companies’ debts, we try to work together with other ministries and company executives to set different criteria for different industries. We set up timetables for them to lower the leverage ratio, encourage them to reduce leverage through mixed ownership reform and introducing private investors.

Meanwhile, China will tighten scrutiny of local government borrowing to contain local government debts. Strict control on debts of state companies and local governments will effectively rein in the overall leverage of the economy.

While lowering financial leverage, we will ensure the financial system’s support to the real economy. Moving forward, the central bank will maintain a prudent and neutral monetary policy and adopt differentiated credit policies to push forward the deleveraging efforts.

Contact reporter Han Wei (weihan@caixin.com)

Read more from the Caixin Roundtable, held April 20 in Washington DC: China and the World: Recalibration and Realignment