Commentary: The roughest terrain in China's central banking?
By William Pesek Jr. Bloomberg News Thursday, November 4, 2004
Zhou Xiaochuan probably didn't have Paul Volcker on his mind when he engineered China's first interest-rate increase since 1995. Yet if anyone knows what China's central bank governor is going through these days, it's the former U.S. Federal Reserve chairman.
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In October 1979, Volcker undertook one of modern history's riskiest inflation fights. With consumer prices surging 14 percent and bond yields at 15 percent, Volcker led a rate-increase campaign that drove the federal funds rate to 14 percent. Global prosperity hung in the balance.
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Volcker's past probably wasn't foremost on Zhou's mind on Friday when he raised borrowing costs, shocking markets around the globe.
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But one hopes Zhou will pay attention to the lessons from Volcker's battle. Who knows, China could even offer the former central banker a consulting job as it struggles to control its own money supply.
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China's challenge seems to have little in common with what the United States experienced in the late 1970s, when it was plagued by unsteady monetary and fiscal policies and an oil embargo that pushed up energy costs.
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Fortunately, the United States had a first-rate financial system, a floating currency and an independent central bank.
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Officials in Beijing are stuck with a pegged currency, capital controls and a monetary policy that is anything but autonomous. Its major banks aren't lenders so much as financing arms of the government. And China's economic boom is largely the product of powerful and unpredictable inflows of foreign capital.
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Yet the Fed circa 1979 and People's Bank of China circa 2004 have something in common: loss of control over the money supply.
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Volcker found his remedy in monetarism. Embracing the idea that one could control an economy by closely regulating the supply of money gave Volcker political cover to drive short-term rates to unthinkable levels and, as he put it, "break the back of inflation."
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The results weren't pretty at first. Volcker's hawkish policies sent the United States into recession and unemployment above 10 percent.
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By the time Volcker handed the keys to Alan Greenspan in 1987, the money supply was under control, inflation was 4 percent and the United States was poised for the economic boom of the 1990s.
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Zhou shouldn't necessarily jump on the monetarist bandwagon. But the nature of China's economic growth raises questions about whether interest rate adjustments alone will counter overheating. Just as Volcker did 25 years ago, Zhou needs to bring fresh thinking and unconventional strategies to cool inflation before it devastates China's economy.
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Last week's 27 basis-point increase in China's one-year lending rate to 5.58 percent could be the first of many rate moves. Still, hopes that a tighter monetary policy will guide the economy to a soft landing may be wishful thinking.
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"The flow of foreign money into the country is what is really causing the inflation problems," says Carl Weinberg, chief global economist at High Frequency Economics in Valhalla, New York. "Foreign currency inflows are bloating the money supply," which grew 13.9 percent in September.
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As a result, Weinberg says, "control over the money supply has been lost. It's growing faster than GDP, which is too fast for price stability."
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One wonders if higher borrowing costs will only encourage companies to finance investment overseas and bring the funds into the country, exacerbating the problem. That's why China also needs more aggressive administrative steps to slow the inflow of foreign funds.
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"Otherwise, inflation will continue to rise until it destabilizes the economy, causing a hard landing," Weinberg says. China's consumer price index rose 5.2 percent in September.
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As if that weren't challenging enough, Zhou also needs to establish credibility for an institution that has little. That, too, isn't unlike Volcker's task in the late 1970s and early 1980s.
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The world is watching Zhou to see if China's central bank has the power - and the slightest bit of autonomy - to get things under control. Central banking is as much about winning the trust of markets as adjusting interest rates.
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And if Zhou is going to try to control the capital flows at the root of China's boom, he may need to cross Communist Party bigwigs.
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Although Zhou attended last month's Group of Seven meeting, it is not clear how much he is consulting with the world's leading monetary authorities. Given how important stability and prosperity in China is to the global economy, he should.
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