The typically mild-mannered Zhou Xiaochuan, China’s longest-serving central banker, has proffered some stern words as of late. It began on the sidelines of the just-concluded 19th Party Congress in late October, where Zhou commented that China needed to defend against the threat of a Minsky Moment. He then followed up with a lengthy essay that the People’s Bank of China (PBOC) published on November 4 to expound on his views. With only months—if not weeks—left of his 15-year stint as PBOC governor, Zhou appears emboldened to share a few things on his mind before he goes. Written ostensibly in the same spirit in which Zhou made the Minsky comment, Zhou’s latest essay describes the risk facing China’s financial system as being “concealed, complicated, could break out suddenly, [potentially] contagious, and harmful.”
For the most part, Zhou’s comments have been reported as a shopping list of risks he sees in the financial system. But what the commentariat has overlooked is that it also contains a concise critique of why those financial risks are so difficult to tame—fairly surprising coming from the man who has sat atop the regulatory apparatus for so long. Zhou argues that those risk has emerged because of serious shortcomings in the regulatory regime tasked with overseeing the financial system, and that its deficiencies have been exploited by companies, local governments, and financial institutions. These interests have been able to create new ways to expand credit in the face of central government efforts to rein it in, thereby destabilizing the economy. As Zhou put it, “some financial institutions and companies exploit regulatory gaps and deficiencies to play games” with the system.
Analysts have been making the case that China needs to overhaul its financial regulatory regime for years, and certainly Beijing is moving in the direction of improving oversight by setting up a Financial Stability and Development Committee, although it’s still unclear how that will work. Generally, the major criticism leveled at the system is that it was designed for simpler times, when China had a banking sector, an insurance industry, and a securities sector. Much like the days of Glass-Steagall in the United States, those industries in China remained siloed, with no cross-pollination of business. Consequently, each of the three industries was given its own dedicated regulator. But today, China has a veritable alphabet soup of financial institutions and financial products that operate across traditional industry lines, and yet the regulators remain mired in their traditional silos.
Beyond the fact that the financial system is sprinting forward faster than the regulatory regime can keep up, Zhou’s essay also singles out the regulatory gaps between central government and local government authority, painting a picture of a far more fragmented regulatory regime than the scenario I outlined above would suggest. It’s not news that local authorities are less stringent when it comes to financial regulation than national-level agencies. But even just a few years ago, that scarcely mattered. That’s because the size of that part of the financial system—namely the leasing companies, and local financial exchanges over which local governments had authority—was fairly small. However, that no longer seems to be the case. Beijing’s efforts to rein in financial risk has led to a flourishing of local-level financial institutions, and while the scope of their activities is incredibly difficult to track, Zhou’s concerns suggest that it’s an area of the financial system that can no longer be discounted. Having diagnosed this growing problem, Zhou stopped short of devising solutions for how to replace the current regulatory regime, other than to say financial regulation must be unified without any regulatory “dead corners.”
The essay has no shortage of frank insights, including Zhou’s concern about regulatory capture—a phenomenon in which the regulators get swallowed up by the very institutions they’re supposed to oversee. He worries about “casting off the real for the empty” (something I’ve written about before), whereby industrial companies move into financial services in the pursuit of easy profits. He calls out local governments for continuing to borrow by disguising their debt as equity, or as part of the procurement process (something my colleague Houze Song wrote about in August). And he complains that the central bank is called upon to print money when excessive borrowing, encouraged by local governments, pushes “financial institutions and the market…[to] the limits of what they can bear.”
Still, it’s not clear who are Zhou’s intended audience. Zhou’s article was originally written as part of a guide to the 19th Party Congress, and is presented as being an elaboration upon certain comments President Xi Jinping made during his speech to the congress. Given the likelihood of his imminent retirement, the essay could be read as a list of priorities for his successor. But the subtext of the essay is that the central bank governor’s ability to resolve the financial sector’s underlying problems are limited. The necessary changes have to come from further up the chain of command—perhaps with the new Vice Premier that is expected to manage the Financial Stability Committee.
Alternatively, Zhou could be putting lower levels of government on notice that their manipulations of the financial system won’t be tolerated much longer. Certainly, in some ways the essay echoes a Q&A with an anonymous senior official—widely thought to be Liu He, President Xi’s economics advisor and now Politburo member—that was printed on the front page of the People’s Daily last year, that warned of the potential for crisis and financial contagion if certain problems weren’t reined in. The audience for that piece was rank-and-file Party members, and seemed to be published with the goal of shocking them out of their complacency about the stability of the economy.
Or, of course, Zhou’s essay might just be the attempt of a globally well-respected central bank governor to sound the alarm about the problems that might one day unravel his legacy—when he’s no longer in a position to do anything about it.