Banking On Reform In China

People's Bank of China's Zhou Xiaochuan is aiming for a floating yuan, real bond and stock markets, and more

Which central banker has the toughest job in 2006? Incoming U.S. Federal Reserve Chairman Ben Bernanke will need to be vigilant about inflation while getting the timing of interest-rate tightening just right. European Central Bank head Jean-Claude Trichet is likely to push through the first ECB rate hike in five years amid signs that inflation is rising and euro zone economies are finally rebounding. Yet all of that is playground stuff compared to what Zhou Xiaochuan, the governor of the People's Bank of China, faces. He is under enormous international pressure to orchestrate a steady appreciation of the yuan vs. the dollar while at the same time preventing a spike in inflation in an economy so white-hot it could hit 10% growth in 2006. As a key overseer of China's bloated banking system, he must also continue reforms to keep bad loans from ballooning.

Failure in any of these areas would not only derail Zhou's standing in President Hu Jintao's government but also destabilize China's financial system and send shock waves radiating throughout the global economy. After all, currency markets hang on Zhou's every word, given the $769 billion pile of foreign-currency reserves he oversees. Given the stakes, "many look to him to carry forward meaningful financial reform," says Stephen Green, a senior economist at Standard Chartered Bank in Shanghai.

If Zhou is feeling the strain, however, he isn't showing it. He is widely regarded as one of the shrewdest political movers in Beijing. A "princeling" whose father, Zhou Jiannan, was a minister in the State Council, China's Cabinet, in the 1980s and a Communist Party power broker, Zhou has been a force for change since he started serving as an adviser on economic restructuring to the State Council in 1986. He later did stints as head of China Construction Bank (CCB) and chairman of the China Securities Regulatory Commission (CSRC) before becoming chief banker in late 2002. "He has been pushing for reform," says Morris Goldstein, a former International Monetary Fund official now with the Institute for International Economics in Washington. "He is a voice of reason on Chinese economic policy and the exchange rate."

Zhou keeps a low profile, and he declined to be interviewed for this article. But he has made clear in speeches that he wants to open the financial sector to Western investment, build robust corporate bond and stock markets, and maintain pressure on Chinese banks to clean up their acts and develop into competitive financial players. More broadly, he wants an end to what he has called "the planned economy mind-set."

Zhou also favors a more flexible currency regime -- and the eventual lifting of capital controls and a fully floating yuan. He orchestrated the recent shift of the Chinese currency's fixed peg to the dollar to a "managed float" against a basket of foreign currencies. That resulted in a 2.1% appreciation of the yuan. Zhou said in a Nov. 4 speech that China's ultra-low labor costs mean the economy could handle more appreciation. There is evidence that he plans to act on that belief. On Nov. 25 the PBOC sold $6 billion to 10 Chinese banks in exchange for yuan. It agreed to buy back those dollars in 12 months for 2.9% less than the current exchange rate, suggesting that the central bank expects the yuan to appreciate by that percentage.

Unlike some Beijing leaders, Zhou thinks opening China's financial sector to Western capital and management practices is vital to the country's long-term prosperity. To honor China's World Trade Organization obligations, Zhou has allowed foreign-currency operations by foreign banks in 18 Chinese cities. And by the start of 2007, Citigroup (C ), HSBC (HBC ), and other foreign banks will be able to open free-standing branches on the mainland. "Competition will enable the financial sector to better serve the national economy," Zhou has said in speeches.

Zhou played a lead role in bank reform when he ran China Construction Bank from 1998 to 2000. The bank did a massive IPO in October, raising $9.2 billion, that attracted thousands of foreign investors. CCB's stock has since risen 8.5%, and Zhou in late November defended CCB against charges that it sold out too cheaply, saying the IPO served the "broader" goal of financial reform. Zhou proved to be a tough reformer when he ran the CSRC from 2000 to 2002; wags nicknamed him "the Flayer" after he cracked down on stock manipulators. One of his reforms -- a pledge to sell off the government's majority stakes in listed companies -- triggered a steep stock market plunge, forcing him to pull back. But the government recently renewed its commitment to sell state-owned shares.

As PBOC chief, Zhou has taken strong steps toward creating a real Chinese bond market. In May the PBOC amended rules to let companies raise cash by issuing short-term commercial paper with maturities of a year or less. Better yet, companies can reissue the notes when they come due, which boosts their liquidity. Some 30 Chinese companies, including oil major Sinopec Corp. (SNP ) and China Telecom Corp. (CHA ), had raised a total of $12 billion as of Nov. 1 -- and the market has lured some 4,000 institutional investors.

Zhou, 57, brings considerable candlepower to the job of central banker. He earned a PhD in economics from Tsinghua University (known as the MIT of China) in 1985 and has published a dozen books and 100-plus academic articles in mainland and Western journals.

Zhou knows better than to challenge Communist Party orthodoxy: his father was persecuted during the Cultural Revolution, and Zhou was once close to Zhao Ziyang, the Communist Party chief who was purged for supporting the democracy demonstrators in Tiananmen Square in 1989. During the 1990s, Zhou was allied with the Shanghai Group of economic reformers led by former Premier Zhu Rongji. "He has taken over the reformist mantle for Zhu," says Standard Chartered's Green.

Zhou's blunt talk about past errors of economic policy has made him enemies. Cheng Li, a China expert at Hamilton College in New York, says there was strong resistance from some Communist Party leaders to Zhou's promotion to PBOC chairman. "He wasn't a popular choice, and it was something of an embarrassment," says Cheng.

In office, Zhou proved to be a decisive leader. Some say he deserves a lot of credit for helping to keep the Chinese economy from running off the rails. When fixed investment in plants, equipment, and government infrastructure surged 43% year-on-year in early 2004, Zhou's team implemented the government's plan to raise bank reserve requirements, impose loan quotas in scorching sectors such as steel and autos, hike interest rates, and crack down on property speculation. That has helped fuel talk that his destiny is to be premier of China. Few doubt he has the brains, the political savvy, and the force of will to make his way to the top.

By Brian Bremner, with Rich Miller in Washington

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