Zhou Pulling China Punch Bowl Set to Shape PBOC Legacy

Zhou Xiaochuan earned distinction as the G-20’s longest-serving central bank chief helping keep China out of a financial crisis the past decade. In the wake of June’s record liquidity squeeze, his legacy hangs in the balance.

Zhou and his colleagues at the People’s Bank of China left investors, bankers and market participants in the dark for four days after the overnight lending rate between banks hit a record 11.7 percent June 20 before releasing a week-old statement as the central bank’s first word on its objectives. Zhou himself kept mum until he reiterated a pledge to maintain market stability on June 28.

The communications gap fanned speculation over the central bank’s intentions, denting confidence in an institution that steered China through the Asian and global financial crises. Zhou’s challenge now, three months into an unprecedented third term as governor, is to implement the curbing of speculative credit that Premier Li Keqiang’s government wants, without further market disruptions that sow confusion.

“Zhou’s reputation is still intact at the moment but it may suffer because of this if nothing fundamentally changes,” said Fraser Howie, Singapore-based co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise.” “They must now follow through and dramatically reduce the dependence on credit.”

China’s new leadership team, cemented in position at a March conclave, kept Zhou, 65, as PBOC governor even as it embarked on efforts to rein in lending that was outpacing economic growth. The need to tighten credit to prevent excesses was expressed as removing the punch bowl at a party in remarks credited to former U.S. Federal Reserve Chairman William McChesney Martin.

‘Baijiu Bowl’

“Central bankers that pull the punch bowl -- or the baijiu bowl -- rarely win popularity contests in the moment,” said David Loevinger, former U.S. Treasury Department senior coordinator for China affairs, referring to the liquor consumed at Chinese banquets. “But history usually serves them well.”

Withholding cash and restricting its communication, the PBOC saw the overnight interbank repurchase rate reach 11.7 percent, compared with 3 percent a month earlier. The fallout ricocheted from Brazil to South Korea, contributing to a 6.8 percent drop last month in the MSCI Emerging Markets Index of stocks.

The squeeze has since eased, with the one-day China interbank rate falling for an eighth day yesterday, down 0.71 percentage point to 3.71 percent, the lowest since May. The Shanghai Composite Index fell 1.3 percent as of the 11:30 a.m. local-time break. The gauge tumbled 14 percent last month.

Services PMI

Zhou and the leadership face an economic slowdown that could deepen. An official gauge today showed China service industries expanding at the slowest pace in nine months in June. The non-manufacturing Purchasing Managers’ Index dropped to 53.9 from May’s 54.3, according to the National Bureau of Statistics and China Federation of Logistics & Purchasing. Readings above 50 indicate expansion.

A private services PMI from HSBC Holdings Plc and Markit Economics rose to 51.3 in June from 51.2.

Premier Li said the conditions are in place for China to achieve its economic targets for this year and for sustainable, healthy development, state television reported yesterday, citing remarks in a meeting with European leaders. The government in March set an expansion goal of 7.5 percent for 2013.

Around the world today, a measure of Australia private new home sales rose 1.6 percent in May from the previous month, according to the Housing Industry Association. Services PMI gauges are also due for the euro region and Germany, France, Italy and the U.K. The U.S. will provide data on the trade balance and initial jobless claims.

Soft Landing

Loevinger, now an emerging-markets analyst in Los Angeles at TCW Group Inc., which oversees $131 billion, said Zhou would “prefer a legacy as the one who navigated China to a soft landing than the one who helped fuel a credit boom.”

The government’s broadest measure of new credit, which includes bank and non-bank lending, rose 52 percent from a year earlier to 9.1 trillion yuan ($1.5 trillion) in the first five months of 2013.

The squeeze was prompted in part by policy makers’ concerns that expansion in money supply and shadow banking could spark a potential financial and economic crisis, said Feng Hui, co-author of “The Rise of the People’s Bank of China,” published last month.

The cash crunch is a reminder to lenders that they need to adjust their “asset businesses,” Zhou said in an interview reported July 1 by China Business News. The central bank was concerned about an unprecedented 1 trillion yuan of loans in the first 10 days of June, the Wall Street Journal reported yesterday, citing a summary of a June 19 PBOC meeting.

Lacks Autonomy

The PBOC didn’t respond to faxed questions on its communications and Zhou’s role in the cash squeeze. The central bank lacks the autonomy of counterparts such as the Fed, meaning senior officials above Zhou must approve major decisions.

“You do this now and create some hardships so that later on you have a stronger basis to move forward,” said Yukon Huang, a former World Bank China director. “Part of this whole grand plan has to be a better reform effort down the line to follow it.”

Zhou, who’s been at the helm longer than any counterpart in the Group of 20 emerging and developed nations, was left off the Communist Party Central Committee in November, making his reappointment a surprise.

Currency Peg

The governor, who represents China at international meetings of finance ministers and central bankers, ended a decade-old currency peg to the dollar, expanded the bond market and gave banks more freedom to set lending and deposit rates.

“He has established himself as being solid, reliable, reasonable, accurate, I’d even say frank, in his approach to his international counterparts,” said Nathan Sheets, former Fed international-finance director and now global international-economics head at Citigroup Inc. in New York.

Some of that stature may be in danger. Actions during the cash squeeze carried reputational risk because the “panic mode was obviously beyond PBOC expectations,” Zhu Haibin, JPMorgan Chase & Co. chief China economist in Hong Kong, wrote in a note last week.

The real estate industry holds lessons. Government efforts this year to control property prices have failed to stem gains. Shopping-mall construction threatens to push retail vacancy rates in some less-affluent cities to more than 30 percent by next year from as low as 6.8 percent in the first quarter of 2013, broker Cushman & Wakefield Inc. estimates.

“Any attempt to bring the credit boom to heel is going to slow investment growth,” with a “significant impact” on gross domestic product, said Patrick Chovanec, New York-based chief strategist at Silvercrest Asset Management Group LLC, which manages $11 billion of assets. “It will lead to defaults. Are they willing to accept businesses or investment vehicles or banks failing? We are going to find out whether they are.”

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