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China's Central Bank Balancing Act

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Zhou Xiaochuan can forget a vacation in 2015. The world is counting on China’s central bank governor to fend off the deflation descending upon his country. There's a real question whether he can do so without making matters worse -- both at home and abroad.

News yesterday that factory-gate deflation deepened -- with prices falling a record 33rd-straight month in November -- leaves zero doubt about China's trajectory. President Xi Jinping's efforts to curb corruption and rebalance growth away from excessive borrowing and exports is set to drive output in China -- and costs -- markedly lower. To add to the mainland’s woes, says Callum Henderson of Standard Chartered in Singapore, "externally, with the currency wars continuing to rage, the euro area and Japan are exporting deflation to Asia ex-Japan, including China."

This rising threat "will push up real interest rates and compel more rate cuts," says Wang Tao, chief China economist at UBS in Hong Kong. She expects at least two benchmark lending rates cuts totaling 50 basis points next year to ease debt burdens for companies, improve corporate cash flow and slow the buildup of non-performing loans.

At what cost? China booming equity markets have long since decoupled from the economic realities; Andy Xie, a former World Bank economist, calls the current rally a “bubble” driven by leveraged traders. Chinese leaders are right to defer to the central bank rather than injecting new stimulus directly, which would raise the risk of a Japan-like debt crisis. But Zhou’s moves could just as easily fuel another dangerous asset bubble alongside real estate.

At the same time, Zhou is hemmed in by a rigid financial system that limits the potency of monetary maneuvers. His surprise November rate cut got the world's attention. But the PBOC is shackled with a closed capital account and fears the currency could fall prey to capital flight if Zhou eases too much. The central bank governor will have to tread very carefully not to unsettle the economy even further.

The delicacy of Zhou’s position only increases the need for the PBOC to start acting more like a normal central bank, embracing greater transparency and issuing clearer guidance. While Beijing's November rate surprise delighted markets, this week's abrupt change in collateral rules for local-government borrowing spooked them. The move to ban the use of lower-rated bonds in securing short-term loans should have been good news -- a sign China is working to halt risky borrowing. And the amount of debt affected -- about $76 billion in debt sold by local government financing vehicles, or LGFVs -- is tiny. But the haphazard way the policy was rolled out caused panic in markets.

All governments -- and their central banks -- are driven by domestic considerations first. And for China, there are almost too many to juggle. Beijing's approach is encapsulated by the old proverb "crossing the river by feeling the stones." The idea is to unveil reforms piecemeal, only when leaders judge the moment is right. But China must understand that given its size and central role in the global economy, every policy twist and turn has the potential to roil markets.

Beijing's provocative actions over disputed territories in the Asian seas damage its "soft power" enough. Routinely surprising the outside world with reform experiments isn’t going to help. It's long past time to develop a better communication plan. Telegraphing policy shifts and explaining their utility better and more consistently would win China friends in both financial and diplomatic circles.

Widely respected, Zhou is the perfect person to spearhead the process. This is China, of course: No one expects the kind of glasnost that Alan Greenspan introduced at the Fed in the 1990s. But as the spotlight shines brighter and brighter on Beijing, is behooves officials there to think more globally when they act.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Nisid Hajari at nhajari@bloomberg.net