Zhou Xiaochuan’s Long March

Submitted by Jennifer Johnsrud, CAIA, Portfolio Manager at TEAM Wealth Investments

Zhou Xiaochuan’s Long March

Rarely does a central banker change the course of history. However, it is possible that Zhou Xiachuan, head of the People’s Bank of China (PBOC), just might. Janet Yellen, Chair of the United States (US) Federal Reserve, pay attention: history is being made without you. The most important leadership lesson learned from Zhou Xiaochuan is that a strategic leader with a deliberate, well-executed and institutionally supported plan can achieve transformational change within a bureaucratic, heavily filtered environment. In Zhou’s case this transformational change is the internationalization of the Chinese currency, the renminbi (RMB). He publicly laid out his plan in a 2009 essay titled “Reform the International Monetary System”. Zhou clearly defines the problem he is trying to solve: the global financial insecurity which is linked to the US dollar (USD) serving as the world’s reserve currency. Zhou’s strategic plan encompasses improving China’s the macro-prudential policies, renminbi inclusion into the IMF’s Special Drawing Rights (SDR) currency basket, and eventual opening of China’s capital account. Following these steps, Zhou sets the stage for the culmination of his plan: replacement of the United States Dollar (USD) as the world’s reserve currency with the Special Drawing Rights.

Steps to globalization

The first step for Zhou and the People’s Bank of China towards gaining global credibility was to improve China’s macro-prudential policies. Macro-prudential refers to the use of regulations to reduce the financial systems inherent risks. Examples of these macro-prudential policies include setting capital reserve requirements for banks, establishing limits on the amounts of leverage used by institutions and individuals and forming sound interest rate policy. Zhou began implementing these policies in the early 2000s. To further strengthen China’s ongoing commitment to improving macro-prudential policy, Zhou has maneuvered to incorporate the goal of opening the capital account into the proposal of the 13th Five Year Plan, China’s traditional planning tool. Opening of the capital account is viewed as the last remaining step to internationalizing the RMB.

Triffin’s Paradox

A leader’s effectiveness is most often measured by what is achieved. Zhou is an example of a leader avoiding a problem by preemptively solving it, creating a solution so the problem doesn’t appear in the first place. In this case, Zhou’s solution dissolves Triffin’s Paradox. The core of Triffin’s Paradox is that the issuer of a reserve currency must serve two entirely different masters: their domestic economy and the international economy. Currently the US dollar is the world’s primary reserve currency. A reserve currency is a currency that is held in significant amounts by governments, banks, and institutions as part of their foreign exchange reserves. A reserve currency is also the standard currency of international transactions. For example, commodities such as oil are priced and transacted in US dollars (USD). This flow of USD puts in place a floor value for the dollar, creates natural demand for dollars that other currencies do not have. So what the US Federal Reserve does matters greatly to the Chinese. If US interest rates are increased, the USD strengthens and the RMB weakens. This is the crux of Triffin’s Paradox: if US Federal Reserve Chair Janet Yellen needs to raise interest rates to normalize the US economy she destabilizes China’s (and other countries) currency. Using the SDR, which is a basket of currencies, (USD, Euro, Yen, Pound Sterling with RMB integrated in October 2016) is an elegant solution. Because the reserve currency is not dependent on any one country, the paradox is completely avoided.

Success in Stakeholder Management

One of Zhou’s strongest leadership traits is his ability to serve two masters: global markets and the Communist Party leadership. An example of how well Zhou maneuvers is exhibited by the devaluation of the RMB in August of 2015. Internally, Zhou proposed a RMB devaluation as a matter of national interest. China’s domestic economic growth was stagnating and devaluation was necessary to jumpstart growth. To the global markets, Zhou portrayed the devaluation as a step towards a freely-tradable currency, an improvement from the current state where the currency is currently pegged to the USD and does not trade freely. (Anderlini, 2015) Devaluation, while highly disruptive to global stock markets, proved to the IMF that China was serious about a freely traded RMB. Zhou achieved a major milestone with the RMB’s inclusion in the SDR in November of 2015. This was not only an acknowledgement of China’s growing global economic importance, but was also a catalyst to drive further reform in the domestic financial sector.

The wheels are in motion for an interim step aimed at the broader use of the SDR as a world currency. Currently, a Chinese led program with the IMF for an SDR capital market initiative allowing domestic Chinese investors to participate in domestic bond issues denominated in SDRs is expected to launch in July 2016. (Marsh, 2016) This means that Chinese companies will issue bonds in SDRs, not just RMB. In October 2016, the RMB will have a weighting in the SDR of 10.9%, USD 41.7%, Euro 30.9%, yen 8.3% and the pound sterling 8.1%. (Marsh, 2016) Not only is this a positive for Chinese investors it also helps to stem the exodus of capital outflows from China.

An SDR Accord

In contrast to Zhou’s meticulous and methodical plan for the future of the Chinese RMB, the world’s other central bankers, Janet Yellen of the US, Mario Draghi of the European Union and Haruhiko Kuroda of Japan, (the Big Three) are floundering. Unorthodox measures such as negative interest rates are the latest tool to try and correct the direction of these stagnating economies. None of these measures, especially in Japan, seem to be working. None of the Big Three have presented or much less published their plans for the future. They may hold press conferences and focus on transparency but there is no strategic plan.

It is time for the world’s central bankers to embrace the PBOC’s plan and work together to create a far reaching inclusive currency accord similar in scale to that of the Plaza Accord Agreement of 1985. In the Plaza Accord, the US, Japan, West Germany, France and Great Britain came together and agreed to depreciate the USD by 50% over a two year period. This depreciation was needed in order to restore the global trade balance and stimulate global economic growth. Because of this accord, the world experienced unprecedented growth for the last thirty years. However, the potency of the Plaza Accord has dulled over time.

The US dollar is exhausted from serving as the world’s reserve currency. It has been quantatively eased, survived a zero interest rate environment (ZIRP) and of late has been rocketing up in value. The time is now for the US dollar to pass the torch of its reserve currency status to the Special Drawing Rights administered by the International Monetary Fund. For the sake of global financial security, which includes the security of the US, US Federal Reserve chair Janet Yellen must embrace PBOC chair Zhou’s solution to the Triffin Paradox. Proactive engagement by US Federal Reserve Chair Janet Yellen is imperative if the US is to maintain its influence over world financial market policy.

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