One of China’s leading economists says that sweeping reforms of the country’s financial regulatory framework will see the People’s Bank of China become a “super central bank” entrusted with macro-prudential regulation and the formulation of banking laws in addition to monetary policy.
The State Council recently unveiled the biggest shake-up of the Chinese financial regulatory system in 15 years, with the proposed merger of the China Banking Regulatory Commission and the China Insurance Regulatory Commission.
Policymakers hope that the merger will improve regulatory efficiency and coordination, enable the authorities to better handle the increasingly integrated nature of the Chinese financial sector, as well as help stamp our “regulatory arbitrage.”
In addition to consolidation of the banking and insurance authorities, the reforms will also expand the role of the People’s Bank of China, by entrusting it with the drafting of legislation for the banking and insurance sectors in order to achieve a more unified and cohesive regulatory system.
Ren Zeping (任泽平), chief economist for the Evergrande Group, says the reforms will make PBOC a “super central bank” whose mission will be to strengthen macro-prudential regulation and make adjustments to financial cycles.
In an essay entitled “The New Mission of the Future ‘Super Central Bank,'” (未来“超级央行”的新使命) Ren says that PBOC’s expanded role will have profound implications for the Chinese economy, as well as financial and asset markets.
“China’s new regulatory reforms are primarily a response to two challenges and trends,” writes Ren. “Regulation on the basis of sector is unsuited to integrated financial operations, while monetary policy is focused on inflation and neglects asset prices.
“The new financial regulatory reforms embody improvements to the macro-prudnetial policy framework, and strengthening the central bank’s core role as the overseer of financial stability…this is the first step in the establishment of a ‘super central bank.'”
Ren points out that financial cycle theory and macro-prudential regulation have emerged an increasingly important areas for regulators ever since the Great Financial Crisis, given that monetary expansion created an asset price bubble and finance sector instability, without driving inflation.
“Monetary policy places an emphasis on adjustments to the economic cycle and has the goal of price stability,” writes Ren. “Macro-prudential policy places an emphasis on adjustments to the financial cycle, and has the goal of financial stability.”
According to Ren the fundamental reason for the emergence of financial cycles in the modern era lies in changes to the money creation mechanism.
“As financial sectors have liberalised, financial innovation, integrated operations and shadow banking have all proliferated, leading to considerable growth in asset markets.”
Consequently, the money creation mechanism has shifted from the original simple model of ‘central banks and commercial banks” to a complex model of “central banks, commercial banks, off-balance sheet bank operations – shadow banking.”
The rise of shadow banking and off-balance sheet bank operations in particular are culpable for excess money creation which doesn’t flow into the real economy, but is instead absorbed by assets markets for real estate, equity or debt.
According to Ren the subsequent application of leverage and maturity mismatches serves to exacerbate financial fragility, or even create financial Ponzi schemes.
Ren further points out that there is a high level of correlation between the financial cycle and the “debt cycle” or the “leverage cycle.”
“Differing from the economic cycle, the financial cycle primarily refers to cyclical fluctuations caused by financial quantitative expansions and contractions.
“When assessing the financial cycle, the two core indicators are broad credit and real estate prices, the former representing financial conditions, and the later reflecting the awareness and attitude towards risk amongst investors.
“Because real estate is key collateral for loans, there is reciprocal amplification between the two, which can lead to a self-strengthening pro-cycical fluctuation…the financial cycle has a collateral accelerator, a loan accelerator and a mood accelerator, which amplifies cyclical fluctuations.”
According to Ren these developments have undermined the theoretical foundations of traditional monetary policy, such as the Taylor rule and inflation targets, resulting in the need for changes and adaptions to modern financial systems.
As a consequence the strengthening of macro-prudential regulation has become one of core aspects of global financial reforms, especially in China, which unveiled a “twin pillar adjustment framework” consisting of monetary policy and macro-prudential policy at the 19th National Chinese Communist Party Congress in October last year.
Prior to this, the Chinese central bank “upgraded” its differentiated dynamic reserve adjustment mechanism to a macro-prudential assessment (MPA) system in 2016, and has since steadily increased its remit.
In the first quarter of 2017 off-balance sheet wealth management products were formally included within the scope of MPA broad credit indicators, while starting from the first quarter of 2018 interbank certificates of deposit will also included in the MPA’s interbank debt ratio index.
Ren expects PBOC to further expand its role as macro-prudential regulator as well as the scope of macro-prudential regulation following the latest round of financial sector reforms.
“In future the central bank will further improve the macro-prudential policy framework, and explore the inclusion of shadow banking, real estate financing and online financing in the macro-prudential policy framework,” writes Ren.
“[It will] include interbank certificates of deposit, green lending performance in MPA’s, optimise cross-border capital flow macro-prudential policy, and make counter-cyclical adjustments to capital flows.
“The themes of regulation will be: strengthening financial regulatory coordination, strengthening macro-prudential regulation to ensure financial stability, using monetary policy to keep the currency value stable, strengthening micro-prudential regulation to ensure the stability of individual financial institutions, and strengthening protections for consumers.”
While the consolidation of China’s financial regulatory system may improve efficiency and help to combat regulatory arbitrage, Ren nonetheless sees potential problems with the merger of the banking and insurance regulators and the establishment of PBOC as a “super central bank.”
“Who will restrain and regulate the ‘super central bank?'” asks Ren. “If you take such a huge amount of power, the incentives and restraints, as well as the responsibilities, should also be commensurate.”