The Chinese central bank is quietly considering a change that says a great deal about the progress and perils of China’s broader reform project. According to Caixin, Beijing may abolish the nine regional branches of the People’s Bank of China, each of which oversees several provinces, and replacing them with more than 30 provincial-level branches – effectively returning to a system it abandoned in 1998. The plan is expected to kick in by the end of the year.
Now, we realize that a bureaucratic overhaul in China is not very dramatic. But as we discussed following President Xi Jinping’s overhaul of the state bureaucracy during the spring, Xi is in a make-or-break wrestling match with the system he heads, and there are still several rounds to go. China is a big and unwieldy place that’s ill-suited for micromanagement. Chinese history is littered with sclerotic, unresponsive governments getting blindsided by crises bubbling up from the provinces. And if the Communist Party of China has any chance of surviving amid slowed growth and trade tension with the West, it will need all the help it can get.
On the surface, at least, this change seems like an admission of defeat. Until 1998, the PBOC had a branch in each of China’s 31 provincial-level administrative units (i.e., provinces, autonomous regions and biggest cities) that answered directly to the central bank leadership – a similar structure to the one under consideration. The problem with this setup was that local governments simply proved too adept at hijacking monetary policy and financial resource allocation to support their immediate interests, often at the expense of Beijing’s macroeconomic goals. Part of the problem was that the incentives of local governments and provincial PBOC branches were too tightly aligned. The quickest way to gain promotion up through the Chinese system, whether as a local administrator or a central bank branch official, was to ensure that your province was producing sparkling economic data. PBOC branches were also too dependent on assistance from local governments, which since the 1980s have had considerable sway over local economic activities and ample wariness of prying eyes, to be able to carry out their mandate.
Thus, a province’s success was the branch’s success, creating incentives to overlook financial risk and support reckless lending and development in the name of economic growth. (And, if all else failed, there were mutual incentives to simply cook the books.) In other words, what Beijing wanted from the bank branches was a clear view into local economic activity and prudent allocation of liquidity. What it got was regulatory capture. This was just the latest manifestation of an age-old problem in China, where the center has always struggled to control the country’s disparate parts.
And so, in an effort to boost the central bank’s independence, the PBOC was restructured to resemble the U.S. Federal Reserve. The provincial branches were abolished, replaced by nine regional branches responsible for overseeing several provinces. More than 300 municipal sub-branches and more than 1,000 county-level sub-branches remained, but their responsibilities were confined to financial supervision, with little ability to alter policy or issue credit independently – and thus leaving local governments with less influence over the PBOC. But this system fostered its own problems. In particular, the regional branches have reportedly struggled to uniformly meet the needs of multiple provinces, in which economic conditions could vary widely.
What Has Changed Since 1998
That the PBOC is reversing course says three things about China’s reform effort. The first is merely that the party leadership feels it now has the tools to prevent regulatory capture and keep local governments in check. For example, Xi’s sweeping anti-graft campaign has extended to every conceivable level of government and, increasingly, into the private sector and civil society as well. Of the nearly 1.5 million officials jailed, purged or otherwise disciplined, the vast majority have not been the high-profile “tigers” (i.e., senior officials ousted, at least in part, as threats to Xi’s consolidation of power), but rather lower-level “flies” – those with the most ability to gunk up the machinery of governance and hijack reform implementation. And Xi’s domestic surveillance apparatus is only growing: In March, Xi unveiled a new and improved National Supervisory Commission, which will embed units across the national, provincial, city and county levels to try to ensure adherence with contentious reforms. Already, this has shown some success in reducing the common practice of lower-level governments cooking their books to stay in Beijing’s good graces.
Second, it says that Xi isn’t done peeling away layers of the bureaucracy that have the capacity to dilute the center’s power and subvert its reform initiatives. With the PBOC, this process has been underway for some time. By 2004, according to unnamed officials quoted by Caixin, the regional branches had largely been defanged, with the sub-branches taking primary responsibility for local execution of monetary policy and financial market supervision. The regional branches had become redundant middle men. Given the scale and complexity of risk in China’s financial system, any bureaucratic bottlenecks, turf wars or conflicting regulations are threats to the party’s agenda that it cannot abide.
Indeed, this is just part of a much broader effort to overhaul China’s sclerotic and chronically overmatched financial supervisory system. For much of the past year, Xi has been gradually wringing the primary institutions responsible for provincial development into submission. In March, for example, Xi stripped the all-powerful National Development and Reform Commission – which has dominated economic planning in China since the Mao era, but which had become rife with corruption – of a wide range of its powers, including some of its oversight responsibilities. The party has also been inserting political committees into state-owned enterprises, which likewise are principal agents for local development. Perhaps most important, the party has been reining in local governments’ ability to sidestep restrictions on how they raise funding and how it’s spent.
Notably, the Communist Party has also focused on tightening its control of the PBOC itself, while simultaneously expanding the bank’s powers to allow it to function as China’s core policymaker on a range of economic matters. (Unlike the Federal Reserve, the PBOC has duties far beyond monetary policy.) Its new powers have come at the expense of China’s top insurance and banking regulatory bodies, which have been merged and stripped of any major role in drafting new laws and rules for the finance sector. In other words, Xi has become confident enough in his control over the PBOC to use it as the party’s pre-eminent tool to rein in other institutions. And by doing away with the regional PBOC branches, the provincial branches will be empowered to carry out Beijing’s wishes more capably at lower levels. Theoretically, at least, this new system will allow Xi’s writ to be felt more clearly down the line.
The third thing this move tells us is that the CPC’s ambitious economic reform agenda is turning into a game of whack-a-mole, with each success breeding a new problem somewhere else. And this game is going to become only more difficult as growth slows in China and as the sting from the trade war worsens.
For example, the success of Beijing’s sweeping deleveraging campaign and crackdowns on shadow lending has come with downsides. For one, China is grappling with a liquidity crunch that risks sparking a cascade of defaults. For another, the crackdown on shadow lending has merely pushed firms, local governments and investors to look for loopholes and embrace even riskier or more opaque fundraising channels.
This risk has been most evident in the private sector, with dozens of firms defaulting on dollar-denominated debt in recent months and a wave of online peer-to-peer lending platforms going belly up since June, leading to small-scale protests by burned investors in Beijing and Shanghai. Meanwhile, at least four times in the past month, Beijing has issued pleas for Chinese banks to boost lending to small-to-medium enterprises, as anxiety among banks about slowing growth, increased regulatory scrutiny and uncertainty stemming from the trade war has compelled them to focus on lending to safer assets such as SOEs, which banks think Beijing would rescue in a crisis.
With heavily indebted local governments, meanwhile, Beijing is simultaneously cracking down on their traditional forms of financing, such as banning state-owned banks from lending to what are known as “local government financing vehicles,” but also making it easier for banks to purchase bonds issued by local governments and help accelerate infrastructure investment (which contracted year-over-year for the first time in modern Chinese history in July). Notably, Beijing is still trying to get a handle on just how big of a risk local government debt poses to the Chinese economy. According to Reuters’ calculations, China’s outstanding local government debt rose 7.5 percent to 16.47 trillion yuan ($2.56 trillion) at the end of 2017 from the previous year. Yet, in July, Caijing reported that authorities have launched yet another nationwide investigation into hidden local government debt, suggesting that things might be considerably worse.
In short, Beijing needs the PBOC to have a better understanding of conditions on the ground and the authority to adapt on the fly. Uncertainties surrounding the trade war only heighten this need, given that Beijing has only limited ability to anticipate how hard any particular sector will be hit and for how long. And considering the high degree of variance in economic risk profiles from one province in China to the next, the regional banks had become blunt hammers at a time when scalpels are needed.