Director of the Center for Pacific Basin Studies,Senior Research Advisor,Federal Reserve Bank of San Francisco

Educational Background

Ph.D. Economics, University of Minnesota, 1997
M.A. Economics, University of Minnesota, 1994
M.A. Economics, Renmin University of China, 1991
B.A.  Economics, Renmin University of China,1988

Research Areas

Macroeconomics, Monetary policy, International finance, Credit frictions, Chinese economy.

China’s Central Bank Must Operate Independently and Transparently

Professor Zheng Liu, who specializes in macroeconomics, monetary economics and international finance, is now Special-Term Professor at Shanghai Advanced Institute of Finance (SAIF). With his penchant for travelling, he taught macroeconomics courses at SAIF when it was just established. From his perspective, the uniqueness of China’s economy leads to various issues worthy of study and discussion. For example, he is concerned about China’s urbanization and financial frictions, and would like to take a closer look in the future. Meanwhile, he expects that SAIF will stand out from the increasingly fierce competition among business schools by being noted for the academic quality in its fields of research. In this interview, Professor Liu shares his views on the prospects for U.S. economic recovery in dealing with the fiscal cliff, China’s monetary policy stance and so forth.

China’s central bank should make sure that inflation expectations remain well anchored, operating independently and transparently

According to the People’s Bank of China, the balance of China’s broad money (M2) by the end of December 2012 was 97.42 trillion yuan, a year-on-year growth of 13.8 percent. The growth rate was slightly below the 2012 annual target of 14 percent. Moreover, new RMB loans in 2012 were 8.2 trillion yuan. December 2012 had 454.3 billion yuan of new RMB loans, showing a new low in three years. In terms of inflation, China’s consumer price index rose 2.5% in December 2012, hitting a 7-month high.

As Professor Liu explains, “If monetary policy aims to bring down inflation, for example, to 2%, then they should stick with a 2% inflation target. If people think that it will work, inflation will be at 2%, otherwise it won’t be at 2% if people doubt it.” Regarding monetary policy and controlling inflation, Professor Liu stressed that the central bank needs to establish credibility through independence and transparency. “The government must give reasons for policies, such as raising or reducing interest rates, in order to achieve the medium-term objectives and long-term goals,” says Professor Liu.

He also points out major determinants concerning future inflation. One main determinant is expectations that people have. Once inflation expectations are settled, the situation can hardly be changed by unexpected events, because there is a very close relationship between inflation expectations and actual inflation. Another factor is cost changes, such as increases in labor costs and commodity prices, all of which drive firms to raise prices. However, if the inflation is expected to be stable, temporary cost changes will have little impact on inflation in the long run. Therefore, Professor Liu suggests that China should carry out inflation expectation surveys and research, learning from the United States and other developed countries. It is crucial for the central bank to monitor inflation expectations, in order to make optimal decisions.

In a new research study called “External Shocks and China’s Monetary Policy” by Professor Zheng Liu and Mark M. Spiegel in December 2012, they noted that since the global financial crisis of 2008, interest rates on China’s foreign assets fell sharply, while yields on Chinese domestic assets remained relatively high, posing a challenge for China’s monetary policy. “As a matter of fact, the challenge is that China sets its monetary policy in a context of capital controls and exchange rate targets. If China does not stick to these controls, for instance, by liberalizing the capital account or allowing the exchange rate to float then the negative effects of changes in global financial conditions would be largely eased.” Professor Liu points out that, after joining the World Trade Organization in 2001, China has been running large current account surpluses every year. However, because of capital controls, private citizens have been prohibited from trading foreign assets freely; meanwhile, it has tightly controlled its exchange rate.

As Professor Liu suggests, either opening the capital account, or allowing the exchange rate to float, can make a difference. In addition, his study shows that either liberalizing the capital account or floating the exchange rate can substantially reduce inflation pressures for China associated with capital flow, even if full liberalization is not immediately feasible. “As a result of capital account liberalization, the People’s Bank of China does not have to purchase all foreign currency revenues of exporters in order to absorb inflows of foreign capital. Once the central bank does not need to sterilize purchases of foreign capital inflows, it can reduce sterilization costs. On the other hand, allowing the exchange rate to float, even without removing capital controls, can also help weather external shocks,” says Professor Liu.

The damage from the fiscal cliff does not happen all at once

At the beginning of 2013, the United States Senate agreed to a deal to avert the fiscal cliff. The fiscal cliff deal includes increasing capital gains tax rates relative to their 2012 levels for annual income over $400,000, and extending federal unemployment benefits for one year. Some analysts claim that the agreement on such extensions and tax increases may advance America’s economic recovery in the short term. However, they believe that uncertainty about the pending automatic spending cuts scheduled to occur on March 1 if no agreement is reached on deficit reductions and hitting the debt ceiling can be threat to the U.S. economy in the future.

In this regard, Professor Liu suggests that the fiscal cliff would negatively impact the U.S. economy and the global economy; yet, the damage does not happen all at once, rather, it happens more gradually. Even if taxes are rising, people make monthly payments. Although salaries become less than they had before, this is not a deduction all of a sudden, and the purchasing power will not decline sharply. In addition, people have expected the fiscal cliff in last year. The damage will not be serious or happens so accidentally if people prepare themselves for bad news. How will these remaining fiscal issues impact China’s economy? Exports, as one way to stimulate the economy, will be affected to a large extent. “People would become unemployed if export enterprises have to lay off employees or even close down. The government needs to cope with such possibilities”, he says, “From the standpoint of economic growth, there is a strategic partnership between the U.S. and China. The latter can benefit from the former’s good performance.”

Some complain that Quantitative Easing (QE) is a painful process to Chinese people, considering the devaluation of the U.S. dollar will cause inflation. But in fact, this issue is derived from the defects of the present RMB exchange rate system. The strategic partnership between the U.S. and China is essential. Consequently, if QE can stimulate the national economy, it will be of benefit to China.” Professor Liu continues, “As far as I am concerned, QE is necessary, and it seems to be the only approach. From this aspect, I am not optimistic about the world economy.”

However, as for the recovery of the U.S. economy, Professor Liu found some positive phenomena, “What makes American people more optimistic is that real estate markets has begun to recover. In the Great Recession period, home prices fell by over 30%, To stabilize the housing market, the U.S. government provided credit for first-time home buyers in 2009 and 2010.  That prompted home prices to rise temporarily.  But the prices declined again when the government credit ran out.  In the past year, however, home prices have increased significantly without any government subsidies to home purchases,” says Professor Liu. He notes that the increase in home prices helps ease borrowing conditions for households and firms and thus provides support for growth in consumption and investment. At the same time, unemployment rate in the United States started to decline, but very gradually. He believes that these trends are likely to continue and the overall economic conditions in the U.S. should improve in the next year or two.

Enhancing academic expertise with a focus on the Chinese economic issues

As Special-Term Professor at SAIF, Professor Liu has a penchant for travelling, and taught macroeconomics courses at SAIF when it was just established. When he came to Shanghai with his wife, he enjoyed the rich cultural atmosphere in the city very much. Additionally, he has known Professor Zhou Lin, who participated in the establishment of SAIF, and Professor Chun Chang (Executive Director at SAIF) for years, and all of them have a particular research interest in China’s macroeconomic issues.

“SAIF is a very promising institute”, Professor Liu says, “Because the organizational system has a strong connection with international standards. Many professors return from abroad and stay at SAIF for some time to interact academically with each other.” When it comes to the prospects for its development, he suggests that it is crucial for SAIF to establish its own brand. In order to stand out from the increasingly fierce competition among business schools, it should raise academic quality as a differentiation competitive advantage, and enhance its unique expertise in research.

In terms of his research plan in the near future, Professor Liu expresses his interests in the urbanization in China, for example, questions like how to promote China’s urban-rural integration, how to improve productive efficiency, how much can urban-rural integration contribute to sustained rapid growth in China’s economic future, or how much impact does cancelling the policies of Hukou system have on productive efficiency? Another topic he is interested in is about financial frictions, which he regards as “financial repression”, frictions in extreme cases within China. As professor Liu explains, since people don’t have access to sufficient channels of investment, it is almost impossible for privately owned and small businesses to get loans from banks. Such situation strangles their opportunities. “There is no alternative for them but to make usurious loans. They had to borrow money from family members and friends, or even from state-owned enterprises, which could easily get loans at low rates from banks and earn interest margins by lending money to those business owners. This kind of financial distortion is a significant constraint on economic development in China,” he says.