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China's central bank drama

For investors, the PBOC succession story will come center stage

| China
Zhou Xiaochuan, outgoing governor of the People's Bank of China, has been involved in China's major reforms in the past 15 years.

Chinese President Xi Jinping's "new era" looks anything but fresh. All six comrades he chose to help run China are in their 60s, likely to retire at the end of this five-year term. By pointedly not naming any potential heirs, Xi telegraphed that he may remain the helmsman for quite some time.

But the sexagenarian foremost on investors' minds these days should be Zhou Xiaochuan, a lame duck as governor of the People's Bank of China. Beijing's most forceful economic reformer turns 70 in January, and it will be the end of an era that spanned three presidencies.

Name any big reform in China's past 15 years and you will find Zhou's fingerprints: ending the dollar peg, liberalizing the capital account, scrapping caps on deposit rates, the yuan's elevation toward reserve-currency status. Zhou steered China clear of the 2008 global crisis and the 2013 Federal Reserve "taper tantrum." He stabilized cascading Shanghai markets in 2015 and led efforts to balance dueling asset bubbles while remodeling China's financial infrastructure.

Zhou's departure from the PBOC could not come at a worse moment for the second-biggest economy.

That is not, of course, the spin emanating from the recent 19th Party Congress, which had all the hallmarks of a coronation for the strongest leader since at least Deng Xiaoping, perhaps even Mao Zedong. As the Communist Party embeds "Xi Jinping Thought" into its constitution, the buzz in Beijing is how Xi might harness his newfound clout to raise China's game.

Beyond fanfare and atmospherics, investors received little to go on. Loads of talk about "standing tall and firm" and China "approaching the center of the world stage," but no details. Zero specifics on curbing government debt that is more than 250% of gross domestic product and a $20 trillion shadow-banking sector. No timelines for accelerating the transition from smokestacks to services. No hints Beijing might forego an annual GDP target in 2018, which skews incentives in favor of stimulus over reform.

But there were hints of a great leap backward. Far from giving markets the "decisive" role Zhou favors, Xi wants inefficient state-owned enterprises to play a "stronger, better and bigger" role in the nation's future.

China must reduce the scale of this most unproductive and crony-ridden sector, one that feeds corruption and lobbies against deregulation. The more reformers push to grow the private sector, the more SOEs, and their political protectors, push back. Heavier state involvement will hobble the development of innovative new industries and stifle financial markets that Zhou spent the last 15 years helping to build.

These days, Xi's men can literally switch off the stock market. Volatility slowed to a 25-year low during the Party Congress, according to Bloomberg data, while companies planning to report earnings losses were pressured to delay announcements. That comes as Beijing angles to take stakes in internet giants like Tencent Holdings and Weibo and expand authority over foreign companies. It belies the party's promotion of "entrepreneurial spirit."

Zhou could be forgiven for feeling dispirited as Xi threatens the big bang championed by his mentor, Zhu Rongji. Premier from 1998 to 2003, Zhu disrupted the state sector as never before, including modernizing China's four biggest banks. By the time he was done, some 40 million jobs were eliminated, accountability among local-government officials increased and Beijing joined the World Trade Organization.

During a June speech, Zhou seemed to channel his mentor -- and flirt with outright insubordination -- in commenting about the policy direction in Beijing. "From the experience of many countries, including our own, protections will lead to laziness and weakness," Zhou said. "Protectionism will lead to weak competitiveness and will hurt the industry's development, and [make for] unhealthy and unstable markets and institutions."

Vital lessons

Protege Zhou learned vital lessons from Zhu. One: locking China into the International Monetary Fund's top-five currency club. It is a Trojan horse of sorts, not unlike Zhu's push to enter the WTO in 2001. Beijing will face public rebukes if it fails to let the yuan trade more freely, loosen the capital account and increase financial-market transparency. Likewise, WTO inclusion gave a change-adverse party no choice but to internationalize.

Another: promote your disciples to ensure continuity. Since 2015, Zhou guided like-minded reformers into key jobs in the PBOC's monetary-policy department, China Securities Regulatory Commission, the IMF and the State Administration of Foreign Exchange, which manages Beijing's $3.1 trillion of currency reserves.

Yet great drama surrounds who Xi chooses to succeed Zhou -- a reformer with the clout to speak truth to power or a monetary yes man? The most commonly floated names: Guo Shuqing, chairman of the Banking Regulatory Commission and a party heavyweight; Jiang Chaoliang, party secretary in the central Hubei Province; economist Yi Gang, one of Zhou's deputies; and securities regulator Liu Shiyu.

None of these candidates is an obvious fit to run one of the globe's most powerful institutions. Press reports often center on Guo and Jiang. Guo, 61, may have the best reformist bona fides. A philosophy major, he has been prodding banks to write down bad loans. Jiang, 60, is credited with turning around state-owned Bank of Communications. Yet who Xi picks may be less important than how much autonomy he gives Zhou's replacement.

The risk is that Xi puts guanxi, or personal connections, over smarts and vision. Xi inherited Zhou and all his global gravitas in 2012. Earlier this month, Zhou warned that without policy changes, China risked a so-called Minsky Moment, the point when a debt-fueled boom comes to a ghastly end. "If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction," Zhou said. No other top official would have such gall. Will Zhou's replacement be such an honest broker?

The last thing unbalanced China needs is Xi installing a personal comrade to enable his contradictory push for freer markets with more party control. The PBOC faces a perilous balancing act: maintaining healthy growth, while avoiding a debt reckoning and not creating new risks by easing too much. If Xi chooses Zhou's successor badly, his new era will face some very old problems as dysfunction trumps dynamism.

William Pesek is a Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He has written for Bloomberg and Barron's.

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