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Weekly Economic Briefing

Emerging Markets

Make M2 great again

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Monetary policy in China is front and centre as policymakers grapple with external pressures, including higher rates in the US and escalating trade tensions. With signs of weakening domestic demand in May and the potential for a damaging trade war, policymakers have begun to loosen policy and may be moving towards an easing bias. As we've written before in this column, gauging monetary and credit policy in China can be difficult due to differing signals from money supply, total social finance flows, and aggregate credit growth. This week we look at money supply (M2) growth and its usefulness as an indicator of liquidity and monetary policy.

Credit boom not reflected in M2Shadow finance behind divergence

Since mid-2016, M2 growth in China has fallen sharply and has recently recorded consecutive record lows. This has occurred amid a massive credit expansion, raising questions about the representativeness and relevancy of M2 as a gauge of monetary policy, and as a leading indicator of growth and inflation. Rapid changes to the structure of China's financial system, followed by regulatory tightening, have likely distorted M2 as a measure. But as the system adjusts, M2 will again serve as a relevant indicator. The rapid growth in shadow financing and subsequent policies to reduce financial sector leverage caused the notable deviation between M2 growth and the underlying credit expansion (see Chart 10). This was driven by the diversification of savings away from traditional bank deposits as more people chose to save with non-bank financial institutions and wealth management products, leading to divergence between M1 and M2 (see Chart 11). Although the value of M2 growth as a liquidity measure has been undermined by thriving shadow bank financing in recent years, policy tightening and increased shadow banking regulations will likely make M2 relevant again.

It helps to understand how money creation has changed in China over the past 10 years. Until the end of 2014, the People's Bank of China's (PBoC) balance sheet was largely a factor of China's twin surpluses and their growing pile of FX reserves. To offset the surge in the monetary base, the required reserve ratio (RRR) was hiked as high as 21.5% to rein in loan growth at commercial banks. It was not until outflows picked up in 2014/2015, that domestic money creation became a factor in monetary policy. As a result, the monetary policy framework and policy tools have changed substantially in the last couple of years, as the PBoC became a 'provider' of liquidity. With monetary policy shifting towards an easing bias, mainly driven by RRR cuts, M2 will likely rebound over the next 2-3 quarters. However, in the medium to long run, the structural downtrend in M2 growth will likely continue. As China's economy slowly shifts from an investment-driven growth model to one more reliant on consumption, its demand for credit should also slow. Monetary policy, in the long run, will reflect these conditions. Additionally, a further expansion of the PBoC's balance sheet will be increasingly difficult, as the PBoC has already become the largest central bank in the world. As a result, M2 growth and money creation will become more reliant on commercial banks extending credit. This suggests the PBoC will likely have to continue cutting the RRR in coming years.

Alex Wolf, Senior EM Economist