Nomura

China: Beyond falling M2 growth

We expect M2 growth to rebound over the next one to two quarters, mainly driven by the targeted reserve requirement ratio (RRR) cut that went into effect in January 2018, and restrictive regulations on bank wealth management products and asset management products of non-bank financial institutions.

However, in the medium to long run, we expect the downtrend in M2 growth to continue. As China’s economy shifts from an investment-driven growth model to one more reliant on consumption, its demand for credit will also slow. Therefore, in the long run, we believe monetary policy will reflect these conditions.

M2 growth has fallen sharply in China since mid-2016 and has recently recorded consecutive record lows. M2 used to be an important liquidity indicator and one of the key intermediate targets of People’s Bank of China (PBoC) monetary policy. Although the validity of M2 growth as a liquidity measure has been undermined by thriving shadow banking financing in recent years (see Anchor Report: China: Coming out of the shadows, 1 September 2017), we believe M2 growth remains a valid indicator of aggregate money supply.

What are the effects of cutting RRR?

Cutting RRR increases M2 growth by raising the money multiplier, depending on the loan demand and the willingness of banks to lend. It also immediately increases the excess reserves for commercial banks, allowing banks to increase their loans, resulting in a rise in bank deposits.

Along with the downtrend of M2 growth, we believe China will cut its RRR several times in the coming years. China’s money creation before 2008 was driven mainly by the PBoC’s credit extension through foreign exchange purchases. After 2008, money creation was driven by the credit expansion of both the central bank and commercial banks. During this period, the RRR was cut several times but remains high. As the PBoC has already become the largest central bank in the world, it is unlikely the PBoC’s balance sheet will expand further. As a result, M2 growth and money creation will become more reliant on commercial banks extending credit. This suggests the PBoC will have to cut the RRR in coming years, although there appears to be little incentive for them to do so right now.

Click here to read more about the implications of long-term downtrend in M2 growth.

Contributors

  • Yang Zhao

    Chief China Economist

  • Albert Leung

    Asia Rates Strategist

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