The risk of Chinese monetary policy failure
Back in October 2012 I wrote a blog post on what I called "My favourite Chinese monetary graph". In this post I am returning to this topic as I think the monetary developments in China has become increasing worrying. My focus was on the development in M1:
Imagine a 4% inflation target – this year’s Chinese inflation target – trend real GDP growth 10-11% and money-velocity growth between -1% and 0% then the money supply (M1) should grow by 15-16% to ensure the inflation target in the medium term. This is more or less a description of Chinese monetary policy over the past decade. Over the past decade People’s Bank of China has been targeting M1 (and M2) growth exactly around 15-16% (give and take a bit…). Overall the PBoC has managed to hit its money supply target(s) and that has more or less ensured nominal stability in in China over the past decade. I find it useful to track the growth of M1 versus two idealized targets path of 15% and 16% going back to 2000. This is my favourite graph for the Chinese economy.This is how the updated M1 graph looks today: Back in October 2012 the actual level of M1 had just broken below the 16% trend line and since then M1 has kept inching downward compared to both the 16% and 15% trend lines and recently we have broken 15% tend line. This is obviously a very crude measure of monetary conditions in China, but I nonetheless think that the indication is pretty clear - monetary conditions are clearly getting tighter in China and I think it is fair to say that monetary conditions are disinflationary rather than inflationary. Since my October 2012-post distress has clearly increased in the Chinese money markets and growth worries have certainly increased. Furthermore, given it is hard to ignore the connection between the continued tightening of monetary conditions in China and the turmoil we have seen in Emerging Markets over the past 6-12 months - after all China is a global monetary superpower. It is time to ease Chinese monetary conditions I think that is totally appropriate that the People's Bank of China (PBoC) initiated monetary tightening in early 2010 and overall the tightening has been warranted - even though it has had negative market implications for particularly some Emerging Markets. However, it is obviously not the task of the PBoC to conduct monetary policy for Brazil or Turkey for that matter. However, I think it is now pretty clear that Chinese monetary conditions has become too tight for China. However, the PBoC has been extremely reluctant to step up monetary easing. In my view there are overall two reasons for this. First, PBoC obviously is worried that it could "reflate the bubble". Second, the Chinese policy makers clearly seem to think that Chinese trend real GDP growth has declined and I would certainly agree that Chinese trend growth likely is closer to 7-8% y/y than to 10%. So there likely has been good reason for a more cautious monetary policy approach in China, but if we indeed assume that Chinese trend growth has declined to for example 7-8% and money velocity on average decline 0-1% per year and the PBoC wants to hit 2-4% inflation over the medium-term then M1 needs to growth by at least 9-13% (7+0+2 and 8+1+4). Since October 2012 - when I put out my original post - Chinese M1 has actually averaged 9%, which is in the lower end of the range I think is necessary to avoid monetary policy to becoming excessively tight. Furthermore, it should be noted that the increased financial distress in China over the past year likely is pushing down both money velocity and the Chinese money multiplier, which in itself is disinflationary. Concluding, I think there is little doubt that Chinese monetary conditions are becoming excessively tight - so far it is probably not catastrophic, but I can't help thinking that the risk of nasty credit events increase significantly when economies go from a boom to a disinflationary weak growth scenario - said in another way I really fear is a "secondary deflation". PS A look at M2 growth would likely paint a slightly less scary picture. PPS The growth rate of M1 in January 2014 was extremely weak (1.2% y/y). I am not certain what to make of the numbers, but it was what really got me to write this blog post.