Reform's Response to the Money Supply Warning
Warning lights are flashing in the context of a widening gap in growth rates for two key measures of money supply – M1 and M2 – and fears that policymaker efforts to boost the real economy are falling flat.
China must now heed the warning by putting into practice long-discussed but largely unimplemented structural reforms. Indeed, the divergence between M1 and M2 highlights an urgent need for reform measures that lift the policy restraints now holding back the Chinese economy.
M1, which includes cash and short-term bank deposits, and M2, which includes long-term deposits, have been growing at different rates since last October. The gap indicates that a People's Bank of China effort to expand the money supply hasn't effectively benefitted the real economy.
M1 grew 25.4 percent in July compared to the same period last year, underscoring a central bank effort to pump liquidity into the market as a way to bolster the slowing economy. The year-on-year rate was only 6.6 percent in July 2015.
Meanwhile, M2's expansion between July and the same month 2015 was only 10.2 percent, suggesting that, despite the liquidity boost, companies are now holding cash or boosting bank deposits rather than spending and investing.
The gap accented several other indicators – such as slowing growth for fixed-asset investment and private investment between January and July – that pointed to a weakening economy.
PBOC on August 15 refuted claims that the money supply gap suggests China is about to fall into a "liquidity trap," a situation that renders a central bank impotent and unable to stimulate the economy through policy adjustments. We agree with the central bank's assessment, since there's still room for interest-rate cuts and additional policy maneuvers. PBOC has not run out of ammunition.
But, undoubtedly, monetary policy as a stabilizer for economic growth is losing its effectiveness. The economic slowdown is more structural than cyclical, which poses special challenges. Over the past four years, economic distortions and divergences have grown more serious, especially in the area of state-private sector relations.
Rather than invest in business endeavors, most state-owned enterprises (SOEs) have been repaying debt or hoarding cash. Private companies, meanwhile, have turned increasingly cautious about new investment, reflecting their limited access to capital relative to SOEs.
Investors, meanwhile, have reacted to often-heard forecasts of further economic cooling and rising risk by preferring targets tied to government projects and SOEs.
Meanwhile, speculators are moving in. The property market in the first half of this year was flooded with cash from companies, especially SOEs, and household savings that pushed up real estate prices in many cities.
After several city governments responded to the mini-boom for real estate by tightening property investment controls, investors started diverting capital into the bond market. But that move triggered concerns about a bond bubble and excessive leverage, prompting analysts to predict that the stock market might become the next favorite investment target.
The central bank has promised to take steps that keep capital flowing to companies that need it most. But PBOC's ability to fulfill this promise is being tested by the economic slowdown, which is expected to last a long time, as well as by the build-up of funds outside the real economy.
A further easing of monetary policy, either by cutting required bank deposit levels or trimming interest rates, would be challenged by market bubbles, yuan depreciation and-or capital outflow.
Many have expected government spending to play a bigger role in keeping the economy on track. But fiscal revenues are declining, narrowing opportunities for a more expansive fiscal policy.
As of July, nationwide government spending grew only 0.3 percent from the same period last year. And spending by the central government alone actually declined 7.4 percent. Fiscal spending is likely to continue to fall in coming months and end the year down from 2015.
Special bond projects and public-private partnerships (PPP) have also been cited as mechanisms for boosting investment and the economy. But these can have negative side-effects by, for example, increasing local government debt and squeezing private investors by favoring debt-ridden SOEs in such projects.
The fundamental solution, though, lies in addressing the structural distortions that have accumulated over the years due to foot-dragging on reforms. China can no longer delay supply-side reforms that reduce state controls over market resources and boost private investor confidence.
Monetary policies can help nurture a proper financial environment that encourages supply-side reforms. But policies cannot replace reforms.
One important supply-side reform measure involves encouraging SOEs to cut excess capacity. Weak companies with little chance of a turnaround should be allowed to go bankrupt, while those with potential should be restructured through debt-to-equity swaps. Further SOE reforms are expected in the form of government-backed asset management and investment companies, which are recently approved by the State Council.
Supply-side reform steps should also encourage private investment, which has been falling due to a negative economic outlook and uncertainties over policy direction. Worth noting, though, is that during the first half of the year, Chinese companies rapidly expanded overseas investments while private sector domestic investments fell.
The best way out is through structural reform which, unlike monetary policies that focus on short-term issues, can have a long-term impact on the economy. As the growth gap between M1 and M2 widens, policymakers look to structural reform as a big-picture solution.
Hu Shuli is the editor-in-chief of Caixin Media
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