The People's Bank of China, the central bank, may not tighten money supply in the near future because of flat inflation figures. Provided to China Daily

Policy makers grapple with the numbers and the possibilities as liquidity surges

A faster-than-expected rise in money supply and soaring bank credit but modest economic growth is an equation that has left Chinese monetary policy makers puzzled and hesitant about their next step.

Any impulse to ease or tighten monetary policy at the moment may lead to unintended consequences, economists say.

Robert E. Hall and David H. Papell wrote in their book Macroeconomics - Economic Growth, Fluctuations and Policy - that "unsound monetary policy is the chief culprit" leading to severe recession and inflation.

By the end of April, broad money supply, so-called M2, had exceeded 103.3 trillion yuan ($17 trillion), up 16.1 percent from a year earlier, compared with year-on-year growth of 15.7 percent in March, according to the central bank.

But the year's target for money supply increase was anchored at 13 percent, which requires average lower-than-12 percent M2 growth in the final eight months of this year, meaning there will have to be relatively tightened monetary policy.

To the end of last year, M2 in China was close to double the total value of the gross domestic product, higher than a world-recognized warning line of 1.5 for the M2/GDP ratio. In comparison, that ratio was only 0.32 in 1978.

Cheng Siwei, an expert in economics, finance and managerial fields and the former vice-chairman of the Standing Committee of the National People's Congress, warns that the excessive money supply is like "a tiger in a cage". "Once it is released, the consequences will be severe."

Cheng attributes high property prices and the recent rush to buy gold to the faster-than-expected increase in money supply. He is concerned about high inflation in the long term.

Since 2009, policy makers have written the annual M2 growth target into the annual Government Work Report, which is announced by the premier at the opening of the National People's Congress every March.

Ji Zhihong, director of the research bureau of the People's Bank of China, says that for making monetary policy, the nation uses money supply as the key control tool, while also paying attention to other gauges including interest and exchange rates.

"The final target is to maintain price stability and steady economic growth," the bank official says.

There has been no sign of inflation spiraling out of control so far this year. In April, consumer prices rose 2.4 percent from a year earlier. That was slightly higher than March's 2.1 percent but still much lower than the year's target of 3.5 percent.

The flat inflation figures are taken by economists to mean that policy makers may not aggressively tighten money supply in the near future.

Because of the increase in interest rate liberalization, money supply may not be used as the main tool in deciding the whole monetary policy mixture, but there will be more of a focus on interest rates, as is the case now with the US Federal Reserve and the Bank of Japan undertake currently, Ji says. "Monetary policy making is in transition."

Money supply is dependent on monetary multipliers and base money. Base money is the total of domestic credit plus foreign exchange reserves.

The total of social financing jumped to a historical high by 160 percent from a year earlier in January and 58.2 percent in the first quarter, fixed-asset investment growth slightly increased to 21.2 percent in January and February, and then slowed to 20.9 percent in March.

GDP growth during January to March slowed to 7.7 percent year-on-year from 7.9 percent in the last quarter of 2012.

It was a different picture four years earlier. Growth in total social financing rose to 114 percent in the first quarter of 2009 and 121 percent in the second quarter, from 26.6 percent in the last three months of 2008. It led to a boost in fixed asset investment, which increased 28.6 percent in the first quarter from 26.8 percent in the fourth quarter in 2008.

In the same period, the official purchasing managers' index rose to 52.4 from 41.2, indicating a fast recovery in manufacturing production.

That provided evidence that the marginal effect of monetary easing on the economy is decreasing compared with 2009, after the global financial tsunami.

"We believe a large part of the new credit supply in the first quarter did not go into the real economy," says Zhang Zhiwei, chief economist in China at Nomura Securities Co.

It is partly because the underlying demand for investment is weak, he adds.

"The overcapacity problem in the manufacturing industry has been exacerbated by aggressive policy easing in 2009 and 2012."

Liu Ligang, chief Chinese economist with the ANZ bank group, says: "Overly loose credit is likely to exacerbate overcapacity in factories. Economic growth cannot rely on monetary easing any more."

China's traditional economic growth pattern that excessively depends on investment increases the fast expansion of bank credit, when other financing channels are underdeveloped. Therefore, the base money is driven high by surging credit, says Ji from the central bank.

"Fundamentally, the nation was urged to transform the growth model but it still needs a long time to come into effect," he says.

Louis Kuijs, the chief economist in China at the Royal Bank of Scotland, says "With economic recovery not particularly strong, we see no change in the headline monetary policy stance any time soon.

"After the implementation of regulatory measures to improve transparency and constrain growth of non-bank lending, the less strictly regulated part of the financial system, we expect more such steps."

A domestic risk for economic growth is that concerns about financial risks may lead to more drastic measures, he says.

The China Banking Regulatory Commission adopted a regulation in March lowering the highest proportion of wealth management products that can be invested in non-standard credit assets.

In addition, bond trading between banks' proprietary accounts and their wealth management products was prohibited last month.

A report from Barclays Bank in Hong Kong says the tightening policy may bring short-term negative effects. "But we believe proper regulation of wealth management products will help lower bank systemic risk and benefit China's banking sector over the longer term," it says.

Another reason for the high monetary supply is continually expanding foreign exchange reserves.

In April, foreign exchange reserves rose by $66 billion. The increase was $99 billion for the whole of 2012. They rose by $157 billion in the first quarter this year, dominated by capital inflows.

While economists predicted no interest rate rise or cut in China until the end of this year, developed economies continued to extend quantitative monetary easing measures in a bet on economic recovery.

The US Federal Open Market Committee is likely to extend its program of longer-term asset purchase plans into 2014 based on its softer manufacturing data and lower inflation, economists say, although a recent speech by Ben Bernanke, chairman of the US Federal Reserve, indicated the possibility of reducing the amount of bond-buying.

Nick Matthews, an economist with Nomura Securities Co, says: "We see one-third probability of a further refi rate cut of the European Central Bank in June, which is more likely accompanied by a narrowing of the corridor than a deposit rate cut - and asset purchases are under consideration." A refi rate is the benchmark interest rate in the European Union.

Wang Tao, the chief economist in China with UBS AG, says multiple rounds of quantitative easing by major central banks have resulted in abundant liquidity flooding the market, putting upward pressure on many emerging market currencies and having negative effects on their competitiveness and exports.

"In China, the currency is no longer much under-valued from a basic current account balance point of view, with the current account surplus now only making up 2 percent of GDP. The yuan has appreciated by more than 12 percent on a real trade-weighted basis. It should be on its guard against further capital flow-induced appreciation," says Wang.

The yuan exchange rate against the dollar reached a record high of 6.1818 on May 28, hitting the lowest limit of the daily trading band.

In the past two months the yuan has appreciated 1.7 percent against the dollar while the Japanese yen depreciated sharply and most other Asian currencies depreciated moderately.

The puzzle is that many economies have recently increased capital controls in order to reduce the pressures on their currencies. However, China made the decision to let the yuan appreciate in line with market pressure, which is "indeed unusual", Wang says.

Economists speculate that a more flexible foreign exchange may be seen this year with the central bank strongly pushing for exchange rate and capital account liberalization.

chenjia1@chinadaily.com.cn

(China Daily European Weekly 06/21/2013 page22)