Tuesday, March 22, 2011

M2 Growth Becomes Less Indicative

1. Why did the central bank continue to raise RRR when M2 growth has fallen below its target?
M2 growth has been an important indicator for us to determine how severe the government’s tightening measures are.
However, M2 growth has been below expectations for two months and February’s figure was already below the 16% target
(and is not expected to rebound visibly in March), so will the government’s further RRR hikes lead to overtightning?

We think the significant slowdown in M2 growth rate cannot be explained by effective credit tightening alone. Meanwhile, the amount of the PBoC’s FX purchase remained large, as evidenced by the fact that January-February M2 growth was
significantly outsized by new loans and the PBoC’s FX purchases. If January-February M2 growth is measured by new loans and FX purchases, then February’s M2 growth should be 17.6%.

Our conclusion is that the sharp slowdown in M2 growth indicates that financial institutions’ other liabilities have
increased substantially, replacing M2 as the source of funding. Going deeper, this reflects the fast growth in direct
financing that led to disintermediation, through which some household and corporate deposits are converted to
interbank items that are not included in M2. The disintermediation process has accelerated this year, making M2
growth less indicative of market liquidity.
side, increases in interbank transactions (interbank lending and deposits) in January-February were of the second largest size, only after deposits. After being deducted by interbank transactions on the assets side, net liabilities from interbank
transactions increased Rmb440bn in January-February, more than half of the increase in deposits.

Disintermediation is the reason why banks have become more dependent on interbank transactions as a source of funding. With negative interest rate, households and enterprises are more willing to invest their funds in the form of wealth management products, funds, insurance, and stocks, through which some of their deposits are converted to interbank deposits (not included in M2).

As we can see from the balance sheet of financial institutions, on the liabilities
The central bank’s introduction of the concept of total financing means that it will not only look at M2 growth for
quantitative monetary controls, but also refer to market interest rates. The substantial pullback of repo rates
probably have been the main trigger of this RRR hike.
play a bigger role in guiding the government’s policy tightening, as market interest rates have a greater impact on direct
financing. Actually, the three RRR hikes this year all took place when repo rate pulled back (7-day repo rate dropped to 2.5% before the previous two hikes, and fell to 2% before this hike), indicating that the central bank’s final objective is to keep market interest rates at reasonable levels—neither too high or too low (may try to keep the 7-day repo rate at ~2.5-3%).
As the share of direct financing increases, market interest rates will

The People’s Bank of China announced it will raise the required reserve ratio by 0.5ppt starting from March 25, the ninth RRR
hike since last year and the third this year. After this hike, the required reserve ratio will reach 20%, well above the peak of
17.5% in 2008.

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