China - What Loosening?

• China's monetary data for August confirmed once again that no significant loosening of monetary conditions is yet underway, even if June-July represented the nadir of the current policy. Without such a loosening there is no reason to expect any recovery of domestic demand momentum during the rest of this year (or early next year, for that matter). 

• So far, the determination to push ahead with a fundamental economic restructuring accompanied by financial liberalization is trumping market demands for organized credit relief. But that means there's no short or medium term prospect of significant domestic recovery. China has chosen a truly hard road.

August's monetary data reported M1 growth slowed to 4.5% yoy, which was below the range of expectations, M2 growth slowed to 13.5% (from 13.9%), but new yuan loans rose by 704bn mom yuan, which beat the 600bn yuan expected. There were no great revelations here: the 0.9% mom rise in M1 was 0.32SDs below seasonal patterns, and the 0.6% mom rise in M2 was 0.26SDs below seasonalized trends. As a result, there was no change in liquidity preference (M1/M2) which continues to fall through historic lows (on a seasonalized basis). We can conclude that transactional and speculative demand for money is not yet recovering.

Similarly, although new yuan loan rose Y700bn mom, and 16.1% yoy, which was slightly more than consensus expected, it only conforms (nearly) to historic seasonal patterns – though this is the first time this year this has been achieved.

However, the price of that is continuing negative cashflow for China's banks, since those Y700bn in new loans were is Y200bn more than the Y500bn in the month's new deposits. As a result, bank loan/deposit ratio rose 50bps mom to 69% - the highest since January's seasonal high.

With reserve ratios not having been cut since May, the loan/available deposits ratio also rose, by 52bps mom to 86.2%. And so the dwindling of Chinese banks net deposit inflows continues, falling to 1.19tr yuan in the year to August 2012 from 3.266tr yuan in the same period last year. When one takes into account adjustments in reserve ratios, the net inflow slows to just 442bn yuan – a modest release of the brakes compared to the net outflow of available deposits of 2.322bn yuan in the same period last year.

One result of this that both real and nominal interest rates are rising. During the last month, 3 month bill rates have risen 26bps to 2.52% and three-year yields have risen 35bps to 2.91%, and they have coincided with the retreat in CPI inflation. Real 10yr yields are once again positive at around 1.5%, which is the highest they have been since late 2009. This is, of course, consistent with the aim of reasserting monetary order in China as a necessary precondition for gradual financial liberalization. But it is not monetary easing.

I measure changes in monetary conditions by tracking four aspects of money:

• how much of it there is (monetary aggregates)
• how much it costs (real interest rates)
• the volatility and underlying strength/weakness of the currency's international value
• the changing shape of the yield curve

Taking these factors together, one can see that conditions have been gradually but consistently deteriorating since the end of 2010, eventually reaching a position of severity similar to that reached in late 2008. The nadir seems to have been reached in May-June, and in the subsequent two months, although conditions remain historically tough, there has been a very modest improvement  

In China, monetary conditions remain the single most important factor determining momentum of domestic demand. The domestic demand indicator in the chart below averages sequential deviations from underlying seasonal historic trends in retail sales, urban investment, auto sales, real estate climate and total traffic volume.

If previous patterns are maintained, we can expect the slump in domestic demand to bottom out over the next couple of months. But, with no significant recovery in monetary conditions, there is no reason to expect any recovery of positive demand momentum any time this year.