Monetary aggregates experienced dramatic changes in the past two months. The supply of broad money (M2) in January rose to a 19-month high of 14.0% from a year ago, but it decelerated to 13.3% one month later. New loans surged to a record Rmb2.51trn in January before fell sharply to Rmb727bn in February, a striking pullback. Looking behind the aggregates, we observe some important changes in the PBoC’s balance sheet, which might go unnoticed by the market but have nontrivial implications for the conduct of monetary policy.

1. Base money has bottomed out after a long decline. As the major liability component of the PBoC’s balance sheet, base money had been shrinking between February and November 2015, when it touched the bottom. Since then, however, it has again embarked on an expansionary path, increasing by Rmb1.42trn in the first two months of 2016 (Figure 1). This pickup was clearly one of the major forces driving the M2 and credit expansion, despite the theory that banks front-loaded lending at the beginning of the year. The loss of momentum in base money growth used to be a constraint on the conduct of monetary policy, even leading to the undershooting of M2 growth for years.  The situation seems to be changing.

2. Relending has become the major channel for base money issuance. In the past, base money expansion was mainly driven by the PBoC’s FX purchases. Raising the reserve requirement ratio (RRR) acted to sterilize the effects of FX inflows, while relending tools (including open market operations, or OMO, broadly) played a role in fine-tuning liquidity conditions. When the growth of domestic assets did not pick up the slack left by the deceleration of FX assets, it dragged down base money growth. However, the roles of FX purchase and relending have recently reversed (Figure 2). In particular, largely a result of its relending operations, the PBoC’s claims on depository corporations jumped a record Rmb2.6trn in the past two months, which was 80.3% of the new credit and more than enough to offset FX outflows. This change, which cannot be fully explained by seasonality, contributed to the expansion of base money.

3. What is behind is that the PBoC has sharpened its various relending tools. The PBoC has developed a range of new instruments such as the Standing Lending Facility (SLF), Medium-term Lending Facility (MLF) and Pledged Supplementary Lending (PSL) to tackle the changing economic landscape. In October 2015, it further sharpened these tools by accepting a wider range of collateral assets from banks for pledged relending.  Of the central bank credit issued in January and February, 42% (Rmb1.1trn) was injected through OMO, mainly reverse repos; 6.9% (Rmb179bn) was channeled via PSL, typically intended to provide direct and effective funding support to policy banks for infrastructure investment and shanty town renovation; and 25.6% (Rmb666bn) was made through MLF, supplying medium-term liquidity to banks (Figure 3).

4. The decline in government deposits has also boosted base money. Holding the balance sheet size constant, base money would move in the opposite direction of government deposits, the second largest liability component. The size of the deposits has trended downward since late 2014, despite fluctuations during the course. With no adjustment, the component has declined nearly Rmb1.0trn, along with the rebound of base money (Figure 4). Even though the change in the last two months was a net gain of Rmb233bn, the downward trend will likely persist as the government steps up spending to support the economy.

Adjusting for RRR changes, the increase in net domestic assets is confirmed to have exceeded the shrinking of net foreign assets, hence driving the growth of base money (Figure 5). Relending—especially targeted operations—could cause various distortions, but it is direct and effective for base money creation and growth support.

Indeed, the NDA-based issuance of base money tends to be associated with a larger money multiplier (Figure 6). Intuitively, issuing base money as external credit is to fund the issuer of FX assets, such as the US government. In contrast, when the PBoC acquires domestic assets for the issuance, domestic entities are funded for their activities, accelerating the process of private credit creation. When policy banks obtain the central bank credit, their spending is similar to fiscal expansion, directly boosting investment. In particular, the PBoC pumped capital of US$93bn into two policy banks last year, allowing them to further leverage up with the relending credit they receive.  From this perspective, changing from the NFA to NDA-based issuance of base money would benefit China’s economic growth.

In conclusion, the central bank balance sheet revealed that the recent credit expansion was largely a result of central bank action. There have also been important changes to the way that base money is supplied. Equipped with its upgraded relending tools, the PBoC’s capacity to grow monetary aggregates seems to have improved, potentially allowing for a somewhat slower pace of RRR cut in face of FX outflows, if the central bank prefers this.