April money and credit data weakened significantly compared with 1Q16, triggering multiple interpretations. In this report, we address several issues investors are most concerned about.

Why did money and credit supply pull back in April?

Local government debt swaps had a significant impact on credit and total social financing (TSF) data. In April, the issuance of local government bonds reached Rmb1.06trn, of which a record high Rmb919bn was to swap existing debt. On the one hand, part of that directly replaced bank loans to local government financing vehicles (LGFV), dragging down incremental corporate loans. According to the PBoC, this reduced the April new loan data by at least Rmb350bn. Adding back this part, new loans would be >Rmb900bn in April, higher than the headline figure of Rmb556bn. On the other hand, local government bonds were not included in the TSF data but still represented the financial system’s support to the real economy. Adding back local and central government bonds, we estimate the adjusted TSF grew 17.2% YoY in April, higher than 16.7% in March and the unadjusted 13.1% in April.

The surge in fiscal deposits was one major cause of the slowdown in M2 growth. Fiscal deposits rose by Rmb932bn in April, Rmb822bn more than the increase in April 2015. There were mainly two reasons: 1) intensive collection of business tax before its replacement by value-added tax pushed April fiscal revenue up sharply; and 2) large issuance of local government bonds turned some bank funds into fiscal deposits. The increase in fiscal deposits had a contractionary effect on monetary aggregates and dragged April M2 growth down by ~0.64ppt to 12.8%.

On the other hand, price signals indicated money market liquidity remained loose. April weighted-average interbank offered rate and pledged bond repurchase rate largely stayed flat MoM and down 38bp and 27bp YoY.

Assessing monetary policy stance as local government debt swaps continue to distort monetary data

In the face of changing money and credit statistical standards and other transitory factors, we should focus on two indicators to assess monetary stance:

Adjusted TSF (quantity signals): The development of direct financing makes bank loans increasingly less indicative of overall financing conditions in the economy, and there are also some important omissions in the TSF data. Adjusted TSF can better reflect the level of total financing and serve as an important indicator of policy stance.

Money market rates (price signals): With the development of new financing means, quantity indicators often have the problem of incomplete coverage and are prone to greater volatility. This is why many countries shift to a price-based monetary policy framework after interest rate liberalization.

Moreover, these indicators should be evaluated together with nominal income growth, inflation and other economic indicators. In 1Q16, nominal GDP growth was 7.2% and the weighted-average lending rate was 5.3%, compared with nominal GDP growth of 6.6% and weighted-average lending rate of 6.56% in 1Q15. The stance of monetary policy has shifted from tight to accommodative. No matter which price index is used to deflate, real interest rates have dropped notably. The economy should continue to gradually reflate.

Where is monetary policy heading?

In our view, while the loosest phase of monetary policy is behind us, the policy stance should remain accommodative:

Policy easing will moderate at the margin. The weaker money and credit data in April were in line with our view that the room for further monetary easing is limited. As the cyclical recovery continues and broadens out to mid and downstream sectors along with the mild reflation, we expect no interest rate cuts this year and see narrowed room for lowering the reserve requirements. In particular, as the amount of local government debt swaps declines, credit and TSF data may improve, but are less likely to expand as rapidly as in 1Q16. The unadjusted TSF growth may stay around the annual target of 13%, while the adjusted TSF growth may gradually return to the level of 15~16%. The surge of fiscal deposits will not persist for a long time, but the PBoC injected a considerable amount of liquidity in 2~3Q15 to stabilize the stock market, leading to a high M2 base. Thus, we may continue to see the YoY growth of M2 below 13%, before rebounding after September or October. Money market rates may stay flat or edge up slightly.

The stance of monetary policy will remain accommodative. As food prices are falling and the pickup in production input prices is boosting supply, the upside inflation risk is limited. The recovery of economic activity is not yet on solid footing. In our view, monetary policy should remain accommodative before the inflationary pressure becomes more visible, though operations may become more targeted and structural adjustment–oriented to facilitate supply-side reforms and contain financial risks.