China’s narrow money (M1) grew 25.4% YoY in July, > 20% for a 5th consecutive month. Its sequential growth of 26.8% MoM, SAAR, shows no signs of slowing. In contrast, broad money (M2) growth was only 10.2% YoY in July, close to the historical low. What has caused M1 growth to persistently rise? When will it slow down?

We decompose incremental M1 using macro and listed-company data. From 1Q15 to 1Q16:

The increase in demand deposits held by corporations and public institutions was the main driver of M1 growth. M1 increased Rmb7.44trn, of which Rmb270bn (3.6%) came from M0, Rmb4.26trn (57.2%) from corporate demand deposits and Rmb2.91trn (39.1%) from public institutional demand deposits.

Real estate, construction and decoration companies increased their liquidity holdings visibly. Cash held by listed non-financial companies increased Rmb993bn (~13.3% of incremental M1). Real estate and construction & decoration companies contributed the most, Rmb248bn and Rmb170bn respectively, representing a marked acceleration in growth.

Corporations face more of an “uncertainty trap” than a “liquidity trap”. Despite the recent declines, the average investment return and lending rate are still much higher than the demand deposit rate in China, which does not support the liquidity trap hypothesis. What’s behind the persistent M1 growth is increased policy uncertainty over the past two years, coming from 1) the tricky balance between reform and growth, 2) the complexity of counter– cyclical management, and 3) exchange rate instability.

Probably the best footnote to the uncertainty trap is the shift of property policy from easing to (partial) tightening in <2 years. Faced with uncertainty, it is a rational choice to hoard cash and wait. Rising M1 growth may be a sign of the self-reinforcing episodes of high policy uncertainty and low economic activity.

Without an obvious change in the policy setting, M1 growth may not fall <20% in 2H16. While M1 growth may have peaked in July, it will likely stay >20% YoY before November and hover around 20% in the last two months.

The real challenge to the conduct of monetary policy is the effectiveness of transmission, that is, how to channel the hoarded liquidity to the real economy, which cannot be done by the PBoC alone. The only thing absent from the government’s growth stabilization efforts in recent years is probably a genuine and effective cut of the tax burden of the private sector, though the replacement of business tax with value-added tax may help to some extent. Lowering corporate and household taxes is the key to fostering investment and consumption, thus enhancing monetary transmission. A consistent and transparent policy setting will also help anchor market expectations and boost economic activity.