25 November 2018
Will M1 growth turn negative?

 

M1 growth has rapidly declined to 2.7% YoY in October from 25.4% YoY a little over 2 years ago. Back then, we published a note highlighting the reflationary impulse indicated by soaring M1 growth.In this note, we analyze the drivers behind falling M1 growth, as well as its implications and likely evolution from here.

M1 growth has rapidly declined to a level dangerously close to “0”, driven by plummeting demand deposit growth of the corporate sector, and to a lesser extent, slower government demand deposit growth. Sequential M1 growth dipped into the negative territory in October, raising the question of whether headline M1 growth will turn negative for the first time (since the monthly series became available in 1996. Granted, the first leg of the M1 growth deceleration in 1H2016-1H2017 was largely a “normalization” process on the back of monetary and fiscal policy tapering. However, sequential M1 growth started to “stall” since 2018 as financial conditions tightened at a more aggressive pace. The pace of M1 growth deceleration this year deviated from the magnitude implied by interest rate changes, indicating that financial condition tightening via quantitative and administrative measures may have directly dampened the corporate and government cash flow. This premise echoes with our observation of the impact from overlapping “deleveraging-oriented” policies this year. Specific to China, M1 includes only demand deposits of the government and corporate sectors, while excluding those of the households. While M1 stock was fairly evenly split between corporate and government deposits, the plunge in corporate demand deposit growth contributed to roughly two-thirds of the decline in headline M1 growth. More specifically, corporate demand deposit growth plummeted to a meager 0.6% YoY in 3Q2018 from 32.5% YoY in 2Q2016, while that of the government sector slowed to 7.9% YoY from 23.8% YoY.

In our view, the plunge in M1 growth was driven by the “aftermath” of policy tightening on multiple fronts, namely rising effective rates, deteriorating corporate profitability, softening property demand, and weakening local government cash flow. In the past 2 years, M1 growth experience a decline similar in magnitude as the one in 4Q2009-1Q2012, however, M2 growth showed much less volatility this time round. In our view, the contrast may have resulted from the growing impact on M1 from the property cycle and local government bond issuance in the past few years – both factors contributed to the more notable upturn of M1 growth from 2015 to 2016, as well as to the sharper deceleration that followed. More specifically,

Deterioration in industrial profitability dampens both corporate cash flow and government tax income. The NBS data indicates that industrial enterprise profit growth has declined to low-single-digit in September 2018 from >30% YoY at the start of 2017. More recently, tax revenue growth has also plummeted to -5.1% YoY in October from the mid-teens earlier in the year.

Deceleration of property transaction growth has been an important driver for weakening corporate cash flow and M1 growth in China. As mentioned above, M1 in China includes demand deposits of the corporate sector, but not those of households. Therefore, property transaction entails a transfer from M2 (household deposits) to M1 (corporate demand deposits). Note that total M1 stands at Rmb 54 trillion in China, while property transaction in the past 12 months amounted to Rmb 14.6 trillion, ~40% of which are down payment paid with household deposits. Given the nature of its higher volatility, swings in property transaction growth have become an important driver to changes in M1 growth. On a 3-month moving average basis, property transaction value growth has declined to single-digit now form ~ 40% YoY in 2016, driven by the highly restrictive demand-side policies, rising mortgage rates, and softening cyclical momentum. More recently, high-frequency data points to continued weakening of property demand, which may dampen M1 growth even further.

More recently, muted local government bond issuance exacerbated the downward pressure of government demand deposit growth. The launch of the local government bond swap program in May 2015 has been one of the key drivers for the improvement of government cash flow. As one of the counter-cyclical measures back then, total local government bond net issuance averaged at Rmb532bn per month between 2H2015-1H2016; however, the amount declined to a monthly average of Rmb299bn in 2018. As the stock of outstanding local government bond builds up, its growth rate moderated to 27.6% YoY in October 2018 from >300% YoY in 1H2016. Moreover, with the Rmb 1.35 trillion annual quotas for local government special construction bond mostly used up, local government bond issuance contracted drastically since October 2018, adding to the tightening pressure of local government cash flow.

Softening momentum in land transaction has also contributed to slower government deposit growth. As an important source of local government income, land transaction proceeds amounted to Rmb 6.4 trillion in the past 12 months. However, land transaction growth has also started to soften amidst tightened property developer cash flow and weakening property market sentiment. High-frequency data indicates that 100-city land transaction value has almost halved (-42.6%) YoY in November MTD, flagging potential downside for local government income growth.

With potential downside of nominal growth and corporate profitability, M1 growth may dip into negative territory in 1H2019 without decisive policy adjustments (especially fiscal and property related policies). In our view, further downside of M1 growth is likely, considering the flagging leading indicators for property demand/investment and corporate profitability. Our forecast of decelerating nominal GDP growth and rapid decline of PPI in the next few quarters implies continued slowdown of corporate profit and government tax revenue growth. Meanwhile, the property market has been showing growing signs of stress– our property team foresees a 10% YoY decline of property transaction value next year, compared with 12.5% YoY growth year-to-date. In the meantime, our property analysts also expect a 15% YoY decline in land transaction value in 2019 in their “base case” forecast, a drastic decline from 32% YoY growth of government land sales proceed year-to-date . Faced with the current challenges, decisively measures are required to backstop the deceleration in nominal growth. More specifically, M1 growth may find support if policy adjustments can effectively boost corporate profitability, property demand, developers’ cash flow, and/or local government financing. In our view, these measures include adjustments on the fiscal and regulatory policy fronts to unblock the monetary policy transmission mechanism, and perhaps more urgently, lifting some of the overly-restrictive policies for property demand and developer financing.

The rapid deterioration of corporate and government cash flow points to further decline in inflationary expectations and money velocity growth. Therefore, more forceful policy adjustments are called for in order to jump-start the domestic demand engine, and to avoid the “negative feedback loop” between falling growth, declining asset prices, and rising financial-sector risks. As we have highlighted in our previous research, M1 growth serves as an effective leading indicator (by just over one year) for changes in inflationary expectations and money velocity. With M1 growth decelerating in the past 8 quarters, money velocity growth will likely weaken further from here. Decline in money velocity indicates that delays in the necessary policy adjustments may result in higher required “dosage” to effectively lift aggregate demand growth. On the other hand, rising deflationary expectations (incl. that of property prices), if left unchecked, may self-reinforce and post greater challenges for growth and financial stability later down the road.