We have received a lot of follow-up questions regarding our note published yesterday, which was entitled “Will M1 growth turn negative?” Coincidentally, the NBS published October industrial enterprise financial data this morning, confirming that industrial profitability and cash flow stay on a weakening path. In this note, we summarize the most frequently asked questions & feedback on our latest M1 note, and share more of our thoughts on the issue. A little more than 2 years ago, we analyzed implication of “rising M1 growth” on leading the economic reflation cycle. The premise of rising cyclical momentum and corporate profitability was later realized. Two years later, with the same framework, we analyze falling M1 growth and its implications on economic fundamentals. Furthermore, we attempt to project the revolution of corporate and government cash flow, as well as its implications or our expectations on future policy adjustments.

Q1: Falling M1 growth points to deterioration of corporate and government cash flow – have the market & the policy makers already fully grasped the seriousness of the issue and as its likely evolution?

A: In our view, there should have been some understanding of the issue, since macro policy has started to signal more “growth stabilization” efforts in the past few months and the equity market valuation has already contracted visibly. However, it is worth pointing out that macro fundamentals are constantly evolving. More recently, we have picked up some signs indicating further downside for corporate and government cash flow growth, as the downward trend has become more pronounced for asset prices and PPI (PPI is highly correlated with corporate profit and fiscal revenue growth). Meanwhile, new TSF issuance came below expectations, (local) government financing slowed again, and etc. in spite of a favorable base effect, the newly published October industrial enterprise financial data points to further deceleration of industrial profit growth (to 3.6% YoY in October from ~20% YoY at the start of 2018). Sectoral analysis indicates that upstream profitability has started to weaken, converging with the trend for that of the downstream since 2Q2018. Meanwhile, industrial enterprise cash flow has also tightened further. In the first 3 weeks of November, 100 city land transaction value nearly halved YoY (-42.6%), pointing to potential downside for government cash flow. Judging from these data, it appears that real economy cash flow positions may continue to deteriorate at an accelerated pace, while the current policy setting indicates some degree of “ignorance” towards this trend, especially in regards to the highly restrictive property-related policies. 

Furthermore, it is worth noting that asset price cycles have the tendency to “self-reinforce” for an extended period of time without any exogenous shocks (e.g. those form policy adjustments). Therefore, the purpose of our note is not only to review what has happened to M1 growth, but more importantly, it is to highlight the potential evolution of this indicator and its profound implications.

Q2: Will policy adjust more forcefully soon, if M1 growth does turn negative?

A: Although the article focused on the analysis of M1 growth, its conclusion is consistent with the rest of our recent reports, which is to emphasize the importance of more timely policy adjustments. It is important to distinguish between “what should happen” and “what will happen”, since the former (which is what our conclusion points to) does not always translate to the latter in a timely manner. However, when “what actually happens” on the policy fronts deviates from “what should happen”, market will re-evaluate (with asset prices movements) accordingly. In this regard, we shared our thoughts on “what should happen” in the M1 note, which aims to provide a “benchmark” for our reader to assess the market impact of the potential policy adjustments (in regards to both their degree and timing).

Q3: More fiscal and monetary policy adjustments appear to be the market “consensus” now. What kind of policies may actually be effective enough to rapidly reverse the downtrend in M1 growth?

A: The market appears to hold high expectations on further policy adjustments to support growth. There is no doubt that more expansionary fiscal policy will help improve corporate profitability via lower fiscal revenue growth, higher expenditure growth, and (especially) the reduction is tax and fees. However, we may be 1-2 quarter away from the implementation of these policies, and their effect on boosting corporate cash flow is unlikely to be imminent.  In addition, we might need to be more “realistic” about the room for conventional fiscal expansion – corporate profit and fiscal revenue growth will likely decline visibly with PPI & nominal growth trending lower, which means fiscal may expand visibly even without any additional tax cuts (note that central government budget deficit is set at 2.6% in 2018, while the “soft limit” has been 3%). In our view, the following two adjustments will likely be more effective in lifting M1 growth in the near future: 1) necessary relaxation of the overly restrictive policies over property demand and developer cash flow may boost M1 growth relatively quickly; and 2) meaningfully expand the quota of local government bond, resume large-scale bond issuance, or open up more financial channels for the local government could help improve government cash flow in a timely manner. Most of the Rmb 1.35 trillion annual quota for local government (special) construction bond issuance was issued in 3Q2018, with every little left for the rest of the year. As mentioned in the previous note, the decline in local government bond net issuance has greatly contributed to slower M1 growth recently. Not only are these two measures more effective in lifting M1 growth, they will likely go a long way in lowering real-economy funding cost, stabilize growth expectations, and alleviate deflationary expectations.

Q4: How do we best interpret the premise that “M1 growth leads changes in money velocity by 4-5 quarters”?

A: We mentioned the potential implication of changes in money velocity, in order to convey two messages. Firstly, the timing of policy adjustment does matter. From a fundamental analysis point of view, changes in financial conditions lead activity growth, while growth leads inflation. Therefore, it takes some time for changes in financial conditions to translate to moves in inflation or inflation expectations. M1 growth has been decelerating for 8 quarters, which indicates that money velocity growth and inflation expectations are set to decline. However, slower money velocity means the “cost” of policy delay may grow with time—i.e. it will require more acceleration in money supply growth to achieve the same extent of pick-up in nominal output growth if we wait for longer. We mentioned the “lag” to highlight the danger of delayed policy adjustments, and to remind our readers that it is important to consider the timing of the adjustments when assessing whether the policy changes are “enough”. Secondly, market will likely react faster to changes in financial conditions than money velocity would. Since market trades on marginal changes of expectations, it does not require a reversal of money velocity growth (which lags) to alter the growth expectations of the markets. In our view, although there is a long lag between changes in financial conditions and inflation expectations/money velocity, market may start to become less pessimistic after the credit cycle has decisively bottomed out.

Q5: Is M1 growth a valuable leading indicator for economic growth and the financial market performance?

A: The simple answer is “yes” -- although the “swing” in M1 growth since 2015 was amplified by a couple of special factors, leading to smaller “coefficient” between M1 & nominal growth, the direction is M1 growth is still highly indicative for that of the nominal output (with a lag). As we have explained in our previous note, the upturn of M1 growth since 2015 was amplified by 2 factors – rising property transaction growth and the launch of sizable local government bond issuance since 2015. As a refresher, M1 in China only include corporate and government deposits but excludes that of households, therefore, property transaction itself entails a sizable transfer of M2 (households deposits) to M1 (corporate demand deposits), especially considering the rising down payment ratio in China. Meanwhile, the launch of large-scale local government bond issuance in May 2015 has boosted local government’s cash flow to a great extent. The combined effect pushed M1 growth to an “above-trend” level in 2015-2016, while they have also contributed to the rapid deceleration of M1 growth in 2017-2018. These 2 factors specific to China have also led to a deviation of M1/M2 ratio from the structural downward trend. Although the cycle of M1 growth has been amplified, M1 growth still serves as an effective leading indicator for nominal growth, albeit with a smaller coefficient. Meanwhile, corporate and local government cash flow level continues to be indicative of market sentiment and performance.